The Importance of Measuring Customer Lifetime Value
Customer Lifetime Value—The Loneliest Customer Metric
I’ve often referred to Customer Lifetime Value (CLV or LTV) as the loneliest CRM key performance indicator, which is particularly troublesome as this metric is forward looking, identifies both the degree of customer-centricity along with customer upside potential, and can be a catalyst for spurring increases in customer share, customer retention, margin improvement and top line revenues.
An Untapped Business Development Opportunity
We all know retaining and growing existing customers costs far less than acquiring new, but for various reasons, sales professionals often show a preference toward new customer acquisitions and gaining new logos for their powerpoint decks. Sales reps and marketers often defer existing customers as they generate incremental sales, as opposed to net new customers which produce first-time, big ticket sales.
However, it’s incumbent upon management to recognize that those incremental sales deliver a lower cost and higher margin per sale, grow customer share and increase customer lifetime value – metrics that often fail to garner attention for the sales team but are critically important to the company.
Sales strategies such as architecting sales compensation plans to reflect value to the company or separating hunters and farmers are simple tactics, but are often born without understanding the overarching importance of CLV.
Defining Customer Lifetime Value
To start, it’s a good idea to define CLV. The Marketing Accountability Standards Board (MASB) defines customer lifetime value as the present value of the future cash flows attributed to the customer during the entire relationship with the company.
Putting this CLV definition into a numerical calculation can look like the following:
Customer Lifetime Value = Profit ($) * Retention (%) / (1 + Discount (%) – Retention (%))
So if your average customer profit is $10,000, customer retention is 90% and discount rate is 10%,
your CLV = $10,000 * 90% / (1 + 10% - 90%) = $9000 / 20% = $45,000.
An additional factor when calculating CLV is referral value. CLV should reflect the measurable benefit for existing customers that give referrals which result in incremental sales.
Two common mistakes I often see when calculating customer lifetime value are to apply an overly broad customer profitability measure and an inaccurate discount rate. For most companies, customer profitability should be based on customer type (which itself may be based on what products or services are procured). Calculating CLV by customer type instead of a lump sum figure will result in a more accurate figure and lead to better customer decisions.
Also, don’t use an interest rate for your discount rate. The best discount rate is the company’s cost of capital or Internal Rate of Return (IRR).
The CLV calculation also assumes customer profits are earned in arrears. If this isn’t true, you should adjust the model. Also, recognize there are multiple CLV calculations. While the models vary a bit, the common end result is to place a monetary value on customer relationships based on the present value of the projected future cash flows.
Customer Lifetime Value Use Cases and Key Questions
Customer Lifetime Value defines the financial value of each customer – and this information can answer some strategic questions and be applied to a number of use cases.
- What’s a lead worth? Most CMOs really don’t know and even fewer CEOs know. When you have a definitive CLV and understand your lead-to-customer conversion rate you know exactly how much a lead is worth, and how much you should be willing to spend on new leads. Marketers who fail to understand their CLV are almost certainly either under spending or overspending in marketing acquisition costs (i.e. cost per lead) and probably also failing to spend the correct amount to keep and grow (existing) customers.
- Are all customers equal? In the infamous words of Peppers & Rogers, "some customers are more equal than others." Lets not kid ourselves, it’s good business strategy to treat different customers differently. By segmenting customers according to margin or profit, smart businesses can deliver higher levels of service to more profitable customers and keep those customers longer. CLV also supports sensitivity analysis so that marketers can explicitly state the financial impact if the company is able to decrease customer churn by a given amount. Once you have a baseline measurement, you can devise CLV growth strategies that can be compared and prioritized against other competing sales objectives.
- What’s the customer potential? By segmenting customers according to CLV and CLV Potential, marketers can apply more relevant campaigns for more predictable results. For example, identifying customers who reside in both a high CLV segment and a low customer-share segment suggest the greatest untapped potential and upside revenue opportunity. Customer segmentation also permits more personalized, timely and contextual campaigns to increase customer share and CLV – and increasing CLV in most segments by even a few percentage points can have a material effect on both top line revenues and bottom line earnings.
Most businesses measure customer profit, but that’s a historical metric. CLV is a predictive analytic that forecasts future value.
Customer Lifetime Value measurement also tends to recognize customer relationships as assets, reposition customer focus from short-term profits to long-term lifetime relationship value, and compliment other customer-centric measures such as customer satisfaction, customer loyalty or NPS (net promoter score).