What's In a Lifetime?

Customer lifetime value is defined as the present value of all current and future profits generated from a customer.

Here’s a formula* to work from:

M = margin or profit from a customer in a certain period
R = your retention rate (most companies are between 60-90%)
I = discount rate (your company’s cost of capital, usually a rate of 8-16%)

For example: if your profit from a customer in a year is $1,000, you retain 80% of your customers, and your discount rate is 12%, multiply $1,000 x 2.5 to get $2,500 as that customer’s lifetime value. Just remember, your Customer Lifetime Value (CLV) will change as your retention rate changes. Still, your CLV could have a big impact on profit even at small percentage retention increases.

Here's another look at how customer retention affects customer lifetime value.

Lifetime value differs from traditional present-value or discounted-cash-flow approaches by looking at individual customers and taking customer retention and defection into account. It's important to note that customer lifetime value also considers the present value of future income.

Annual and quarterly revenue plus market share are the general benchmarks for success. But if the value of a customer over his/her entire life is $400 for example, it doesn't make sense to spend more than that, or even half of that, to acquire the customer. The idea is to focus not on the sheer number of customers for growth sake, but on the most profitable customers - those with the greatest lifetime value. Still, this straightforward and instinctive notion is commonly ignored in the pursuit of growth. Remember, businesses that incorporate customer lifetime value into their strategy do three key things:

Position business units by customer, not product.

Traditionally, managers are aligned by product within a business. A bank, for example, has a manager for checking and savings, another for investments, and a third for mortgage. Such a structure easily overlooks important opportunities such as cross-selling and on a whole, makes it difficult to comprehend the total value of a customer. Rather, businesses should organize themselves around customer segments with dependent products. This means focusing customer managers on customer acquisition, retention, and expansion.

Measure performance.

As mentioned earlier, market share and revenue growth shouldn't be your only measures of success. Your overall profitability is much more reliant on customer-by-customer profitability and customer-retention rates. However, this doesn't mean you need to track extremely complex metrics. Instead, basic metrics tracked should be easily acquired, and formulas used (such as CLV) should be understood to be estimates, not reality. Systems that strive for total accuracy are impossible to create and quickly become too complex or worse - unreliable.

Adjust their work culture.

Most businesses use incentives that rely on capturing customers, not keeping them. Customer-centric businesses plan their rewards and incentives according to strategies that encourage customer loyalty. They also broadcast the value of their customers to all employees - making each employee's role in the customer lifetime value known. This is most essential for frontline personnel who interact with customers most. Such an undertaking requires ample training and clear communication but it doesn't necessarily take fancy CRM tools. "It's as simple as Domino's Pizza telling its franchisees that the lifetime value of the average customer is more than $1,000. So when that customer says he doesn't like his $10 pizza and wants a new one free, the lifetime-value formula is simple: Make him another pizza."

Source: "What Are Your Customers Worth?" Sunil Gupta and Donald R. Lehmann

* Source: "Managing Customers as Investments," Sunil Gupta and Donald R. Lehmann (1 to 4.5 = margin multiple. This multiple depends on the customer retention rate and the company's discount rate. For most companies, retention rates range between 60-90%. For most companies, discount rates range between 8-16%. Within these ranges, some typical margin values can be provided, out of which 1 to 4.5 has been determined.)