The profits generated during the retention phase of a customer relationship are often referred to as customer lifetime value or customer retention equity. Intuitively, we know that Customer Lifetime Value (CLV) is an important metric for every company. It represents the value of your organization’s relationship with the customer.

What is Customer Lifetime Value

Lifetime Value is the value of the customer over the Life Cycle. Repeat behavior is often used as an indicator of higher life time value and as a predictor of future repeat behavior. Using customer behavior to predict “relative” Life Time Value and loyalty is a 40 year old technique. The RFM (recency frequency monetary) model helps you address relative Life Time Value.

Measuring Customer Lifetime Value Facilitates Business Decisions

Avoid falling into the trap of calculating ROI (return on investment) for every marketing program/tactic/campaign. Most tactical efforts are not executed in isolation. They are a part of a larger effort. Or at least should be if you believe in the power of integrated marketing and marketing communications. How do we show return on marketing investment? If you believe as we do that one of the primary objectives of marketing is to keep and grow the value of customers, than we can use LTV to help calculate ROMI.

While CLV has tremendous financial implications, it also serves to facilitate marketing investment decisions. As with any investment portfolio, you want to invest more in assets that produce a higher yield. It makes sense to invest more of your marketing dollars in customers that are more profitable and prefer to buy from you, cost less to serve, and recommend your services thereby helping to reduce new customer acquisition costs.

CLV helps you determine in which existing customers to invest and which types/profiles of customers produce the highest CLV. You can use these profiles to acquire new customers that best resemble your existing high value customers. CLV can serve as a valuable guide for deciding how much to spend on acquiring a new customer. A good rule of thumb is to spend 1/3 of the customer lifetime value (LTV) to acquire a new customer. This assumes you have a retention rate within normal ranges. Most companies experience 20-25 percent attrition each year. If your customer attrition rate is much higher than 25 percent, you may have a brand loyalty problem. Remember, it costs 5 times more to acquire a new customer than it does to retain an existing one. Also, if 1/3 your LTV is less than 10 percent of sales, you may have an overhead expense problem that needs to be addressed.

Using CLV insights, you can identify both existing and prospective high value customers and shape your marketing to uniquely meet their message, offer, and channel.

Calculate Customer Lifetime Value

How do you calculate CLV? To calculate “absolute” lifetime value (LTV) or customer lifetime value (CLV), the first you will need to define is the lifetime. If you haven’t been in business long enough to know the lifetime of a customer, you can put a stake in the ground by looking at the lifetime of defected best customers. Look at the last date of purchase for the defected best customer and the date of the first purchase, subtract and you have a life time number.

Most offline marketers would call a customer who has had zero activity for over 2 years a defected customer; online is more like 6 months for the average customer (unless you’re in a seasonal business). You can use this length of time as the “standard” customer Life Time, realizing the average lifetime is probably much shorter. ( Tip: A defected customer that comes back after the average Life Time number should be treated as a new customer. Otherwise all customers will have infinite lifetimes, and you lose the relevance of the metric.)

There are various approaches for calculating CLV. At its core, Lifetime value is built from the following equation:

LTV = (Frequency of Purchase) X (Duration of Loyalty) X (Gross Profit)

To use this formula you need to be know:

How frequently your customer buy
How long your customer stays with you
Your profit (average order size minus average order cost of goods, fulfillment and service)

You will then need to decide your approach and apply it consistently.

For a more comprehensive approach for calculating CLV incorporate the following.:

the total cost of the product on a per unit basis (this includes the cost to make and support the product)
what the average unit returned costs you in terms of overhead. If you don’t know this, you might look at the average units sold, and break up all the revenue and cost components that comprise the unit.
once you get to a profit/unit, multiply by units sold to a customer over the “lifetime”, minus overhead and promotional costs.

This is the Life Time Value. (One way to get to customer service cost is take the number of units sold annually and divide by the annual customer service cost and to have a number for each unit. You can do the same thing for returns, support, invoicing, etc. and eventually come up with a total cost number per unit.)

Need a simpler method? Here’s an alternative for calculation customer retention equity or CLV:

Determine the average retention rate of your customer base.
Compute the average expected duration of a relationship with a customer using this retention rate.
Determine the average per period margin and costs that are associated with retaining this customer.
Multiply the period net profits by the number of periods the relationship lasts.

Here’s an example using this method:

Suppose for the past four years your retention rate for a set of customers has been 60%, 61%, 62%, and 61% over a 4 year period. This equates to an average retention rate of around 61% (i.e., 61 = (60+61+62+61) / 4).
Analysis reveals that the expected relationship duration for the average customers is 1/(1-average retention). (1/1.61). In this case that is 2.56 years.
After analyzing the historical data over the same 4 year period, the firm has determined that the average margin is $7500 and the average costs over this period $750. This equates to a net margin of $6750
Expected retention equity is $17,280 ($6750*2.56).

You may find some customers have a negative LTV – which is what helps you determine which customers are profitable and which ones aren’t.

The Power of Customer Lifetime Value

Take the CLV of your customer franchise for the current year, subtract the CLV of your customer franchise for the previous year. (Hopefully you have a positive number). Divide this number by this year’s marketing expenditures (dollars). You will now have a ROMI (return on marketing investment) number.

Want to improve your CLV? Choose one or more of these three levers. Improve the revenue per customer, lower your cost to acquire and serve, and/or increase your overall customer retention rate. Calculating CLM is a very powerful way to get a handle on your customer portfolio and to segment your customers.

Use one of our workbooks included in our Metrics Workshop to create and use these eight customer-centric metrics.