Customer Lifetime Value

Simple commerce example

(Avg Monthly Revenue per Customer * Gross Margin per Customer) ÷ Monthly Churn Rate

The numerator represents the average monthly profit per customer, and dividing by the churn rate sums the geometric series representing the chance the customer will still be around in future months.

For example: $100 avg monthly spend * 25% margin ÷ 5% monthly churn = $500 LTV

A retention example

CLV (customer lifetime value) calculation process consists of four steps:

1. forecasting of remaining customer lifetime (most often in years)
2. forecasting of future revenues (most often year-by-year), based on estimation about future products purchased and price paid
3. estimation of costs for delivering those products
4. calculation of the net present value of these future amounts

Forecasting accuracy and difficulty in tracking customers over time may affect CLV calculation process.

Retention models make several simplifying assumptions and often involve the following inputs:

• Churn rate, the percentage of customers who end their relationship with a company in a given period. One minus the churn rate is the retention rate. Most models can be written using either churn rate or retention rate. If the model uses only one churn rate, the assumption is that the churn rate is constant across the life of the customer relationship.
• Discount rate, the cost of capital used to discount future revenue from a customer. Discounting is an advanced topic that is frequently ignored in customer lifetime value calculations. The current interest rate is sometimes used as a simple (but incorrect) proxy for discount rate.
• Contribution margin
• Retention cost, the amount of money a company has to spend in a given period to retain an existing customer. Retention costs include customer support, billing, promotional incentives, etc.
• Period, the unit of time into which a customer relationship is divided for analysis. A year is the most commonly used period. Customer lifetime value is a multi-period calculation, usually stretching 3–7 years into the future. In practice, analysis beyond this point is viewed as too speculative to be reliable. The number of periods used in the calculation is sometimes referred to as the model horizon.

Thus, one of the ways to calculate CLV, where period is a year, is as follows:

${\displaystyle {\text{CLV}}={\text{GC}}\cdot \sum _{i=1}^{n}{\dfrac {r^{i}}{(1+d)^{i}}}-{\text{M}}\cdot \sum _{i=1}^{n}{\dfrac {r^{i-1}}{(1+d)^{i-0.5}}}}$,

where $GC$ is yearly gross contribution per customer, $M$ is the (relevant) retention costs per customer per year (this formula assumes the retention activities are paid for each mid year and they only affect those who were retained in the previous year), $n$ is the horizon (in years), $r$ is the yearly retention rate, $d$ is the yearly discount rate. In addition to retention costs, firms are likely to invest in cross-selling activities which are designed to increase the yearly profit of a customer over time.

Simplified models

It is often helpful to estimate customer lifetime value with a simple model to make initial assessments of customer segments and targeting. If $GC$ is found to be relatively fixed across periods, CLV can be expressed as a simpler model assuming an infinite economic life (i.e., ${\displaystyle {\text{N}}\rightarrow \infty }$):

${\displaystyle {\text{CLV}}={\text{GC}}\cdot \left({\frac {r}{1+d-r}}\right)}$

Note: No CLV methodology has been independently audited by the Marketing Accountability Standards Board (MASB) according to MMAP (Marketing Metric Audit Protocol).