How to Compute Your Customer Lifetime Value by Arthur Middleton Hughes Everyone talks about customer lifetime value,

but few have actually calculated it. The process is not that difficult. When you finish this article, you will be an expert. In the first place, what is lifetime value? It is the expected profit that you will realize from sales to a particular customer in the future. Although it builds on past customer history, LTV is all about the future. It is based, primarily, on the customer's expected retention and spending rate, plus some other factors that are easy to determine. To understand LTV, let's begin with a typical LTV table. Acquisition Year Customers Retention Rate Orders per Year Avg Order Size Total Revenue 100,000 60% 1.8 $90 Second Year 60,000 70% 2.5 $95 Third Year 42,000 80% 3 $100

$16,200,00 $14,250,00 $12,600,000 0 0 70% 65% 65% $8,190,000 $20 $840,000 $9,030,000

Costs Cost of Sales Acquisition/Mkt. Cost

$11,340,00 $9,262,500 0 $55 $20

Marketing Costs $5,500,000 $1,200,000 Total Costs $16,840,00 $10,462,50 0 0 ($640,000) $3,787,500 1 1.16

Gross Profit Discount Rate Net Present Value Cumulative NPV Profit Customer LTV

$3,570,000 1.35 $2,644,444 $5,269,531 $53

($640,000) $3,265,086 ($640,000) $2,625,086 ($6) $26

In this table, 100,000 customers are acquired originally. We are following their purchase history for the next three years. The first thing you will notice is that 40% of them disappear after the first year. The retention rate is only 60%. In future years the retention rate grows. The loyalty of retained customers is higher than that of newly acquired customers. As customers stay with you, their number of orders per year and their average order size tends to increase. We are assuming a 70% cost of sales. Your number may be different. The cost typically goes down after the first year. The cost of customer service to existing customers is usually lower than that to new customers. It costs you $55 to acquire a new customer. This is computed by taking all your advertising and sales costs and dividing this by the 100,000 customers that you acquired. We are assuming that you spend $20 per customer per year on subsequent marketing, including the cost of the database that provides the information needed for this table, and is used to provide the personal communications needed to improve the retention rate. The Gross Profit is simply the revenue minus costs. We have to divide this by a discount rate to get the Net Present Value of the expected profits. The discount rate (based on interest rates) is needed because future profits are not worth as much in today's money as present profits. The formula for the discount rate is: D = (1 + (i x rf))n Where D = Discount rate, i = interest rate, rf = the risk factor, and n = number of years that you have to wait. With a risk factor of 2 and an interest rate of 8%, the discount rate in the third year (two years from now) is D = (1 + (.08 x 2))2 or D = (1.16)2 = 1.35. The lifetime value is calculated by dividing the cumulative LTV by the originally acquired 100,000 customers. The LTV in the third year is $53. That means that the LTV of the average newly acquired customer is $53 in the third year. In this one number we have encapsulated the retention rate, the spending rate, the acquisition, marketing and goods costs, and the discount rate. It is a wonderful number. From this table, you can learn quite a lot. As you can see, acquiring new customers is not a profitable activity. Customers, in this case, become profitable only in the second and third years. This is typical. It is why money spent on increased retention has a higher payoff than money spent on acquisition. We have calculated an average LTV for a group of 100,000 customers. We now have to figure out the LTV of each individual customer. This is done by creating customer segments. How you develop customer segments is an art. It depends on your customer base and marketing program. Segments might be by age (Senior Citizens, College Students, etc.) or by spending habits (Gold, Silver, Bronze) or by product type (Deluxe, Regular, Economy), etc. However you do this, you can redo your LTV table to create a

LTV for each segment. Jane Adams, one of your customers, may be a Deluxe customer, who spends about $300 per year. The LTV of the Deluxe customers for example, may be $100 in the third year. They may spend an average of $200 per year. So Jane Adams third year LTV is $150 ((300/200)*100)). You can set up a program to compute this number for every customer and put that number into your customer database. LTV can thus be a valuable tool in your marketing arsenal. You treat customers with high LTV (high expected future profits) differently from those with low LTV. You spend more to retain them. Some customers may even have negative LTV. Why spend a lot of money trying to retain these losers? The LTV table can be used to evaluate the expected results of new marketing programs before you have spent millions on them. When you come up with a new initiative, estimate what it will do to the retention rate and the spending rate (orders and average order size). Some marketing programs will fail this test. Their benefits will be lower than their costs. They may cause LTV to drop rather than to rise. Don't fund them. The table can also be used to validate your LTV calculations. All of the numbers shown in the table above are real numbers (not assumed numbers like "awareness"). When the second year arrives, you can go back and see what was your actual retention rate and spending rate. If you have been too optimistic or pessimistic, you can learn that and do a better job next year. LTV is thus a wonderful marketing tool which costs very little to calculate, and can return rich rewards in terms of improved marketing strategy. You now know how to calculate it. Go forth and make money.

The Customer Lifetime Value Formula

June 16th, 2008 by Doug Bright

Last week in What is Customer Analysis? we found that the first step in a customer analysis is determining customer lifetime value across segments. Armed with this information, we can determine which customers are worth focusing our marketing efforts on and which customers should be fired. The concept behind modeling customer lifetime value is relatively straightforward. We can group customers into segments which behave similarly and then based on historical data, determine how much a customer in each segment produces in profit over the course

of his/her lifetime. One thing to understand with calculating customer lifetime value is that there are many different ways to do it. Practically speaking, as long as you remain consistent in your usage across all your customer segments and across time, you should be ok using any of them. With this in mind lets look at one of the simpler customer lifetime value formulas:

Where, m is the average gross margin i is the discount rate r is the customer retention rate In using this simplified formula we to pick one average profit margin value and one average customer retention rate. We can calculate m for each segment as m = revenue - product or service costs - cost of servicing (includes acquisition and promotion costs) over the course of a period (usually a year). To find r, we calculate from historical data what percentage of customers in a segment repurchase in the next period (again, usually the next year). We then assume that this will also be the retention rate for subsequent years for the segment. This is generally not the case but thats a price were willing to pay to keep things simple. Finally, i is the cost of capital (sometimes called a hurdle rate). If you dont know what your companys discount rate is, your CFO will likely be able to give you the number. If not, youll usually be ok using a value between 8% and 15%. Using the customer lifetime value formula to rank each of your customer segments will give you a solid understanding of which to court and which to forget about. In particular, any customer segment with a customer lifetime value less than zero is costing your company money. Shed

yourself of these customers as quickly as possible! Anxious to get started calculating customer lifetime value? Our customer lifetime value calculator will help you get started. If you sell online and are looking for a way to increase customer lifetime value across all your customer segments youll want to check out our recommendation engine.