How to Measure Customer Lifetime Value?
The most important thing is to forecast where customers are moving, and to be in front of them. – P.Kotler
With significant resources being spent on customer retention, growth, loyalty development and relationship building, it is a logical question as to what is their economic worth for the company. One measure that has been developed to answer this question is Customer Lifetime Value (CLTV). CLTV is the sum of present value of company’s future cash flows generated from its customer. It is also called Customer Equity.
It is a generally agreed among marketers that bringing a new customers is more expensive than retaining the existing ones. This understanding has provided a renewed focus to companies to retain their existing customers for long term. These companies aggressively pursue ways and means to develop an intimate long term relationship with their customers in order to maximize their economic worth.
One important component of the CLTV is customer acquisition costs. In today’s highly competitive environment it is difficult and economically expensive to acquire new customers. With major focus of marketing now on retaining customers through significant investment in developing their loyalty and level of satisfaction, no company is willing to lose their profitable customers to their competition. But marketers cannot completely forego acquiring new customers. They need to keep new customers in the pipeline to make up for some inevitable loss of existing customer.
Before they pursue new customers, companies carefully measure and evaluate cost of acquiring new customers so that they do not overspend and keep these newly recruited customers profitable from the beginning. In its simplest form the customer acquisition costs can be calculated as the total acquisition spending divided by the number of new customers acquired during a period.
The average Acquisition Cost metric helps companies to track profitability of their new customers. It also helps them to optimize their strategy of balancing between acquiring new customers and retaining existing ones. Customer acquisition costs are all the costs spent in acquiring new customers. These usually include prospecting costs comprised of cold calling, visiting, demos, samples, marketing materials and time of sales and marketing people spent in pursuing new customers.
In a B2C environment, for companies dealing with large number of customers e.g. telecommunication, banks, insurance, and healthcare it makes sense to measure this metric for segments of customers with similar characteristics. For these companies, this is a critical measure as these industries lack customer loyalty and migration to competitors is frequent. While highly attractive promotional offers motivate the customers to switch carriers, it becomes extremely difficult for the company to make money on these new customers in the short term.
One of the challenges with acquisition cost metric is how to segregate marketing costs between acquisition costs and other marketing costs. Many marketing programs overlap and mutually benefit to their objectives. For example, the money spent on a program to create brand awareness may also lead to acquiring new customers.
While Customer Profitability metric clearly depicts the level of current profitability of a customer, the CLTV model provides a longer term perspective and approach. It provides the opportunity and confidence for companies to manage and grow their existing customers as their most valuable asset. A strong and positive customer lifetime value justifies keeping a low profit or even a negative profit customer in anticipation of getting higher returns in future.
But CLTV measurement has its own challenges. Like ROMI, its calculation requires assumptions about future. Converting future cash flows in present value using the NPV approach may be challenging for many marketing managers. Despite these difficulties, however, CLTV has its own advantages which may justify its practice.
The reward for the marketing efforts to retain customers and build their loyalty is not only limited to customers’ current level of profitability. An effective retention program is focused on opportunities
to further increase the customer value through cross-selling (selling other complementary products) and up-selling (selling more expensive version of similar products). On top of it, a highly satisfied and loyal customer is also expected to provide referrals. These referrals create additional revenue and profit opportunities for the company.
In data gathering for CLTV computation, the major challenge is predicting the buying behavior of customers. In addition, estimating the profit from projected purchase transaction is quite challenging. Costs at the transaction level are usually not available except the gross margin in most cases. It would therefore be necessary to develop assumptions not only for contribution margin or gross margin but for the assignment of the sales, marketing and service department costs as well.
The accuracy of estimates is enhanced if the model is developed for aggregate profile of customers based on historical data available in computer systems. This is applicable to large retailers who have detailed information available in their computer files about the buying patterns of their millions of customers.
Despite uncertainties associated with predicting the assumption for future, there is substantial value in developing, and maintaining a CLTV metrics model. It provides the framework to develop and operate a marketing strategy to acquire, retain, and grow customers for long term shareholder value creation.