Loyalty Management: CUSTOMER LIFETIME VALUE (CLV) Part2.

August 21, 2008

CUSTOMER LIFETIME VALUE (CLV) Part2.

The definition of the CLV given in Part 1 is useful for expressing the principle and explaining the concept but things are a little more complex in the “real world” so a couple of comments are in order.

We calculated the CLV in the example used in Part 1 as $3,300. This assumes that future dollars are as valuable as today’s dollars but they aren’t so the future dollars must be discounted to establish their current value. This is especially important if the CLV is to be used to justify expenditures based on future gains, for example, how much can be invested to acquire a new customer.

The formula used to convert the value of future dollars into their current value is;

Discount rate = (1 + ab)ⁿ

Where a = interest rate b = risk factor, and n = number of years into the future.

We’ll use the formula later when we do the maths to calculate the CLV but a brief discussion prior to that is useful.

The interest rate is usually the current commercial rate (possibly modified for guesses of future changes). The risk factor is difficult to estimate, but because looking into the future is fraught with danger it’s wise to assess the risk of things happening which could reduce the Customer Lifetime Value, loosing customers for example.

Determining the risk factor is a subjective decision usually based on a company’s own historic experience or on industry data. For example, if your company sells a product or service where your customers are tied by contract, then the future risk is small. If you sell a product or service that is complicated to install making it difficult for the customer to switch suppliers then the risk will be greater than the contract situation but much less than say for a company providing high fashion apparel. Hair salons have a lower risk factor than, say, hardware stores because their customers often develop strong attachments to the stylist (called “stickness”) and are loath to switch. Most managers are conservative when assessing risk since it’s safer to have a low rather than high expectation of future benefits.

Reducing the risk factor is at the heart of customer loyalty programs and this will be discussed in the section devoted to ways to increase the CLV.

Another point to bear in mind is that very few companies have just one product sold to the same type of customers in one location - so while calculating a global CLV is interesting it has limited value as a management decision making aid.

The ideal position is to calculate the CLV for each distinct product/customer combination – market segmentation in other words. Doing this requires that the company has detailed customer data, unfortunately not too many companies do. Companies using good contact management systems such as ACT! or better still CRM systems such as Sage CRM have a tremendous advantage. That said companies that do not have these systems can collect enough customer data to calculate the CLV for broad segments of their business.

Knowing the CLV of the various market segments helps managers to concentrate their resources on the high profit segments and to investigate and improve those segments that are performing less well.

Frank Friend

friend@ffauk.com

Part 3 of the report will be posted on August 24

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