Customer Lifetime Value

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Customer Lifetime Value
Can a Customer Be Worthless to Your Brand?

A few years back, I was living in
the UK when my cell phone
stopped working.

I went to the store to get a
replacement.

I got to the store at 8:55 am to
find there was already a long
line, and when the store opened
at 9, I told them that I had a
flight to catch to Madrid and
needed a phone.

I was politely but firmly told that
I had to wait my turn and it
would be 45 minutes before I
could see a representative.

I tried to explain that I really
needed a phone and had to leave
for a flight, but was told -

“But sir, all of these people are
ahead of you; they are just as
important.”

I had been a loyal customer for
many years and as a result of this
interaction, when I got back from
Madrid, I canceled my cell
service, data plan and other
services with the same company.

While the customer service rep
in the store had given the “right”
answer, the result was the loss of
a high-value customer who
defected to a competitor.

What went wrong?

Egalitarian – those who believe
every customer is equal –
marketing & sales are not limited
to B2C companies.

We once consulted for a Fortune
500 B2B company with a massive
sales force.

The sales force had just done an
analysis that showed that 8% of
the company’s B2B customers
were 93% of its revenues

But the sales force treated every
B2B customer equally.

What would happen if one of the
8% were to defect to another
company?

A better approach is to realize
that all customers are not equal
and develop a marketing and
sales strategy grounded in this
reality.

Customer Profitability
Calculating the Value of the Customer

Companies look at their performance in
the aggregate – in other words, past
activity.

A common phrase within a company is
something like “We had a good year, and
the business units delivered $400,000 in
profits.”

When customers are considered, it is
often an average such as “We made a
profit of $2.50 per customer.”

Although these can be useful metrics,
they sometimes disguise an important
fact that not all customers are equal and
worse yet, some are unprofitable.

Rather than measuring the “average
customer,” we can learn a lot by finding
out what each customer contributes to
our bottom line.

Customer Profitability
The difference between the revenues
earned from and the costs associated
with the customer relationship during a
specified period

The overall profitability of the company
can be improved by treating dissimilar
customers differently.

So when we think about customers, we
need to think in three different tiers

Tier One – Reward
Your most valuable customers are the
one you most want to retain. They get
more attention.

Tier One – Reward
Look for ways to reward them in ways
other than simply lowering your price.
These customers probably value what
you do the most and may not be price
sensitive.

Tier Two – Grow
The customers is the middle – with
middle to low profits associated with
them – might be targeted for growth.

Tier Three – Fire
The company loses money on servicing
these people. If you cannot easily
promote them to the higher tier of
profitability, you should consider
charging them more for the services
they currently consume.

Tier Three – Fire
If you can recognize this group
beforehand, it may be best not to
acquire them in the first place.

How do we calculate Customer
Profitability?

(Revenue from a customer)
- (Cost to serve each customer)
Profitability for the Customer

Now doing this for every customer may
not make sense, so you may have to
abandon the notion of individual
customers and work with meaningful
groups of customers instead.

After you calculate the value, you sort
the customers based on profits.

Once you have the sorted list, you plot
the percentages of total profits vs total
percentage of total customers.

Here we have a clear illustration that if they were no longer to serve the least
profitable 20% of customers, they would be $28 million better off.

Customer Lifetime Value

This metric is the most advanced that
we will cover in this course and value-
based marketing strategies often require
industrial-strength infrastructure to
achieve the strategy.

As a first step, most organizations often
start by looking at plain sales revenues
so that marketing effort and the sales
force are directed at the customers with
the most revenues.

The problem is that this does not include
the cost of serving the customer, which
might be considerable, and the
customer’s revenues today do not
accurately tell us about the value of the
customer in the future.

Customer Lifetime Value (CLTV)
addresses both of these issues and is
probably the most important metric to
learn in marketing.

Even if you don’t use CLTV, everyone in
marketing should understand the
concepts of value-based marketing.

One of the biggest mistakes marketers
make is confusing customer profit with
CLTV.

Customer Profit measures the past while
CLTV looks forward.

CLTV shapes managers’ decision but is
much more difficult to quantify than
customer profit.

Customer profit is calculated through
careful reporting and summarizing the
results of past activity; CLTV involves
forecasting future activity.

CLTV is the present value of the future
cash flows attributed to the customer
relationship.

CLTV – The Math

AC = Acquisition Cost
Mn = Margin Produced by the Customer in each time period
Cn = Cost of marketing & serving the customer
p = Probability the customer will not defect in a year
N = Total number of years or time periods
(1 – r) = Discount rate (because money is worth less in the future)

To best understand this metric, think of
CLTV as the Net Present Value of a
customer.

Time Period 1 Time Period 2
(M – C) = Margin – Cost in a Specific Time Period (Profit)
x (1 – c) = Probability that the Customer Will Stay (c = Churn Rate)
(1 + r) = Discount Rate (Profit in the future is worth less)
Time
Period0

So how does this work?

Margin is easy to calculate –
how much profit do you make on each
product/service you sell?

Cost, on the other hand, is a bit more
difficult

On the cost side, we need to understand
all touches of the customer with the call
centers, web site, customer service,
marketing communications,
maintenance, and so on…

The Cost of the Customer to the Company in Time Period 0 is the
Acquisition Cost. Since they are not a customer yet, there are no margins or
service costs – so no profits to calculate.
Time
Period0

Once the customer becomes a customer, we start calculating their value to
the company. We take the profit generated from the customer (M) and
subtract it from the cost of maintaining/serving the customer (C). We
multiply it by the probability of the customer leaving within a year (1 – c).
Time
Period0

Once we have the top side of the equation, we take the amount that money
will devalue over the life of the customer, or discount rate – (1 + r)
Time
Period0

Looks really complicated doesn’t it?

CLTV = Margin * Retention Rate (%)
1 + Discount Rate – Retention Rate (%)

Let’s try an example

An Internet Service Provider (ISP)
charges $19.95 per month. Variable
costs are about $1.50 per account per
month. With marketing spending of $6
per year, their attrition is only 0.5% per
month. At a monthly discount rate of
1%, what is the CLV of a customer?

Margin = $19.95
Cost = $1.50
AC = $6/12
Churn Rate = 0.995%
Discount Rate = 0.01

CLTV =
Margin = ($19.95 - $1.50 – 6) = $17.95
Retention Rate = 0.995
Discount Rate = 0.01

CLTV =
$17.95 * [0.995/(1 + 0.01 – 0.995)]
$17.95 * [66.33]
$1,191

Remember – we are just taking the
profit in each time period for the value
of the money.

Now, I am sure you are all asking 1
question –
“What is the correct length of time to
use for calculating CLTV?”

I have seen company’s calculate CLTV
over 85 years – the natural “lifetime” of
a customer, which is wrong.

Customer Lifetime Value is not about the
life of the customer, but the length of
time that a customer will stay with your
brand.

The best practice is 3 – 5 years.

While a customer may stay with a brand
much longer than that, it is better to
focus on a shorter time period for
decision making so that you have
reliability, not incredibility.

Cohort & Incubate
Which Customer is More Valuable – New or Existing?

One way to project the value of future
customer cash flows is to make the
assumption that the customers acquired
several periods ago are no better or
worse that new customers.

To prove that, we go back and collect
data on a cohort of customers all
acquired at the same time and break
down their cash flows over specific
periods.

The next step is to discount the cash
flows for each customer back to the time
of acquisition to calculate the CLTV and
then average the CLTVs together to
produce an estimate CLTV of each new
customer.

We call this the “cohort and incubate”
approach.

How do we calculate
Cohort & Incubate?

(Total Cash Flows from the Cohort)
/ (Number of Customers)
Average CLTV for the Cohort

If the value of customer relationships is
stable across time, the average CLTV of
the cohort sample is an appropriate
estimator of the CLTV of newly acquired
customers.

An Example

In 1993, 6,094 customers of a cruise ship
line were tracked (incubated) for a
period of 5 years.

The total net present value of the cash
flows from these customers was
$ 27,916,614.

These flows included revenues from the
cruises taken (6,094 customers took
8,660 cruises over 5 years), variable cost
of the cruises and promotional costs.

The total 5-year net present value of the
cohort on a per customer basis was
$4,581 per customer.
$27,916,614/6,094 = $4,581

Cohort and Incubate works best when
customers are stationary – changing
slowly over time.

When the value of relationships changes
slowly, we can use the value of
incubated past relationships as the
predictive value of new relationships.

Value Based Marketing
Marketing Based on the Value of the Customer

Value-Based Marketing drives significant
performance gains and firms that bridge
the marketing divide focus on customer
value in all marketing activities.

An Example of Direct Mail Offers
Low to Medium CLTV
+ Low to Medium
Response Rates are
not sent a mailing
From a ROMI point of
view, these
customers are slow
on the take rate, so
why waste marketing
dollars here?

High CLTV + Low
Response Rates are
also not sent a
mailing
The cost of the
mailing is not justified
Our focus, as
marketers, must be
on the medium to
high CLTV + Medium
to High Response
Rate customers

Notice
Highest Expected
Response Rate + the
Highest CLTV get the
2nd most expensive
offer
Highest Expected
Response Rate +
Medium CLTV get the
3rd most expensive
offer
While the Lowest
CLTV don’t get an
offer at all

Why do you think that is?

Those that have the lowest CLTV are
coming anyway so they get the lowest,
most cost effective offer. They are
coming because they value your product
but don’t respond to the “offers”; so it
would be a waste targeting them.

By focusing this single strategy on a
value-basis, we cut our marketing costs
in half – since we now focus on less than
50% of the potential customer base, but
the impact is significantly higher
because we are focusing on profitability.

What Makes a High-Value Customer?

This is one of the most important
questions to ask your business and you
may need focus groups, surveys and
analysis to answer it.

In banking, a high-value customer has a
portfolio of services – cash deposits,
credit cards, auto loans, and perhaps a
mortgage.

To best manage this customer, you have
to ensure – first and foremost – that
they don’t leave

Secondly, up-sell and cross-sell
additional products and services. Sell
deep to high-value customers.

Selling bundles of services to high-value
customers has the advantage of creating
lock-in

What is lock-in?

Lock in means that there is a significant
switching cost to the customer if they
want to change to a competitor.

But you need to be careful of customer
lock in backlash – poor service can result
in negative customer satisfaction (CSAT)
that results in mass defections when a
competitor enters with a low-switching
cost alternative.

Customer Service and Service Recovery
are extremely important to retain high-
value customers.

Customer Lifetime Value

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