The concept of Customer Lifetime Value (CLTV) has existed for a long time, but it is now more relevant than ever with the evolution of retail into omnichannel initiatives. We all want our customers to have the best shopping experience possible, because satisfied customers lead to repeat sales and brand loyalty. If we can zero in on what a customer likes, where they like to shop, when they like to shop, their emotional touchpoints, and what they’re willing to pay, then we can create a personalized promotional campaign that maximizes the CLTV.
If you are familiar with finance, you will recognize the CLTV equation as net present value. We can calculate the future cash flow, but we need to figure out what that future value is worth today. I’ll show an example at the end, but suffice it to say it’s a simple math problem.
CLTV is the sales minus the costs associated with getting those sales, or acquisition costs.
AC = Acquisition Cost
N = Number of potential years (usually 3 to 5)
P = Probability the person will remain a customer
r = Weighted average cost of capital
Acquisition costs, or AC, are a topic by itself because it can include all sorts of marketing efforts like affiliate programs, paid advertising, email campaigns, and SEO (search engine optimization). Some retailers will take the total marketing spend and divide by the number of customers that purchase something in the same time period the marketing expenses occurred.
The probability of the person remaining a customer, or P, is easy to calculate if you have enough transaction data. Just look at the repeat purchases binned by purchase frequency or average transactions per year or season.
The weighted cost of capital, or r, is a combination of the cost of debt and equity. Most retailers have an agreement with their bank to pay a certain interest rate on their revolving credit. We can assume that for a company that traditionally doesn’t have that much long term debt will mostly use short term interest rates. Equity (stocks) have a built in annual growth expectation from investors which can be roughly estimated by looking at the price to earnings ratio, or P/E. When finance performs any kind of investment analysis, they will refer to the discount rate as the weighted average cost of capital, or WACC.
WACC = Cost of Debt * Percentage + Cost of Equity * (1 – Percentage)
Let’s say we spend a certain number of Euros or Dollars per year to acquire one customer. Without any fancy math, you can easily determine that the customer will need to generate present value gross margin that is a little more than what we spent for the Company to break even.
Now let’s extend the example to show how CLTV is calculated over three years:
Customer lifetime value may be one of the most important advanced analytics for retail, wholesale, and even consumer products because it shows a direct link between your company and your customer. What is your customer worth?
For further reading, I recommend Data-Driven Marketing: The 15 Metrics Everyone in Marketing Should Know, Mark Jeffery, 2011.