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Purpose[edit]
The purpose of the customer lifetime value metric is to assess the financial value of each
customer. As Don Peppers and Martha Rogers are fond of saying, “some customers are more
equal than others.”[4] Customer lifetime value (CLV) 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]
Customer lifetime value (CLV):
The present value of the future cash flows attributed to the customer during his/her entire
relationship with the company.[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 dollars 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 dollar 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 dollar 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]
Construction[edit]
When margins and retention rates are constant, the following formula can be used to
calculate the lifetime value of a customer relationship:
Customer lifetime value ($) = Margin ($) * (Retention Rate (%) ÷ [1 + Discount Rate (%) Retention Rate (%)])[2]
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]
Methodology[edit]
Simple ecommerce 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:
1. forecasting of remaining customer lifetime (most often in years)
2. forecasting of future revenues (most often year-by-year), based on
estimation about future products purchased and price paid
3. estimation of costs for delivering those products
4. calculation of the net present value of these future amounts[6]
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:

Churn rate, the percentage of customers who end their relationship with a
company in a given period. One minus the churn rate is the retention rate. Most
models can be written using either churn rate or retention rate. If the model uses
only one churn rate, the assumption is that the churn rate is constant across the
life of the customer relationship.

Discount rate, the cost of capital used to discount future revenue from a
customer. Discounting is an advanced topic that is frequently ignored in
customer lifetime value calculations. The current interest rate is sometimes used
as a simple (but incorrect) proxy for discount rate.

Contribution margin

Retention cost, the amount of money a company has to spend in a given
period to retain an existing customer. Retention costs include customer support,
billing, promotional incentives, etc.

Period, the unit of time into which a customer relationship is divided for analysis.
A year is the most commonly used period. Customer lifetime value is a multiperiod calculation, usually stretching 3–7 years into the future. In practice,
analysis beyond this point is viewed as too speculative to be reliable. The
number of periods used in the calculation is sometimes referred to as the
model horizon.
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. Possibly the simplest way
to estimate CLV is to assume constant and long-lasting values for contribution
margin, retention rate, and discount rates, as follows:[9]
Note: No CLV methodology has been independently audited by the Marketing
Accountability Standards Board (MASB) according to MMAP (Marketing Metric Audit
Protocol).
Uses and advantages[edit]
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:

management of customer relationship as an asset

monitoring the impact of management strategies and marketing investments on
the value of customer assets, e.g.: Marketing Mix Modeling simulators can use a
multi-year CLV model to show the true value (versus acquisition cost) of an
additional customer, reduced churn rate, product up-sell

determination of the optimal level of investments in marketing and sales
activities

encourages marketers to focus on the long-term value of customers instead of
investing resources in acquiring "cheap" customers with low total revenue value

implementation of sensitivity analysis in order to determinate getting impact by
spending extra money on each customer[10]

optimal allocation of limited resources for ongoing marketing activities in order to
achieve a maximum return

a good basis for selecting customers and for decision making regarding
customer specific communication strategies

measurement of customer loyalty (proportion of purchase, probability of
purchase and repurchase, purchase frequency and sequence etc.)[11]
The Disadvantages of CLV do not generally stem from CLV modeling per se, but
from its incorrect application.
Misuses and downsides[edit]
NPV vs. nominal prediction[edit]
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 (nondiscounted) figures. Nominal CLV predictions are biased slightly high, scaling higher
the farther into the future the revenues are expected from customers.
Net profit vs. revenue[edit]
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.
Segment inaccuracy[edit]
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.
Comparison with intuition[edit]
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.
Over-values current customers at the expense of potential
customers[edit]
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 math 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.
CLV is a dynamic concept, not a static model[edit]
A Customer Life Time Value is the output of a model, not an input. If you change the
model inputs (e.g., let's say marketing is effective and you increase your retention
rates), your average CLV will increase.