Friday, March 31, 2006

Customer Lifetime Value

Customer Lifetime Value measures a customer’s total profit contribution to an organization. In its simplest form it’s measured by using this simple formula:

(Revenue - Cost) * Retention.

Retention is the length of time the customer frequents the business. There are more complex ways of looking at CLTV including the addition of a discount rate to determine the present value of future cash flows.

Customers don’t stick around for ever although most companies would like them to. Some businesses don’t keep their current customers for much longer than a few years due to aging. Clothing stores that sell to the teenage market will typically see customers for a few years and then leave as tastes and lifestyles change with age. Customers who don’t stick around are the fuel for churn analysis models. Anyone in a service business needs to understand why customers leave in order to maximize profits.

The CLTV metric can be created from different areas of the business independently and then analyzed overall to understand the profit contribution from each area. For example, some areas might not be as profitable as others but they might be a key component in bringing in new customers to the business. Cross selling into this area is likely not going to add to the bottom line but customers who are part of this business unit would be ideal candidates for cross selling opportunities into other areas of the business.

In addition to CLTV you might want to consider creating a Customer Lifetime Market Basket (CLTMB). Companies that want to reduce inventories might look at certain products as being unprofitable and decide to remove them from the regular inventory. By determining what makes up a customer’s basket, a company might decide that certain inventory items are required for customer retention.


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