Customer Lifetime Value

This technical note introduces important metrics firms use to monitor customer relationships. An important summary of customer activity is the profit the firm receives from each customer. Customer profit (CP) is the metric that summarizes the past financial performance of a customer relationship and is covered in a companion note, "Customer Profit" (UVA-M-0799). The central difference between CP and customer lifetime value (CLV) is that CP measures the past and CLV looks forward. This note addresses the forward-looking metric that attempts to put a dollar value on a customer relationship.This technical note is an excerpt of the more comprehensive treatment of customer metrics found in "Customer Profitability" (UVA-M-0718). Excerpt UVA-M-0800 Rev. Jun. 19, 2014 Customer Lifetime Value As Don Peppers and Martha Rogers are fond of saying, “Some customers are more equal than others.” One way to examine these differences is through customer profit (CP), the difference between the revenues and the costs associated with the customer relationship during a specified period. The central difference between CP and customer lifetime value (CLV) is that CP measures the past and CLV looks forward. As such, CLV can be more useful in shaping managers' decisions but is much more difficult to quantify. Quantifying CP is a matter of carefully reporting and summarizing the results of past activity, whereas quantifying CLV involves forecasting future activity. Customer Lifetime Value: The Present Value of the Future Cash Flows Attributed to the Customer Relationship The concept of CLV is nothing more than the concept of present value applied to the cash flows of the customer relationship. The present value of any stream of future cash flows is designed to measure the single lump-sum value, today, of those future cash flows. CLV represents the single lump-sum value, today, of the customer relationship. Even more simply, CLV is the dollar value of the customer relationship to the firm. It is an upper bound on what the firm would be willing to pay to acquire the customer relationship as well as an upper bound on the amount the firm would be willing to pay to avoid losing the customer relationship. If we view a customer relationship as an asset of the firm, CLV would represent the dollar value of that asset. One way to project the value of future customer cash flows is to make the heroic assumption that the customers acquired several periods ago are no better or worse (in terms of their CLV) than the ones currently acquired. We then go back and collect data on a cohort of customers, all acquired at about the same time, and carefully reconstruct their cash flows over some finite number of periods. The next steps are to discount the cash flow for each customer back to the time of acquisition, to calculate the sample customers' CLVs, and then to average all sample CLVs together to produce an estimate of the CLV of each newly acquired customer. This method is referred to as the “cohort and incubate” approach. Equivalently, one can calculate the present value of the total cash flow from the cohort and divide by the number of customers to get the average CLV for the cohort. If the value of customer relationships is stable across time, the average CLV of the cohort sample is an appropriate estimator of the CLV of newly acquired customers. . . .