Customer lifetime value is an important metric because it represents an upper limit on spending to acquire new customers. One of the first accounts of the term customer lifetime value is in the book Database Marketing , which includes detailed worked examples. The purpose of the customer lifetime value metric is to assess the financial value of each customer. While quantifying CP is a matter of carefully reporting and summarizing the results of past activity, quantifying CLV involves forecasting future activity.
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. For example, money received ten years from now must be discounted more than money received five years in the future. 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 we view a customer relationship as an asset of the firm, CLV would present the monetary value of that asset. 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.
Customer Lifetime Value metrics are used mainly in relationship-focused businesses, especially those with customer contracts.
- The Importance of Understanding CLV.
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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. When margins and retention rates are constant, the following formula can be used to calculate the lifetime value of a customer relationship:.
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.
Customer lifetime value
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. 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. 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. 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.
Forecasting accuracy and difficulty in tracking customers over time may affect CLV calculation process.
The Importance of Customer Lifetime Value (CLV) and How to Calculate It
Thus, one of the ways to calculate CLV, where period is a year, is as follows: . 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. It is often helpful to estimate customer lifetime value with a simple model to make initial assessments of customer segments and targeting.
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.
Additionally, CLV is used to calculate customer equity.
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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.
The CLV is equal to the total value of each transaction multiplied by your average gross margin. This average customer lifetime value formula requires several data points:. Multiplying these numbers together will give you the predictive CLV.
What is Customer Lifetime Value Exactly?
Now that you know how to calculate CLV, how do you improve it? Follow these nine tips to boost your customer lifetime value and retain more of your customers. You also need a segment for repeat customers.
Too many marketers focus on bringing in new customers and forget about those who have already spent money on their businesses. Instead, build relationships with them. The number of products or services you sell will depend on several factors, including whether or not the customer is likely to quickly buy more of what you have. For instance, someone who sells socks will sell more products than someone who sells washing machines. People need new socks more often than they need new washers. However, you can build products or services that complement your existing lineup to encourage more purchases.
For instance, maybe you sell washing machines as well as your own brand of detergent. Customers who buy your machine might also want the detergent made specifically for it, and might therefore become recurring customers. Alternatively, maybe you sell one great product that people buy over and over again. Instead of creating something else to sell, focus on recommending your product as a potential gift idea. One of the best examples of the freemium model increasing customer lifetime value is in-app purchases.
You can play Candy Crush without spending a dime, but if you want to purchase extra lives or other boosts to the game, you need to pull out your wallet. This model increases customer lifetime value because customers get to try out your product, become enamored of it, and decide to spend money.
The Importance of Customer Lifetime Value (CLV) and How to Calculate It
For instance, you might manufacture three different blenders that increase in efficiency and price point. That way, your customers not only have more choices, but they can upgrade to the better model, thus spending more money. Coupon codes are vastly underrated. People love getting a deal, and even if your percent-off coupon still leaves you a healthy profit margin, consumers will take advantage of it. The question is when to send out your coupon codes or other special offers. Try offering a discount on the purchase of two or more items. Product and service packages work well for a reason. Gratitude goes a long way in business.
A thank-you email is a message you send customers right after they purchase something from you. And, as a free gift, you might include a coupon code to boot. The point is to make contact with the customer right away. Keep your brand top-of-mind to encourage repeat visits to your website — and, with any luck, repeat purchases.
Thank-you emails can also be the starting point for a new drip campaign. This constant contact can increase customer lifetime value exponentially. If someone buys from you, they might also follow you on social at the same time. Keep in touch with your regular customers via social and target them with offers to come back to your site, such as to a landing page.
Send out lots of gratitude when people buy your products and services so they know how much you appreciate them. At one time, your online presence might have existed solely on your website. People often fail to purchase products from a company more than once because of problems with the buying experience. Conversely, customers who enjoy a seamless buying experience often share that fact with their friends.
Consider offering more payment options, reducing form fields, and estimating shipping costs from the beginning. Another great way to boost customer lifetime value is to get in touch with dormant customers. These are people who have bought from you in the past, but have been inactive for a long period of time, such as six months.
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- 1. Publish an engaging and informative e-blast or newsletter.!
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This might seem like a bad thing, but scrubbing your email list of dormant or inactive subscribers can have a positive impact on your business. Those who do still want to hear from you might remember how much they liked your products and services and return. That will increase your customer lifetime value.
Want your customer lifetime value to shoot through the roof?