Marketing managers today are collecting information about their

customer base than ever before. Mangers can capitalize on the value
of this information by applying a simple formula to determine the life
time value of the customer.

It is formula that helps the marketing manager arrive at dollar value

associated with the long term relationship with any giver customer,
revealing just how much a customer relationship is worth over
the period of time.

It becomes extremely useful in considering customer acquisition

processes as well as selecting optimal services levels to provide
different customer group.

Customer lifetime value has intuitive appeal as a marketing concept,

because in theory it represents exactly how much each customer is
worth in monetary terms, and therefore exactly how much a
marketing department should be willing to spend to acquire each
customer. In reality, it is difficult to make accurate calculations of
customer lifetime value. The specific calculation depends on the
nature of the customer relationship.

Customer relationships are often divided into two categories. In

contractual or retention situations, customers who do not renew are
considered "lost for good". Magazine subscriptions and car
insurance are examples of customer retention situations. The other
category is referred to as customer migrations situations. In customer
migration situations, a customer who does not buy (in a given
period or from a given catalog) is still considered a customer of
the firm because she may very well buy at some point in the
future. In customer retention situations, the firm knows when the
relationship is over. One of the challenges for firms in customer
migration situations is that the firm may not know when the
relationship is over (as far as the customer is concerned).

In the first place, what is lifetime value? It is the expected profit

that you will realize from sales to a particular customer in the
future. Although it builds on past customer history, LTV is all about
the future. It is based, primarily, on the customer's expected retention
and spending rate, plus some other factors that are easy to determine.
To understand LTV, let's begin with a typical LTV table.
 Acqui Secon
Third
  sition d
Year
Year Year
Custome 100,00
60,000 42,000
rs 0
Retentio
60% 70% 80%
n Rate
Orders
1.8 2.5 3
per Year
Avg
Order $90 $95 $100
Size
Total $16,20 $14,25 $12,60
Revenue 0,000 0,000 0,000
       
Costs 70% 65% 65%
Cost of $11,34 $9,262 $8,190
Sales 0,000 ,500 ,000
Acquisiti
on/Mkt. $55 $20 $20
Cost
Marketin $5,500 $1,200 $840,0
g Costs ,000 ,000 00
Total $16,84 $10,46 $9,030
Costs 0,000 2,500 ,000
       
Gross ($640, $3,787 $3,570
Profit 000) ,500 ,000
Discount
1 1.16 1.35
Rate
Net
($640, $3,265 $2,644
Present
000) ,086 ,444
Value
Cumulati
($640, $2,625 $5,269
ve NPV
000) ,086 ,531
Profit
 Custome
($6) $26 $53
r LTV

In this table, 100,000 customers are acquired originally. We are

following their purchase history for the next three years.  The first
thing you will notice is that 40% of them disappear after the first year.
The retention rate is only 60%. In future years the retention rate
grows. The loyalty of retained customers is higher than that of newly
acquired customers.  As customers stay with you, their number of
orders per year and their average order size tends to increase.

We are assuming a 70% cost of sales. Your number may be different.

The cost typically goes down after the first year. The cost of customer
service to existing customers is usually lower than that to new
customers. It costs you $55 to acquire a new customer. This is
computed by taking all your advertising and sales costs and dividing
this by the 100,000 customers that you acquired. We are assuming
that you spend $20 per customer per year on subsequent marketing,
including the cost of the database that provides the information
needed for this table, and is used to provide the personal
communications needed to improve the retention rate.  

The Gross Profit is simply the revenue minus costs. We have to divide
this by a discount rate to get the Net Present Value of the expected
profits. The discount rate (based on interest rates) is needed because
future profits are not worth as much in today's money as present
profits. The formula for the discount rate is:

D = (1 + (i x rf))n

Where D = Discount rate, i = interest rate, rf = the risk factor, and n =

number of years that you have to wait.  With a risk factor of 2 and an
interest rate of 8%, the discount rate in the third year (two years from
now) is D = (1 + (.08 x 2))2    or   D = (1.16)2 = 1.35.

The lifetime value is calculated by dividing the cumulative LTV by

the originally acquired 100,000 customers. The LTV in the third year
is $53. That means that the LTV of the average newly acquired
customer is $53 in the third year. In this one number we have
encapsulated the retention rate, the spending rate, the acquisition,
marketing and goods costs, and the discount rate. It is a wonderful
number.

From this table, you can learn quite a lot. As you can see, acquiring
new customers is not a profitable activity. Customers, in this case,
become profitable only in the second and third years. This is typical.
It is why money spent on increased retention has a higher payoff than
money spent on acquisition.

We have calculated an average LTV for a group of 100,000

customers. We now have to figure out the LTV of each individual
customer.  This is done by creating customer segments.  How you
develop customer segments is an art. It depends on your customer
base and marketing program.  Segments might be by age (Senior
Citizens, College Students, etc.) or by spending habits (Gold, Silver,
Bronze) or by product type (Deluxe, Regular, Economy), etc. 
However you do this, you can redo your LTV table to create a LTV
for each segment. 

Jane Adams, one of your customers, may be a Deluxe customer, who

spends about $300 per year.  The LTV of the Deluxe customers for
example, may be $100 in the third year. They may spend an average
of $200 per year. So Jane Adams third year LTV is $150
((300/200)*100)).  You can set up a program to compute this number
for every customer and put that number into your customer database.

LTV can thus be a valuable tool in your marketing arsenal. You treat
customers with high LTV (high expected future profits) differently
from those with low LTV. You spend more to retain them.  Some
customers may even have negative LTV.  Why spend a lot of money
trying to retain these losers?

The LTV table can be used to evaluate the expected results of new
marketing programs before you have spent millions on them.  When
you come up with a new initiative, estimate what it will do to the
retention rate and the spending rate (orders and average order size).
Some marketing programs will fail this test. Their benefits will be
lower than their costs. They may cause LTV to drop rather than to
rise.  Don't fund them.

The table can also be used to validate your LTV calculations. All of
the numbers shown in the table above are real numbers (not assumed
numbers like "awareness").  When the second year arrives, you can go
back and see what was your actual retention rate and spending rate. If
you have been too optimistic or pessimistic, you can learn that and do
a better job next year.

LTV is thus a wonderful marketing tool which costs very little to

calculate, and can return rich rewards in terms of improved marketing
strategy. You now know how to calculate it. Go forth and make
money.