04.09.06
Customer Lifetime Value
Leveraging my discussion of NPV calculations in a previous post, I’m going to discuss the concept of Customer lifetime value (CLTV).
This analysis is critical for many businesses, especially membership type services like netflix because it helps the firm balance customer acquisition costs with customer retention costs. Most often firms are too heavily focused on acquiring new customers and often neglect their installed consumer base (remember the cell phone plans that would give steep discounts on phones, but only if you were a new client?).
There are four factors that impact the CLTV calculation.
A - Per customer acquisition costs, the costs incurred to turn a lead into a customer.
M – Maintenance costs, the costs incurred to keep a customer.
C – Gross profit revenues generated per customer per period.
r – Retention rate
i – Discount rate (I discussed this in the post on NPV calculations)
CLTV = SUM[ (C – M)*r^t/(1+i)^t ] – A
The way this works conceptually is that we follow a fictitious customer though time. Each period a smaller and smaller fraction of him exists until he is totally eliminated.
With a little math-magic we can simplify the above equation to:
CLTV = (C-M)*[ (1+i)/(1+i – r) ] - A => (C-M) * ‘Margin Multiplier’ – A
Now we can examine the impact that the margin multiplier (MM) has on profitability at different levels of i.
We can see that the marginal impact of increasing the retention rate (which impacts the MM) is far greater going from 90% -> 95% than it is even from going from 50% - 80%. This is profound!
From these types of calculations we can determine where our marketing dollars are best spent between customer retention and customer acquisition…
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