Marketing operations |
---|
In marketing, customer lifetime value (CLV or often CLTV), lifetime customer value (LCV), or life-time value (LTV) is a prognostication of the net profit contributed to the whole future relationship with a customer. The prediction model can have varying levels of sophistication and accuracy, ranging from a crude heuristic to the use of complex predictive analytics techniques.
Customer lifetime value can also be defined as the monetary value of a customer relationship, based on the present value of the projected future cash flows from the customer relationship. [1] Customer lifetime value is an important concept in that it encourages firms to shift their focus from quarterly profits to the long-term health of their customer relationships. Customer lifetime value is an important metric because it represents an upper limit on spending to acquire new customers. [2] For this reason it is an important element in calculating payback of advertising spent in marketing mix modeling.
One of the first accounts of the term customer lifetime value is in the 1988 book Database Marketing, which includes detailed worked examples. [3] Early adopters of customer lifetime value models in the 1990s include Edge Consulting and BrandScience.
The purpose of the customer lifetime value metric is to assess the financial value of each customer. Don Peppers and Martha Rogers are quoted as saying, "some customers are more equal than others." [4] Customer lifetime value differs from customer profitability or CP (the difference between the revenues and the costs associated with the customer relationship during a specified period) in that CP measures the past and CLV looks forward. As such, CLV can be more useful in shaping managers’ decisions but is much more difficult to quantify. While quantifying CP is a matter of carefully reporting and summarizing the results of past activity, quantifying CLV involves forecasting future activity. [2]
Present value is the discounted sum of future cash flows: each future cash flow is multiplied by a carefully selected number less than one, before being added together. The multiplication factor accounts for the way the value of money is discounted over time. The time-based value of money captures the intuition that everyone would prefer to get paid sooner rather than later but would prefer to pay later rather than sooner. The multiplication factors depend on the discount rate chosen (10% per year as an example) and the length of time before each cash flow occurs. For example, money received ten years from now must be discounted more than money received five years in the future. [2]
CLV applies the concept of present value to cash flows attributed to the customer relationship. Because the present value of any stream of future cash flows is designed to measure the single lump sum value today of the future stream of cash flows, CLV will represent the single lump sum value today of the customer relationship. Even more simply, CLV is the monetary value of the customer relationship to the firm. It is an upper limit on what the firm would be willing to pay to acquire the customer relationship as well as an upper limit on the amount the firm would be willing to pay to avoid losing the customer relationship. If a customer relationship is viewed as an asset of the firm, CLV would present the monetary value of that asset. [2]
One of the major uses of CLV is customer segmentation, which starts with the understanding that not all customers are equally important. CLV-based segmentation model allows the company to predict the most profitable group of customers, understand those customers' common characteristics, and focus more on them rather than on less profitable customers. CLV-based segmentation can be combined with a share of wallet (SOW) model to identify "high CLV but low SOW" customers with the assumption that the company's profit could be maximized by investing marketing resources in those customers.
Customer lifetime value metrics are used mainly in relationship-focused businesses, especially those with customer contracts. Examples include banking and insurance services, telecommunications and most of the business-to-business sector. However, the CLV principles may be extended to transactions-focused categories such as consumer packaged goods by incorporating stochastic purchase models of individual or aggregate behavior. [5] In either case, retention has a decisive impact on CLV, since low retention rates result in customer lifetime value barely increasing over time.
When margins and retention rates are constant, the following formula can be used to calculate the lifetime value of a customer relationship:
The model for customer cash flows treats the firm's customer relationships as something of a leaky bucket. Each period, a fraction (1 less the retention rate) of the firm's customers leave and are lost for good. [2]
The CLV model has only three parameters: (1) constant margin (contribution after deducting variable costs including retention spending) per period, (2) constant retention probability per period, and (3) discount rate. Furthermore, the model assumes that in the event that the customer is not retained, they are lost for good. Finally, the model assumes that the first margin will be received (with probability equal to the retention rate) at the end of the first period. [2]
The one other assumption of the model is that the firm uses an infinite horizon when it calculates the present value of future cash flows. Although no firm actually has an infinite horizon, the consequences of assuming one are discussed in the following. [2]
Under the assumptions of the model, CLV is a multiple of the margin. The multiplicative factor represents the present value of the expected length (number of periods) of the customer relationship. When retention equals 0, the customer will never be retained, and the multiplicative factor is zero. When retention equals 1, the customer is always retained, and the firm receives the margin in perpetuity. The present value of the margin in perpetuity turns out to be the Margin divided by the Discount Rate. For retention values in between, the CLV formula tells us the appropriate multiplier. [2]
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. [ citation needed ]
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:
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:
Thus, one of the ways to calculate CLV, where period is a year, is as follows: [7]
where is yearly gross contribution per customer, 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), is the horizon (in years), is the yearly retention rate, 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. [8]
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 is found to be relatively fixed across periods, CLV can be expressed as a simpler model assuming an infinite economic life (i.e., ) : [9]
Note: No CLV methodology has been independently audited by the Marketing Accountability Standards Board (MASB) according to MMAP (Marketing Metric Audit Protocol).
Customer lifetime value has intuitive appeal as a marketing concept, because in theory it represents exactly how much each customer is worth in monetary terms, and therefore exactly how much a marketing department should be willing to spend to acquire each customer, especially in direct response marketing.
Lifetime value is typically used to judge the appropriateness of the costs of acquisition of a customer. For example, if a new customer costs $50 to acquire (COCA, or cost of customer acquisition), and their lifetime value is $60, then the customer is judged to be profitable, and acquisition of additional similar customers is acceptable.
Additionally, CLV is used to calculate customer equity.
Advantages of CLV:
The disadvantages of CLV do not generally stem from CLV modeling per se, but from its incorrect application.
This section needs additional citations for verification .(September 2019) |
The most accurate CLV predictions are made using the net present value (NPV) of each future net profit source, so that the revenue to be received from the customer in the future is recognized at the future value of money. However, NPV calculations require additional sophistication including maintenance of a discount rate, which leads most organizations to instead calculate CLV using the nominal (non-discounted) figures. Nominal CLV predictions are biased slightly high, scaling higher the farther into the future the revenues are expected from customers.
A common mistake is for a CLV prediction to calculate the total revenue or even gross margin associated with a customer. However, this can cause CLV to be multiples of their actual value, and instead need to be calculated as the full net profit expected from the customer.
Often ecommerce reporting systems will report lifetime revenue (LTR), rather than lifetime value based on net profit, due to the difficulty most ecommerce platforms have generating an accurate profit figure (i.e. calculating accurate sold item costs, marketing costs and delivery costs) on an order by order basis. Lifetime revenue can still be a very valuable and useful metric for ecommerce stores to report on in order to measure site performance. [14]
Opponents often cite the inaccuracy of a CLV prediction to argue they should not be used to drive significant business decisions. For example, major drivers to the value of a customer such as the nature of the relationship are often not available as appropriately structured data and thus not included in the formula.
More predictors, such as specific demographics of a customer group, may have an effect that is intuitively obvious to an experienced marketer but are often omitted from CLV predictions and thus cause inaccuracies in certain customer segments.
The biggest problem with how many CLV models are actually used is that they tend to deny the very idea that marketing works (i.e., that marketing will change customer behavior). Low-value customers can be turned into high-value customers by effective marketing. Many CLV models use incorrect mathematics in that they do not take account of the value of a far greater number of middle-value customers, over-prioritizing a smaller number of high value customers. Additionally, these high-value customers may be saturated (i.e., not have the ability to buy any more coffee or insurance), may be the most expensive group to serve, and may be the most expensive group to reach by communication. The use of survey data is a viable way to collect information on potential customers. [15]
A customer lifetime value is the output of a model, not an input. If the model inputs change (e.g., marketing is effective and retention rates increase), the average CLV will increase. However, when engaging with customers in such way which cause detraction, the opposite may happen and average CLV will go down (e.g. the invoicing department sends them the wrong or unclear invoices).
In economics and finance, arbitrage is the practice of taking advantage of a difference in prices in two or more markets – striking a combination of matching deals to capitalise on the difference, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the possibility to instantaneously buy something for a low price and sell it for a higher price.
In finance, discounting is a mechanism in which a debtor obtains the right to delay payments to a creditor, for a defined period of time, in exchange for a charge or fee. Essentially, the party that owes money in the present purchases the right to delay the payment until some future date. This transaction is based on the fact that most people prefer current interest to delayed interest because of mortality effects, impatience effects, and salience effects. The discount, or charge, is the difference between the original amount owed in the present and the amount that has to be paid in the future to settle the debt.
The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the annual effective discount rate. NPV accounts for the time value of money. It provides a method for evaluating and comparing capital projects or financial products with cash flows spread over time, as in loans, investments, payouts from insurance contracts plus many other applications.
In economics and accounting, the cost of capital is the cost of a company's funds, or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
Rational pricing is the assumption in financial economics that asset prices – and hence asset pricing models – will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.
In business and accounting, net income is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, and taxes for an accounting period.
Profit margin is a financial ratio that measures the percentage of profit earned by a company in relation to its revenue. Expressed as a percentage, it indicates how much profit the company makes for every dollar of revenue generated. Profit margin is important because this percentage provides a comprehensive picture of the operating efficiency of a business or an industry. All margin changes provide useful indicators for assessing growth potential, investment viability and the financial stability of a company relative to its competitors. Maintaining a healthy profit margin will help to ensure the financial success of a business, which will improve its ability to obtain loans.
Working capital (WC) is a financial metric which represents operating liquidity available to a business, organisation, or other entity, including governmental entities. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Gross working capital is equal to current assets. Working capital is calculated as current assets minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit and negative working capital.
In business, operating margin—also known as operating income margin, operating profit margin, EBIT margin and return on sales (ROS)—is the ratio of operating income to net sales, usually expressed in percent.
Gross margin is the difference between revenue and cost of goods sold (COGS), divided by revenue. Gross margin is expressed as a percentage. Generally, it is calculated as the selling price of an item, less the cost of goods sold, then divided by the same selling price. "Gross margin" is often used interchangeably with "gross profit", however, the terms are different: "gross profit" is technically an absolute monetary amount and "gross margin" is technically a percentage or ratio.
Churn rate is a measure of the proportion of individuals or items moving out of a group over a specific period. It is one of two primary factors that determine the steady-state level of customers a business will support.
Valuation using discounted cash flows is a method of estimating the current value of a company based on projected future cash flows adjusted for the time value of money. The cash flows are made up of those within the “explicit” forecast period, together with a continuing or terminal value that represents the cash flow stream after the forecast period. In several contexts, DCF valuation is referred to as the "income approach".
Customer attrition, also known as customer churn, customer turnover, or customer defection, is the loss of clients or customers.
Payback period in capital budgeting refers to the time required to recoup the funds expended in an investment, or to reach the break-even point.
Return on marketing investment (ROMI) is the contribution to profit attributable to marketing, divided by the marketing 'invested' or risked. ROMI is not like the other 'return-on-investment' (ROI) metrics because marketing is not the same kind of investment. Instead of money that is 'tied' up in plants and inventories, marketing funds are typically 'risked'. Marketing spending is typically expensed in the current period.
Customer profitability (CP) is the profit the firm makes from serving a customer or customer group over a specified period of time, specifically the difference between the revenues earned from and the costs associated with the customer relationship in a specified period. According to Philip Kotler, "a profitable customer is a person, household or a company that overtime, yields a revenue stream that exceeds by an acceptable amount the company's cost stream of attracting, selling and servicing the customer."
Customer retention refers to the ability of a company or product to retain its customers over some specified period. High customer retention means customers of the product or business tend to return to, continue to buy or in some other way not defect to another product or business, or to non-use entirely. Selling organizations generally attempt to reduce customer defections. Customer retention starts with the first contact an organization has with a customer and continues throughout the entire lifetime of a relationship and successful retention efforts take this entire lifecycle into account. A company's ability to attract and retain new customers is related not only to its product or services, but also to the way it services its existing customers, the value the customers actually perceive as a result of utilizing the solutions, and the reputation it creates within and across the marketplace.
According to PIMS, an important lever of business success is growth. Among 37 variables, growth is mentioned as one of the most important variables for success: market share, market growth, marketing expense to sales ratio or a strong market position.
Residual income valuation is an approach to equity valuation that formally accounts for the cost of equity capital. Here, "residual" means in excess of any opportunity costs measured relative to the book value of shareholders' equity; residual income (RI) is then the income generated by a firm after accounting for the true cost of capital. The approach is largely analogous to the EVA/MVA based approach, with similar logic and advantages. Residual Income valuation has its origins in Edwards & Bell (1961), Peasnell (1982), and Ohlson (1995).
Customer acquisition cost (CAC) is the cost of winning a customer to purchase a product or service. As an important unit economic, customer acquisition costs are often related to customer lifetime value.