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Customer Lifetime Value and Data Management

Originally published December 16, 2010

What is customer lifetime value? At the most basic level, it is a theoretical value of a customer calculated as the net present value of the average predicted profit expected from sales to (or cash flow attributed to) any customer. From a practical perspective, the concept of customer lifetime value is appealing because it not only provides a tangible value to be associated with customer acquisition, but it also directs the key stakeholders in the company to take a long-term view associated with managing and maintaining the customer relationship. The customer lifetime value concept can also provide guidance into strategies for dealing with different kinds of customers—more on that in a bit.

There are many models for calculating customer lifetime value. Although these models can incorporate many different variables, most focus on key concepts such as these:

  • Acquisition cost: This incorporates the costs associated with convincing a prospective customer to purchase your product or service.
  • Customer lifetime: This is the duration of the company’s relationship with the customer.
  • Retention rate: The annual retention rate is the percentage of customers that remain engaged with your company.
  • Retention cost: These include any costs incurred related to actively maintaining the customer relationship, such as rebates or elimination of service fees.
  • Revenue per customer: The annual average revenue per customer is the cumulative amount of revenue divided by the total number of (engaged) customers.
  • Servicing cost: These costs include ones associated with supporting the customer and providing service.
  • Gross profit: This is the difference between what is brought in as revenue and the cost of creating and providing the product and/or service prior to deducting the operating expenses (including overhead, direct costs, taxes, etc.).
  • Discount rate: In this context, this is the rate used to calculate the current value of future cash flows.
A customer’s lifetime value is then a function of the net present value of the revenue per customer over the customer’s lifetime minus the acquisition, retention, and servicing costs. Of course, there could be other variables as well. For example, when a customer severs his or her relationship, there might be a cost to the business associated with the tasks of attrition. On the other hand, the customer agreement may stipulate that severing the relationship prior to the end of an agreed-to period may incur additional charges (check your mobile phone contract!), which then adds in a variable associated with severance revenue!

How can customer lifetime value be used? One simple way looks at the value proposition for customer acquisition. Plainly stated, if the cost of acquisition is less than the customer lifetime value, there would have to be some motive other than profitability that drives customer acquisition!

Another use involves more comprehensive customer segmentation. Average customer lifetime value across the entire customer base may be a single data point, but analyzing customer lifetime value within discrete customer segments may influence marketing and sales. For example, a company’s overall average customer lifetime value may be $25, but if the customer lifetime value of males between the ages of 18 and 34 is $40, it may make sense to orient the marketing budget toward individuals meeting that specific demographic profile because the potential return on investment is much greater.

One more use is looking at evolving optimizations in the organization to increase customer lifetime value. This can be done by focusing on optimizing the dependent variables, such as lowering the associated costs, increasing customer lifetime, or increasing the profitability. Yet one big challenge for calculating and managing customer lifetime value is accumulating the right data needed for each of the dependent variables.

Let’s look at one of these variables: duration of the customer lifetime. Calculating customer lifetime requires historical data detailing all customer transactions across all areas of the business. You cannot just depend on the dates of the sales transactions, especially when the sales cycle requires numerous steps each time the customer is engaged. At the same time, there may be other customer touch points that indicate engagement (such as calls to the call center), while monitoring of service usage could signal a reduction in use, signifying an imminent disengagement. In each case, coming up with a definition for customer engagement and determining what data is necessary to confirm that a customer continues to be engaged requires both defined policies and directed data management effort.

The same can be said about any of the other variables: What are the actual costs of acquisition? Does that include the costs of manufacturing the product, marketing, and general administrative costs allocated to each customer? What are the ongoing servicing costs? Do those include specific service and maintenance activities for each customer, or do we also allocate part of the infrastructure charges (such as placing a new cell tower) to service costs?

Customer lifetime value is a very powerful concept that can help drive specific actions, both strategic and tactical. And you can see that while the concepts are straightforward, the devil is in the details. There can be a lot of value in assembling a program to calculate and monitor customer lifetime value, but there are many hidden business policy and data management challenges that will require attention before the model can come to life.

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