Customer lifetime value (CLV)

As modern economies become predominantly service based, companies increasingly

derive revenue from the creation and sustenance of long-term relationships with their

customers. In such an environment, marketing serves the purpose of maximizing

customer lifetime value (CLV) and customer equity, which is the sum of the lifetime

values of the company’s customers. Customer lifetime value (CLV) is gaining increasing

importance as a marketing metric in both academia and practice. Companies such as

Harrah’s, IBM, Capital One, LL Bean, ING, and others are routinely using CLV as a tool

to manage and measure the success of their business.

Traditional marketing metrics such as brand awareness, attitudes, or even sales and share are not enough to show a

return on marketing investment. Financial metrics such as stock price and aggregate profit of the firm or a business

unit do not solve the problem either. Although these measures are useful, they have limited diagnostic capability.

Recent studies have found that not all customers are equally profitable. Therefore, it may be desirable to “fire” some

customers or allocate different resources to different group of customers1. CLV is a disaggregate metric that can be

used to identify profitable customers and allocate resources accordingly. At the same time, CLV of current and

future customers (also called customer equity or CE) is a good proxy of overall firm value

Fundamentals of CLV CLV is generally defined as the present value of all future profits obtained from a customer over his or her life of

relationship with a firm. CLV is similar to the discounted cash flow approach used in finance. However, there are

two key differences. First, CLV is typically defined and estimated at an individual customer or segment level. This

allows us to differentiate between customers who are more profitable than others rather than simply examining

average profitability. Second, unlike finance, CLV explicitly incorporates the possibility that a customer may defect

to competitors in the future.CLV for a customer is

Where

pt price paid by a consumer at time t,

ct direct cost of servicing the customer at time t,

i discount rate or cost of capital for the firm,

rt probability of customer repeat buying or being “alive” at time t,

AC acquisition cost, and

T Time horizon for estimating CLV.

Researchers use different variations in modeling and estimating CLV. Some researchers have used an arbitrary time

horizon or expected customer lifetime whereas others have used an infinite time horizon.

Importance of understanding Customer Lifetime Value Knowing and fully understanding the customer lifetime value changes the business perspective to a great extent. To

begin with, company can use it to estimate the current value of all its customers. By knowing the current value of the

customer, you can then segment customers into different categories. Segmenting helps to concentrate more on the

profitable customers. For instance, ICICI Bank answers its best customer's phone calls within 15 seconds while

other customers have to wait for as long as 10 minutes to have their calls answered. Once customers are segmented based on profitability, you can tailor your offerings to various segments.

e.g.

a) cost of attracting a new customer = (cost of average sales call includes salary, commissions, benefits

and average number of sales to convert an average prospect into customer ) = Rs.300x4 = Rs 1200

1 (Blattberg, Getz, and Thomas 2001; Gupta and Lehmann 2005; Rust, Lemon, and Zeithaml 2004)

b) estimate of average customer lifetime value : annual customer revenue = Rs 500. Average number of

loyal years=20 Company profit margin=10

Customer lifetime value= Rs 1000

Thus we can see that (cost of acquiring new customers) > (customer lifetime value).

Segmenting Customers Today, companies around the world are increasingly segmenting their customers in

order to increase profitability. Segmenting helps companies to tailor their offerings to each of the segment. One of the common ways of segmentation is based on loyalty &

profitability. After segmenting customers, companies tailor their offerings, marketing

strategies to convert existing customers to become more loyal and more profitable.

Segmenting helps companies to allocate their marketing resources based on the

customer value. Customer lifetime value give a formalized depiction of a long-term

view of the customers and gives a better picture of what the company is going after.

Increasing customer lifetime value To increase customer lifetime value, one has to increase the profits generated from that customer. The most common

ways to achieve that is either to up-sell or to cross-sell to the same customer, i.e., make your existing customers buy

more products from you and buy it more often. It is noted that highly satisfied customers often recommend it to their

friends, relatives and others. This recommendation results in new customers and referral sales. The cost of acquiring

new customers by referrals is substantially lower than traditional methods. In the long run, high customer

satisfaction results in lower customer acquisition costs and higher margins, thus increasing customer life time value.

As marketing strives to become more accountable, we need metrics and models that help us assess the return on

marketing investment. CLV is one such metric. The easy availability of transaction data and increasing

sophistication in modeling has made CLV an increasingly important concept.

i

i References

1.Modeling Customer Lifetime Value, Sunil Gupta, Dominique Hanssens, Bruce Hardie, Wiliam Kahn, V. Kumar, Nathaniel Lin, Nalini Ravishanker and S. Sriram, Journal of Service Research 2006; 9; 139

2. http://www.answers.com/topic/customer-lifetime-value?cat=technology

3. Getting Real About Customer Lifetime Value by Uta Wer ner

4.Marketing Management,Kotler Keller Koshy & jha, 12th

ed.

Report Submitted by

R S Raghav