In the first part of our series on the topic of client value we explained that it is important to look at the advertising budget not only in relation to the direct sales, but also to the entire value of a client relationship. The customer lifetime value concept represents the gain or loss that a company generates through the entire duration of the customer relationship and from the transactions affected by the client. While in the first part we discussed the strategic importance of the client evaluation, we will now explain how the customer lifetime value can be calculated.
The customer lifetime value concept sees the client as an investment, which should just like any other capital investment pay off sooner or later. To calculate this you should use the ‘net worth method’, to determine the current value of a client (at the time of the investment).
The formula to calculate the client’s value is the following:
In basic terms, the net worth method compares the overall costs for every client (order costs, product costs, etc.) with the overall revenue (sum of all orders).
In addition the costs and revenues are “discounted”, which means the further these cash flows are in the future the less value is attributed to them. This interest return is carried out for strategic reasons, to make the customer investment comparable to an alternative capital investment. Acquisition costs are deducted from the difference of revenue and costs, in online marketing these are the proportionate address costs.
Spending in the different online marketing disciplines, such as display advertising, affiliate marketing, search engine advertising, etc. will be allocated to the acquisition of new customers. If the CLV is positive, the investment pays off since both the acquisition costs and the running costs for the client, are covered by the customer revenues. The investment is therefore more valuable than an investment on the capital market.
Usually the calculation of the interest rate and the determination of the acquisition costs do not represent a big challenge for companies. The prognosis for future revenue and cost flows, on the other hand, is very complex. Here, you have to resort to econometric methods such as modeling.
This rather abstract explanation on how to calculate the customer lifetime value can be illustrated with a concrete example:
The operator of an online store receives an order from a new customer. What is the monetary value of that customer?
Initially it’s useful to look at the order history of existing customers to determine how many orders a customer places on average during a given period of time and what was their average value. For instance, in recent years an average of 1.8 orders per client and year were registered with an average value of €80.
Unfortunately customers never stay for the entire lifetime of an online store. Therefore, you must estimate what percentage of the consumers will still be customers of the online store in the next financial year.
But when is a customer relationship considered terminated?
For this it is worthwhile to look at the retention rate of newsletter subscribers, it will tell you how many of the acquired readers continue to receive the newsletter in the following year. Experience shows that this figure is a relatively good approximation to the actual customer retention rate. If, for instance, you assume that 80 percent of all clients will continue to shop in the online store next year.
In order to be able to calculate the value of a client, you need to take the costs for customer retention into consideration. Therefore, in a simplified way, the product and order costs will need to be deducted from the clients purchase revenues: the contribution margin for every transaction will be calculated. Assuming in the example that 20 percent of the sales will remain as profit, the average profit per order would then be €80.00 x 20 percent = 16.00 EUR.
In summary all data for the average customer
Without taking the discounting into account, the following sales and profits arise for the retention period of an average customer:
In this example a client achieved a value of 138.93 EUR, without taking acquisition costs into account. If we only consider the first order, the value is only 16.00 EUR – a significant difference. For the planning of an advertising budget it’s far better to measure projected CLV instead of the first order.
However, CLV estimated value isn’t sufficient for calculating trading recommendations. In our next article about CLV we will explain how it is that by transferring the one-dimensional estimated value into a multidimensional value, a detailed recommendation can be given on managing customer relations of different customer groups.