Definition of customer lifetime value

What is Customer lifetime value?

Customer lifetime value is a measure of customer profitability over time. To help explain this concept, let’s start with a formal definition of customer lifetime value (CLV) from a well-regarded marketing metrics textbook. In the textbook Marketing Metrics: the definitive guide to measuring marketing performance (Farris et al 2010), the authors defined customer lifetime value as:

“Customer lifetime value is the dollar value of a customer relationship based on the present value of the projected future cash flows from the relationship.”

At first glance, this looks a little complicated and financially focused – but it is really quite straightforward.

The present value of the projected future cash flows is simply the amount of profit/loss you expect to make from a particular customer over time (calculated in today’s dollars).

Therefore, in this definition of customer lifetime value, CLV is defined as a single dollar amount that measures the potential profit/loss of a customer to a firm or brand.

Definitions of Customer Lifetime Value (CLV)

Some approaches to defining customer lifetime value (CLV) include:

• Customer lifetime value is the economic net worth of a customer to the firm.
• Customer lifetime value is the net profit contribution of the customer to the firm over time.
• Customer lifetime value is a measure of a customer’s aggregate profit to the firm over the total time that the customer deals with the firm.
• Customer lifetime value measures the total profit derived from a customer during the time that they are a customer of the firm.

Key Points of the CLV Definitions

All of these definitions are appropriate to use, and are essentially communicating the same definition of customer lifetime value. The key points to note are:

• Customer lifetime value is calculated as a single dollar number,
• CLV summarizes total revenue and costs related to a customer over time,
• CLV provides a net profit/loss summary of the customer’s total relationship with the firm,
• It is calculated on per customer basis, or more usually on the average value for a customer within a particular market segment,
• CLV is an important measure of customer profitability and
• Customer lifetime value is usually considered to be a very important marketing metric, because of the range of the marketing objectives it measures within a single number.

Related Topics

Difference between Customer Profitability and Customer Lifetime Value

The Benefits of Customer Lifetime Value

Why calculate customer lifetime value?

Why has customer lifetime value – along with many other marketing metrics – becoming more important for marketers to use and understand? One of the key drivers is the shift from “art” to “science” in the marketing profession.

For many years, marketing was essentially a creative process or a people relationship skill – with the majority of marketers working either to deliver promotional campaigns or undertaking personal selling activities.

However, along with the Internet era, has been an increasing requirement for marketers to be more analytical and financially savvy in the development of marketing strategies and tactics. Marketing metrics, which enables marketers to analyze and determine the success of their marketing programs, are increasingly expected in the business community.

SHIFT FROM ART TO SCIENCE IN THE MARKETING PROFESSION

Therefore, there has been a significant shift from marketing essentially being an “art” form to now becoming far more scientific and analytical. There are several reasons for this increase in the importance of evaluating marketing performance, these include:

• Significantly more customer and marketing data is now captured through new technologies,
• Marketers have software programs that make marketing data analysis much easier than in the past,
• Marketing environments are changing faster than in previous eras, with emerging new competitors being more of a threat than in the past,
• Many marketers realize that demonstrating financial expertise is a key requirement to being accepted at the executive and CEO level,
• The easy availability of website analytics (such as, Google analytics) is exposing more marketers to marketing metrics, and
• Many companies now view marketing as an investment (ROI) to be justified.

Customer Lifetime Value Benefits

Regardless of its potential challenges, customer lifetime value (CLV) is a powerful tool and a very important marketing metric – sometimes referred to as “the golden metric”. In particular it helps the marketer to:

• Measure and demonstrate the bottom-line financial impact of marketing activities,
• Clearly align marketing programs with financial objectives and targets,
• Focus on marketing from an marketing ROI perspective by determining the optimal balance between acquisition, share-of-customer, and enhanced loyalty objectives,
• Scenario test a range of possible strategic marketing directions,
• Determine the impact of internal marketing programs, as well as competitive and environmental factors on long-term customer profitability,
• The stress testing of various marketing goals and environmental impacts,
• Balance the competing needs of short-term profitability and longer term goals,
• Understand the bottom-line profit contribution of different customer segments,
• Demonstrate a long-term financial return for a range of marketing investments and
• As demonstrated in the diagram, the effective management of the customer relationship will result in enhanced profitability over time.

 Related Topics

Drivers of the shift from art to science in the marketing profession

Customer Profitability Metrics versus CLV

What’s the difference between customer profitability analysis and customer lifetime value?

Before we start discussing the inputs to the customer lifetime value formula, it is probably worthwhile to clarify the distinction between customer profitability analysis and customer lifetime value calculation. These two sets of terms are quite similar and may often be somewhat confused.

Customer profitability analysis

It is likely that most marketers conduct customer profitability analysis from time to time, even perhaps on a regular basis. In this process, a marketer with look at the historical data – most likely from a customer database – and try to determine the level of profitability of each customer or each segment of customer.

It is similar to the customer lifetime value calculation in that customer profitability should also include customer revenues and customer costs over time to determine the profit contribution of the customer. Also similar to the customer lifetime value calculation, customer profitability also take into account initial acquisition costs in order to derive a “net” profit contribution.

MARKET SEGMENTATION PERSPECTIVE

As part of this analysis, the marketer will look to see if there are any differences in consumer behavior depending upon the method of acquisition, any segment profile information, and different marketing approaches over time designed to gain greater share-of-customer or to enhanced loyalty.

In other words, in addition to simply looking at customer profitability (usually on a segment basis), the marketer should consider the impact of various marketing strategy.

For example, does a first-time customer who was attracted by TV advertising more loyal have a high retention rate than a first-time customer attracted by a sales promotion discount? By answering these types of questions, the overall effectiveness and marketing ROI of various marketing strategies and campaigns can be evaluated.

In addition to looking at customer profitability in conjunction with acquisition costs, the marketer should also look at customer profitability in conjunction with special offers and incentives provided to the consumer to purchase more products or remain loyal. Again, this type of analysis will demonstrate the effectiveness of marketing from an ROI perspective.

All of these forms of analysis can also be scenario tested using the customer lifetime value formula – so what exactly is the difference between customer profitability analysis and CLV?

Key distinctions of customer lifetime value (CLV)

Customer lifetime value (CLV) is a forward looking tool – it is a forecast of customer profitability. The marketer will build in various assumptions regarding future revenues, costs and retention into the model to construct a view of customer lifetime value across different customer segments.

The obvious question is why would a marketer run forecasts given have they have real historical data where they can calculate customer profitability precisely?

The answer to that question is that marketing is dynamic. It is dynamic because the marketplace changes, consumer preferences changes, new technologies emerge, customer lifestyles change over time, and so on. In addition to all these external environmental changes, it is hoped that the marketing department is conducting marketing experiments and developing greater insight and understanding of how to create responsive customers and to increase conversion rates.

Therefore, in most industries, it would be generally inappropriate to rely upon historical data only. No doubt historical data is a critical input to compare the data and assumptions to calculate the customer lifetime value. Basically the intention is to utilize the prior customer profitability analysis and modified according to the dynamic marketing environment and to the firm’s proposed marketing programs.

To make a very simple distinction between customer profitability and customer lifetime value – customer profitability looks at the past (and the previous marketing environment and the previous marketing programs of the firm), whereas customer lifetime value looks at the future marketplace in conjunction with the proposed marketing programs of the firm.

Related Topics

Reconciling CLV and Total Profits

Relationship between CLV and Brand Equity

Customer lifetime value and brand equity

Customer lifetime value calculates the profit contribution of a customer over time, by essentially utilizing a financial formula. The accumulated value of all CLV’s (across customer segments) is equal to the firm’s customer equity.

Therefore, it would be expected that there is a correlation between customer lifetime value, customer equity and brand equity.

Consulting firms that calculate and publish brand equity valuations usually do so from the perspective of the “economic-use” of the brand. This means that they value the brand essentially on its financial contribution (that is, the additional profitability due to using/having the brand).

Therefore, both customer lifetime value and most brand equity valuations are financially based. And as brand equity resides in the minds of consumers and the firm’s customers and the sum of all customers’ profit contributions will equal the overall gross profit of the firm – it stands to reason that the two elements are closely related.

This is demonstrated in the following model below, which identifies that the sum of customer’s purchase actions essentially determine the customer lifetime value, which is a strong driver of overall profitability, which will also contribute to the brand equity valuation.

It is important to note the customer lifetime value contributes to the behavioral aspects only of the brand equity valuation – not the emotional or attitudinal aspects, although the two obviously related in most cases.