Use this framework for estimating customer spend over their lifetime
This is a business model to assess the value of a customer over its lifetime with a company.
Customer lifetime value first emerged in 1988 in a book entitled Database Marketing by R Shaw and M Stone. The model has been quickly and widely adopted by many consultants. Calculating customer lifetime value analysis is now standard procedure among most large retailers though it is still to be widely adopted in business to business markets.
The customer lifetime value model is especially useful to companies that have an extended relationship with customers – i.e. customers that continue to buy over a number of years. Some businesses are not like this. They are also appropriate where a business has a high churn rate as it could indicate the importance of spending more money on customers to reduce the churn and improve their lifetime profitably. Such businesses include fitness gyms, telecommunications, airlines, banking and insurance services, and many companies in the business-to-business sector.
The formula for calculating customer lifetime value has three components:
The cost of customer acquisition.
The annual profit per customer.
The average customer retention rate.
The customer retention rate is calculated by knowing, on average, how many customers are lost each year. Assuming that a company loses 20% of its customers a year (this is known as its churn rate) and it retains 80%, we can determine that the average lifetime of a customer is five years.
During the lifecycle of a customer with a company it can be expected that sales will be slow during the initial period of doing business. Growth in sales to the customer will speed up until it flattens off and eventually stops or declines. Customers seldom last for ever and on average they have a life cycle – a number of years during which they are active. When customers start buying from the company they may do so with trial orders. Once satisfied that the products meet their requirements, sales will likely increase. During the early stage of the life-cycle, the newly acquired customer may not be profitable. This is illustrated in figure below.
The customer lifetime value (CLV) model can drive business strategy.
The CLV can help segment customers. Analysing customers by their lifetime value may indicate that there are groups of customers that are highly profitable over their lifetime and some that are not. A profile of profitable segments could indicate what types of customers should be acquired in the future.
Linking the CLV with share of wallet could identify customers with a high lifetime value and a low share of wallet. These would be obvious targets as the low share of wallet suggests an opportunity to win more sales.
The CLV analysis may show that customers that arrive by different channels have different lifetime values and this could be another pointer as to where to focus for improved profitability.
The CLV could identify a segment of customers that have been loyal over a number of years. This could lead to the development of a special loyalty scheme to reward them and to ensure that they do not go elsewhere.
The CLV may indicate that it is worth spending more on acquiring certain customers even though this would result in higher upfront costs. The extra acquisition cost will be justified if it can be shown that the customer will carry on buying products well into the future. The analysis could point to the justification for more marketing activities in order to improve the CLV.
The CLV could be useful in improving customer relationship management and customer experience. If it can be shown that additional communications during the lifetime of a customer generate more sales, the customer lifetime value will increase and the customer experience will be enhanced.
The challenge in calculating the customer lifetime value is obtaining realistic data on the profit generated by a customer in its lifetime. This requires suppositions to be made on the future behavior of the customer. Will they continue to buy the same amount of product? Will they buy through the same channel and, if not, how will this change the costs of maintaining the customers?
The biggest problem with the customer lifetime value model is the assumption that customers will carry on buying as they always have done. For example a baker may acquire a customer who visits the shop once a week and at first just buys a loaf of bread. But what if this customer can be persuaded to call in three or four times a week to buy confectionery products? This build-up of business may not happen for a number of weeks or months and so there needs to be some additional sophistication to show how on average, a customer’s spend changes during their lifetime.
Things to think about:
What is your profit per customer: Work out the average revenue per customer and crucially the net profit per customer.
What is the average lifetime of your customers: Work out how long a customer stays a customer.
What is the acquisition cost of winning a customer: Work out how much it costs to win a customer by adding up all your annual marketing costs and dividing it by the number of new customers you acquire in a year.
Now work out the lifetime value of your customer based on the formula:
Customer lifetime value = (Profit per customer X Average lifetime of customer) -Acquisition cost per customer
Now figure out which metric(s) you can change to improve the customer lifetime value.