Customer lifetime

value (CLV)
Customer lifetime value

Outline
▪ The concept of customer lifetime value
(CLV)
▪ Comparison of CLV with related metrics
▪ Analyzing CLV
▪ Extensions of CLV analysis
▪ Drivers of CLV
▪ Uses of CLV metrics
 Customer lifetime value

Customer lifetime value (CLV)

▪ the discounted cumulative cash flows that a
customer brings to the firm over the entire duration
of the relationship with the company (Kumar 2006);
▪ takes into account both revenues and costs and
emphasizes relationships, not transactions;
▪ allows firms to assess the true worth of customers
and to target their marketing efforts to the most
profitable customers;
 Customer lifetime value

Comparison of CLV with other metrics

▪ RFM method:
□ Recency: time since last purchase
□ Frequency: number of purchases within a given time
period;
□ Monetary value: average purchase amount per
transaction;
▪ How RFM is used:
□ Assign weights to R, F, and M and then calculate the
value of each customer; rank customers by value;
□ Only available for historical customer data;
□ Sensitive to the specification of the weights used;
 Customer lifetime value

Example RFM analysis

Purchase R (months R points Weight Weighted F F points Weight Weighted M M Weight Weighted RFM
number since last of R R points of F F points points of M M points score
purchase)
A B C D E F G H I J K L M N O

John 1 2 20 0.5 10 1 3 0.2 0.6 40 4 0.3 1.2 24.9

2 4 10 0.5 5 1 3 0.2 0.6 120 12 0.3 3.6
3 9 3 0.5 1.5 1 3 0.2 0.6 60 6 0.3 1.8
Jordan 1 6 5 0.5 2.5 2 6 0.2 1.2 400 25 0.3 7.5 11.2
Judy 1 2 20 0.5 10 1 3 0.2 0.6 90 9 0.3 2.7 30.4
2 4 10 0.5 5 1 3 0.2 0.6 70 7 0.3 2.1
3 6 5 0.5 2.5 2 6 0.2 1.2 80 8 0.3 2.4
4 9 3 0.5 1.5 1 3 0.2 0.6 40 4 0.3 1.2

R points:
=IF(C2<=2,20,IF(C2<=4,10,IF(C2<=6,5,IF(C2<=9,3,IF(C2<=12,1,0)))))

F points:
=G2*3

M points:
=IF(K2<=250,0.1*K2,25)
 Customer lifetime value

Comparison of CLV with other metrics

(cont’d)
▪ Share-of-wallet (SOW):
□ at the aggregate level, it is the proportion of category
value accounted for by a brand or firm within a certain
base of buyers;
□ at the individual level, it is the proportion of category
value accounted for by a brand or firm within all
category purchases of the buyer;
▪ Example: Lisa spends $500 per month on groceries
and she spends $300 at Wegman’s. Wegman’s
SOW is what?
▪ Problem that good data on purchases of other
brands or at other stores are often hard to come by.
 Customer lifetime value

Comparison of CLV with other metrics

(cont’d)
▪ Past customer value (PCV): total contribution
toward present profits based on all past transactions
𝑇

𝑃𝐶𝑉𝑖 = ෍ 𝐺𝐶𝑖𝑡 ∗ 1 + 𝑑 𝑡

𝑡=1
□ GCit = gross contribution of the ith customer’s
transaction at time t
□ T = number of time periods prior to the current time
□ d = discount rate (e.g., 15% per year, 1.25% per
month)
 Customer lifetime value

Example of PCV
Bill has made regular purchases at Best Buy between
January and May. Assuming a gross margin of 30% and a
monthly discount rate of 1.25%, what is Bill’s PCV at the
end of May?

Jan Feb Mar Apr May Total

Purchase amount 800 50 50 30 20 950

GC (purchase
240 15 15 9 6 285
amount x .3)

Multiplier (1+d)^t 1.064 1.051 1.038 1.025 1.013

PCV 255.38 15.76 15.57 9.23 6.08 302.01

PCV is calculated for all customers and PCV scores are

used to prioritize customers.
 Customer lifetime value

How does CLV differ from

traditional metrics?
▪ RFM, SOW and PCV are backward looking and do
not take into account future revenues and future
costs of servicing customers (depending on how
long customers will be active) ;
▪ CLV takes into account the probability that a
customer will be active in the future and thus future
revenues as well as the costs of marketing to
customers in order to retain them;
 Customer lifetime value

Analyzing CLV
Assume that we have estimates of the average
contribution margin per customer per period (M); then
the average CLV of a customer is:
𝑇
𝑀 𝑡
𝐶𝐿𝑉 = ෍ 𝑟
1+𝑑 𝑡
𝑡=0
□ r = constant rate of retention of customers per period
□ d = constant discount rate
□ t = time period
□ T = total number of time periods considered
This assumes there is no discounting in the first period
and all customers contribute in the first period.
 Customer lifetime value

Example CLV calculation

Margin per period: 120
Retention rate: 30%
Discount rate: 10%
Number of periods: 8

Year 1 2 3 4 5 6 7 8 CLV

Margin 120 120 120 120 120 120 120 120

Discounted Margin 120.00 109.09 99.17 90.16 81.96 74.51 67.74 61.58

Likelihood of retention 100.0% 30.0% 9.0% 2.7% 0.8% 0.2% 0.1% 0.0%

Discounted
120.00 32.73 8.93 2.43 0.66 0.18 0.05 0.01 165
Margin*likelihood
Customer lifetime value

Example CLV calculation in ME

Marketing
Segments / Segment Number of
Gross margins costs, next
description customers
period

Active customers 1 $120 $0

Lost customers 0 $0 $0

Last period / Next period Active customers Lost customers

Active customers 30% 70%

Lost customers 0% 100%
Customer lifetime value
 Customer lifetime value

Example CLV calculation in ME (cont’d)

Customer Lifetime Value Contractual
Individual's customer lifetime value (discount rate 10%), per segment.
Number of Marketing costs, Customer lifetime
Segments / Segment description Gross margins
customers next period value
Active customers 1 $120 $0 $165
Lost customers 0 $0 $0 $0

Customer Base's Lifetime Value

Customer base's lifetime value (discount rate 10%) and discounted net margins, over 8 periods.
Margins and costs /
N+1 N+2 N+3 N+4 N+5 N+6 N+7 N+8
Periods
Gross margins $120 $36 $11 $3 $1 $0 $0 $0
Marketing costs $0 $0 $0 $0 $0 $0 $0 $0
Net margins $120 $36 $11 $3 $1 $0 $0 $0
Discount factor (10%) 1.00 0.91 0.83 0.75 0.68 0.62 0.56 0.51
Discounted net
$120 $33 $9 $2 $1 $0 $0 $0
margins
Discounted net
$120 $153 $162 $164 $165 $165 $165 $165
margins (cumulated)
 Customer lifetime value

Example CLV calculation in ME (cont’d)

Retention Rate (Active customers)

Retention rate of a customer currently in the "Active customers" segment.

Segments / Periods N+1 N+2 N+3 N+4 N+5 N+6 N+7 N+8

Active customers 1.00 0.30 0.09 0.03 0.01 0.00 0.00 0.00
Lost customers n/a 0.70 0.91 0.97 0.99 1.00 1.00 1.00
 Customer lifetime value

Analyzing CLV (cont’d)

▪ With certain simplifying assumptions, we can get a
general solution for CLV:
□ Constant contribution margin, discount rate and retention
rate
□ Infinite time horizon

∞
𝑀 𝑡
1+𝑑
𝐶𝐿𝑉 = ෍ 𝑡
𝑟 =M
1+𝑑 1+𝑑−𝑟
𝑡=0

▪ Example: Margin per period = 120, d = .1, r = .3

1+.1
𝐶𝐿𝑉 = 120 =165
1+.1−.3
Customer lifetime value

When does the customer pay?

If customers pay at the beginning of the period, the
contribution margin for the first period does not have to be
discounted.

Beginning of 𝟏+𝒅
𝑪𝑳𝑽 = 𝑴
period 𝟏+𝒅−𝒓

Timing of
payments
𝟏
End of period 𝑪𝑳𝑽 = 𝑴
𝟏+𝒅−𝒓

[assuming there is no churn during the first period]

Customer lifetime value

When does the customer leave?

𝑀 𝑀
𝐶𝐿𝑉 = σ∞
𝑡=0 𝑟 𝑡 vs. σ∞
𝑡=0 𝑟 𝑡+1
1+𝑑 𝑡 1+𝑑 𝑡

When does the customer leave?

After next payment Before next payment

(no churn during first period) (already churn in first period)

𝟏+𝒅 𝟏+𝒅 𝒓
𝑪𝑳𝑽 = 𝑴 𝑪𝑳𝑽 = 𝑴
𝟏+𝒅−𝒓 𝟏+𝒅−𝒓

[assuming there is no discounting during the first period]

 Customer lifetime value

Four CLV formulas

When does the customer leave?

After next payment Before next payment

𝟏+𝒅 𝟏+𝒅 𝒓
Beginning 𝑪𝑳𝑽 = 𝑴 𝑪𝑳𝑽 = 𝑴
𝟏+𝒅−𝒓 𝟏+𝒅−𝒓
When of period
does the
customer
pay? 𝟏 𝒓
End of 𝑪𝑳𝑽 = 𝑴 𝑪𝑳𝑽 = 𝑴
𝟏+𝒅−𝒓 𝟏+𝒅−𝒓
period
 Customer lifetime value

Example: Comparing the four formulas

Margin per period: 120
Retention rate: 30%
Discount rate: 10%

When does the customer leave?

After next payment Before next payment

Beginning
When 165$ 50$
of period
does the
customer
pay? End of
150$ 45$
period
 Customer lifetime value

How to get these numbers in ME?

When does the customer leave?

After next payment Before next payment

Do not apply discount Do not apply discount

Beginning
factor to period 1 factor to period 1
of period
When Contractual Transactional
does the
customer
pay? Apply discount factor Apply discount factor
End of
to period 1 to period 1
period
Contractual Transactional
 Customer lifetime value

In-class exercise
▪ Andrew is a regular customer at Otto’s brew pub in SC.
He usually goes there once a week and has 2 pints
(assume a price per pint of $5 and a gross margin for
Otto’s of 80%).
▪ Assume that Andrew will be in SC for five years (use 4
weeks per month and 48 weeks per year).
▪ Using month as the discount period and a monthly
discount factor of 1%, what is Andrew’s CLV to Otto’s?
▪ Repeat the calculations under various scenarios that
Andrew may not remain a loyal Otto’s customer.
Specifically, assume monthly retention rates of .99, .95,
and .90. What’s the likelihood that Andrew will still be a
customer after one year under these scenarios? How
does CLV change?
 Customer lifetime value

Extending CLV analysis

▪ Gross contribution margins GM (revenues minus
variable costs) and marketing or customer retention
costs RC (contact costs to retain customers, costs of
loyalty programs, etc.) can be considered separately;
▪ Margins and costs need not be constant over time;
▪ Customer acquisition costs (AC) can be considered:
□ Only applies to new customers
□ Free trial period, sign-up incentives, etc.
□ Acquiring customers can be expensive

𝑇
𝐺𝑀𝑡 − 𝑅𝐶𝑡 𝑡
𝐶𝐿𝑉 = ෍ 𝑡
𝑟 − 𝐴𝐶
1+𝑑
𝑡=0
 Customer lifetime value

Extending CLV analysis (cont’d)

▪ Different customer segments may be considered
which have different contribution margins, marketing
costs, and retention rates
▪ This requires the specification of a switching matrix
which specifies the probability that a customer from
one segment will switch to a different segment in the
next period (including a lost-for-good customer
segment, from which there is no return)
Customer lifetime value

CLV analysis for three segments:

Office Star data
Segment Description
Segment labels and number of customers currently in each segment.
Gross margins relate to current period, while marketing costs are anticipated expenses for next
period based on current segment membership.
Number of Marketing costs,
Segments / Segment description Gross margins
customers next period
Active Customers 12000 $90 $25
Warm Customers 4000 $0 $15
Cold Customers 3000 $0 $10
Lost customers 6000 $0 $0

Transition Matrix
Transition probabilities of customers from one segment to another across periods.
Each line sums up to 100%.
The very last segment represents customers who are assumed to be lost forever.
Active Warm Cold
Last period / Next period Lost customers
Customers Customers Customers
Active Customers 75% 25% 0%
Warm Customers 30% 70% 0%
Cold Customers 8% 92%
Lost customers 0% 0% 0% 100%
Customer lifetime value
Customer lifetime value
Customer lifetime value

CLV analysis for three segments:

Office Star data (cont’d)

Customer Lifetime Value

Transactional
Individual's customer
lifetime value (discount
rate 15%), per segment.

Marketing
Segments / Segment Number of Gross Customer
costs, next
description customers margins lifetime value
period

Active Customers 12000 $90 $25 $138

Warm Customers 4000 $0 $15 $51
Cold Customers 3000 $0 $10 $7
Lost customers 6000 $0 $0 $0
 Customer lifetime value

CLV analysis for three segments:

Office Star data (cont’d)
Number Of Customers Per Segment

Simulations of number of customers per segment, over 20 periods.

Segments / Periods N+1 N+2 N+3 N+4 N+5 N+6 N+7 N+8
Active Customers 10440 8954 7667 6568 5626 4819 4128 3537
Warm Customers 3000 2610 2239 1917 1642 1407 1205 1032
Cold Customers 2800 2100 1827 1567 1342 1149 985 843
Lost customers 8760 11336 13268 14949 16390 17625 18682 19588
Customer base evolution (Enginius)
N N+1 N+2 N+3 N+4 N+5 N+6 N+7 N+8 N + 9 N + 10 ... Infinity
Active
customers 12000 10440 8954 7667 6568 5626 4819 4128 3537 3030 2595 0
Warm
customers 4000 3000 2610 2239 1917 1642 1407 1205 1032 884 757 0
Cold
customers 3000 2800 2100 1827 1567 1342 1149 985 843 722 619 0
Lost
customers 6000 8760 11336 13268 14949 16390 17625 18682 19588 20364 21029 25000
Total 25000 25000 25000 25000 25000 25000 25000 25000 25000 25000 25000 25000
 Customer lifetime value

CLV analysis for three segments:

Office Star data (cont’d)

Customer Base's Lifetime Value

Customer base's lifetime value (discount rate 15%) and discounted net margins, over 20 periods.

Margins and costs

N+1 N+2 N+3 N+4 N+5 N+6 N+7 N+8 N+20
/ Periods
Gross margins $939,600 $805,860 $689,985 $591,083 $506,343 $433,748 $371,562 $318,291 $49,699
Marketing costs $390,000 $334,000 $284,000 $243,510 $208,609 $178,696 $153,076 $131,130 $20,475
Net margins $549,600 $471,860 $405,985 $347,573 $297,734 $255,053 $218,486 $187,161 $29,224
Discount factor
0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.06
(15%)
Discounted net
$477,913 $356,794 $266,942 $198,726 $148,027 $110,266 $82,137 $61,183 $1,786
margins
Discounted net
margins $477,913 $834,707 $1,101,649 $1,300,375 $1,448,401 $1,558,667 $1,640,804 $1,701,988 $1,875,428
(cumulated)

GM = GM per segment * # of customers per segment at N+1 (summed across all segments)
Marketing costs = Marketing costs per customer per segment * # of customers per segment at N
(summed across all segments)
 Customer lifetime value

CLV analysis for three segments:

Office Star data (cont’d)

Retention Rate (Active Customers)

Retention rate of a customer currently in the "Active Customers" segment.

Segments /
N N+1 N+2 N+3 N+4 N+5 N+6 N+7 N+8
Periods
Active Customers 1.00 0.75 0.64 0.55 0.47 0.40 0.34 0.30 0.25
Warm Customers n/a 0.25 0.19 0.16 0.14 0.12 0.10 0.09 0.07
Cold Customers n/a 0.00 0.18 0.13 0.11 0.10 0.08 0.07 0.06
Lost customers n/a 0.00 0.00 0.16 0.28 0.38 0.47 0.55 0.61
Customer lifetime value

Lifetime Value per Segment

$160

$140

$120

$100
Lifetime Value

$80

$60

$40

$20

$0
Active Customers Warm Customers Cold Customers
 Customer lifetime value

Number of Customers per Segment

12000

10000

8000

6000 Active Customers

Warm Customers
Cold Customers

4000

2000

0
N+1 N+2 N+3 N+4 N+5 N+6 N+7 N+8 N+9 N+10N+11N+12N+13N+14N+15N+16N+17N+18N+19N+20
Period
Customer lifetime value

Profits and Costs

1000000

900000

800000

700000

600000

Margins and costs / Periods

500000
Gross margins
Marketing costs
400000 Net margins

300000

200000

100000

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
Period
 Customer lifetime value

Drivers of CLV
▪ If CLV is calculated for individual customers, the
drivers of CLV can be investigated;
▪ Previous research has identified various
determinants of CLV:
Driver Measure Impact
Spending level Average monthly spending +
Cross-buying # of different product categories purchased +
Focused buying Purchase within one category only -
Loyalty instrument Customer’s participation in a loyalty program +
Mailing efforts # of mailings by the company +
income Customer’s income +

Reinartz and Kumar (2003)

 Customer lifetime value

Benefits of using CLV metrics

▪ the most profitable customers can be selected for special
retention efforts (not necessarily those generating the
most revenue, those who have been with the company
the longest, etc.)
▪ customers can be grouped into segments based on their
CLV and the segments can then be profiled using
various drivers of CLV
□ Cross-classify CLV with relationship duration
□ Cross-classify CLV (future profitability) with PCV (historical
profits)
▪ resource allocation can be optimized based on the
responsiveness of customers to marketing contacts
▪ new prospects can be targeted based on profiles that are
similar to existing high CLV customers
Customer lifetime value

Segmentation by CLV and relationship

duration
Low High
relationship duration relationship duration

Butterflies True Friends

High
Aim for transactional Establish attitudinal
CLV
satisfaction and behavioral
loyalty

Barnacles
Strangers
Measure size and
Low share of wallet; if
CLV Minimize investment
SOW is low, cross-
in these customers
sell, otherwise
control costs

(Kumar 2006)
Customer lifetime value

Segmentation by past and future profitability

Low High
PCV PCV

Rising Stars True loyalists

High
Invest to deepen Invest to
CLV
relationship nurture/defend/
retain

Total misfits Falling angels

Low
CLV No relationship Optimize (minimize)
investment marketing costs

(Kumar 2006)
 Customer lifetime value

Review: CLV
A cell phone provider has acquired 10,000 new customers
who have decided to sign up for unlimited cell phone
service for at least one year for a monthly fee of $80. The
variable costs of providing the service are $10 per customer.
Payment is due at the end of each month. What’s the net
present value of the profits from this customer base for the
first year? Assume a yearly discount rate of 12 percent.
What would we need to know to calculate the net present
value of the profits over five years?
 Customer lifetime value

Review: CLV

A catalogue marketer groups its customers into two

segments: premier and regular. There are 1000 customers of
each type. The contribution margins of the two segments are
$100 and $50, respectively.
The retention rates of premier and regular customers are
60% and 50%, respectively. Each period 30% of premier
customers become regular customers and 10% are lost
forever. Also, 10% of regular customers become premier
customers and 40% are lost forever.
Customer lifetime value

Review: CLV
Customer lifetime value

Review: CLV
Customer lifetime value
Review: CLV
Review: CLV
Customer lifetime value

Review: CLV
 Customer lifetime value

Computing the ROI of marketing investments

▪ Assume that without a certain marketing investment gross
profit is $100,00, whereas with the investment it is $200,000
(where the investment of $50,000 has not been considered in
the gross profit calculation):

𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔

𝑀𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔 𝑅𝑂𝐼 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔

▪ Assume that without a certain marketing investment gross profit is

$100,00, whereas with the investment it is $150,000 (where the
investment of $50,000 has already been subtracted from the initial
gross profit):

𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑣𝑎𝑙𝑢𝑒

𝑀𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔 𝑅𝑂𝐼 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔