A business model for estimating customer spend over their lifetime with the company
What is customer lifetime value?
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.
A formula is used to calculate the customer lifetime value.
Customer lifetime value = (Profit per customer X Average lifetime of customer) – Acquisition cost per customer
This formula can be refined by taking into account the fact that a dollar earned in five years’ time is worth less than a dollar in the hand today.
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.