Customer lifetime value (CLTV) is a simple and powerful concept. However, this very fact can easily cause confusion because CLTV is applied in so many areas and in so many different ways. It seems to put on a slightly different face every time I see it. This column summarizes my views of the key concepts and uses of CLTV. I hope that this will reduce, not add to, the confusion.

Definition and Benefits of Customer Lifetime Value

I define CLTV as the expected value of profit to a business derived from customer relationships from the current time to some future point in time.

There are several aspects of this definition that should be noted:

  • It doesn’t really look at a customer’s whole lifetime. It is common to work with a cutoff point two to three years out. Marketing plans that require consideration of revenue more than three years away need to be examined in much more depth than a simple CLTV calculation would provide.
  • It doesn’t include past contributions to profit. The purpose of today’s marketing activities is to increase future profitability.
  • It is probabilistic. Customer-by-customer profitability cannot be known in advance but will average out for customer segments.
  • It can include prospects, not just current customers.

The specific mathematical formula for CLTV depends on the application. For example, a cable television company measuring the CLTV of its base of basic service customers might use the following formula:
 


CLTV for a Household =

Present Value over 24 Months of[

{(direct profit per month of basic service)*(probability that household is still a customer) +

(incremental profit from premium service)*(probability that household upgrades service) +

(profit of pay-per-view purchases)*(expected number of pay-per-view purchases)} *

(probability that household does not default on bill) –

(cost of service calls)* (probability that household will require a service call)]
This example demonstrates one of the key benefits of CLTV: it incorporates into one metric all of the elements of revenue, expense and customer behavior that drive profitability. The above formula incorporates aspects of retention, cross-selling, credit risk, pricing and expense. Of course, it is important to pay attention to each one of these elements of CLTV in order to understand the drivers of CLTV results. If each of these elements were just reported separately, it would be difficult to understand if the results were good or bad. CLTV combines them all into one bottom line metric.

Other advantages of CLTV as a metric include:

  • It allows (and forces) a focus on the customer (instead of products) as the driver of profitability.
  • It measures both current and future profitability.

Uses of Customer Lifetime Value

I find it useful to separate the uses of CLTV into three categories: 1) aggregate metrics, 2) program evaluation metrics, and 3) customer-level targeting tools.

Aggregate CLTV Metrics: CLTV is an ideal metric for identifying the profitability of customer segments and for tracking segment performance over time. Segments with high CLTV represent the most important customers. Segments with low or negative CLTV indicate that change is needed in the way the business markets to and services these customers.

While it is not required, the most flexible way to determine segment CLTV is to predict CLTV for each member of the segment and sum the results across the segment. This provides information not only on the average CLTV, but also on the distribution of CLTV within the segment. If you are losing money on 10 percent of your customers, you need to know this – even if your overall profitability is high. Individual level CLTV calculations also allow you to slice and dice customers into subsegments.

CLTV for Program Evaluation: Calculating the CLTV impact of a proposed marketing program is essentially the same as running a business case by calculating the ROI of the program. The important thing to remember is that positive incremental CLTV is the key criteria for program evaluation. Avoid thinking, "If these customers are worth $500 in CLTV, then I can certainly afford to spend $100 on retention." The purpose of marketing is to increase CLTV, not to spend it.

Customer Level CLTV: The definition of CLTV previously mentioned for cable TV providers includes several elements that represent customer-level actions (retention, upgrading, cross-purchasing, payment, service calls). Building predictive models for each of these customer actions allows an individual level assignment of CLTV. This information can be used for differentiated marketing in several ways:

  • Identify individual customers who are not profitable and change the customer relationship to improve profitability (reduce service levels, increase price, etc.) or minimize the customer relationship (accept attrition, end proactive marketing).
  • Identify the drivers of CLTV and create programs that improve CLTV (marketing triggers, retention programs, etc.).
  • Identify high value prospects by cloning the profitable customer base (find prospects with similar characteristics).

Actual vs. Predicted Profitability

Because it does not involve building predictive models, it is often easier to track actual customer profitability instead of predicted CLTV. Sometimes actual customer value can provide similar insights. For example, by profiling unprofitable vs. profitable customers, it may be possible to understand what factors are driving profitability. It is also possible to determine the profitability patterns of different customer segments.

However, it is important to understand that past profitability does not predetermine future profitability. For example, if past marketing campaigns have sent out very costly offers to a group of customers, these customers may look unprofitable based on recent results. The problem is not with the customers; it is with the marketing.

Conclusion

It is my impression that the level of attention given to CLTV as a key driver of business strategy has declined in the past year. If this is true, it may be due to confusion over when and how to use CLTV. I still believe that CLTV is a critical metric. It can provide insights beyond traditional metrics by capturing the full implications of all profitability drivers. Especially at a time when major investments in customer relationship management are being made, it certainly makes sense to measure marketing results with the focus on customer profitability.