Understand Your Customer Lifetime Value and its Limitations

Posted by barry on July 24, 2015 Business Intelligence, Data Analytics

Customer Lifetime Value is a simple way to estimate the value of each additional customer you acquire. The beauty of CLV is it allows you to evaluate the performance of your marketing channels, while giving you insight into the KPI’s that drive your company’s value.

You can use CLV to calculate the number of new customers a marketing  or sales campaign must generate to break even.

Because it’s so simple, CLV can conceal its assumptions about the future. You should understand those assumptions fully any time you calculate your CLV.

Let’s explore the traditional CLV model, the variables that go into it, and the assumptions they make about the future.

The Traditional CLV Model is Simple to Calculate

We’ll use the traditional formula for measuring CLV for subscription businesses. CLV calculations can be more complex and incorporate more variable revenue flows. But the traditional CLV calculation is a good place to start and is the only formula most businesses need.

The traditional customer lifetime value calculation

The traditional customer lifetime value calculation

The Harvard Business Review also has a clever CLV calculator that considers a few more elements. It’s handy for a one-time calculation and for gaming out a particular scenario, but for regular use, you should have your own spreadsheet, or ideally (from Chartio’s point of view) a dashboard that keeps track of your CLV by segment, and the elements that go into it.

Churn Rate May Be the Key Element of Customer Lifetime Value

While it’s simple to calculate your CLV once you have all the elements, calculating those elements can be tricky. You should already have a good estimate of most of these numbers. However, calculating and monitoring the elements of your CLV is an ideal task for a business intelligence system.

Margin: Your margin is the difference between the revenue you receive per unit (e.g. one month’s subscription revenue) and the variable cost of delivering your product or service to one additional customer. Remember that this is only the additional cost of serving one more customer. Don’t include overhead. Also, don’t include sales costs, because you’re going to compare the CLV to the cost of customer acquisition later.

Churn Rate: Churn Rate is the percentage of customers who end their relationship with your service during a specific time period. The Churn Rate is arguably the single most important number for a subscription business. If you have 1,000 customers and lose 10 in a month, your Churn Rate for that month is 1%.  You’re always going to have some churn, but managing churn through product improvements and customer service is a key to building successful subscription business. We’re going to be writing more about churn in a future post.

Retention Rate: Retention Rate is the percentage of your customers who don’t cancel in a given period. It is simply 1 minus your Churn Rate. So, if your Churn Rate is 1%, then your Retention Rate is 99%.

Customer Lifetime: If you know your Churn Rate, you know your Customer Lifetime. Customer Lifetime is 1 divided by the Churn Rate. So, if your Churn Rate is 1% per month, your Customer Lifetime is 1/.01=100 months, or a little over eight years.

Discount Rate: You’re unlikely to be able to get this number from your business intelligence system. It’s your cost of capital. If you have to borrow capital from the bank, it’s your interest rate. If you’re seeking investors, it’s going to be more difficult to determine your discount rate. The longer your customer lifetime, and you want it to be long, the more your discount rate matters. A decent rule of thumb for Discount Rate 10% per year, but you should consult your CFO or financial advisor for a more accurate number.

CLV Makes Some Assumptions About the Future

When using CLV to evaluate, for example, a particular marketing initiative, it’s important to understand the assumptions that are built into it. While CLV is a good rule of thumb, you should give some thought to how the market will change in the next three to five years. There are some limitations built into CLV’s assumptions:

Includes no new revenue from customers:  The CLV formula assumes that you will not be able to increase your revenue per customer. In most businesses, it’s possible to increase billings from customers over time by selling them more services. If you’re executing on your plans, your goal should be that your average customer will be paying you more in three years than they are today. Also, as your customer base increases, your cost of serving a customer may drop sharply.

Projects recent behavior far into the future:  Let’s say your monthly Churn Rate is 1%, which means your Customer Lifetime is 1/.01 = 100 months = 8.3 years.  Eight years is pretty far horizon for your forecast, but it’s especially far if you only have two years of data.

Treats all your customers as average: The CLV formula is based on the idea that your customers, or even your customer segments, are mostly uniform. How reliable is your historical data? If you’ve changed your pricing or sales model recently, your churn rates may no longer be reliable, because the demographics of your customer base have changed. If you’re selling more annual contracts than in the past, you may have more churn in your pipeline than is reflected in your current monthly numbers. You may need to segment your customers by plan,  lead source, or purchase channel and calculate a CLV for each segment.

Assumes fixed market conditions: The traditional CLV model assumes that market conditions will remain the same during the lifetime of the customer relationship. This has always been a risky assumption, and it’s getting riskier all the time. But even if your customers are buying more services from you, it’s likely that there will be pressure on your prices. As you broaden your target market, your less successful competitors get desperate, more competitors enter the market, or substitutes emerge. You may find that you have to cut prices.

Ignores the fight for market share: In new and fast-growing markets, one competitor (maybe it’s you) will adopt strategy of growing market share early at the expense of margins, or even profitability. In that case, CLV will not be the primary metric for evaluating marketing and sales initiatives. However, it’s still an important element of strategic planning.

Make the Elements of CLV Your Key Performance Indicators

Once you understand how Customer Lifetime Value is calculated, you can begin to manage its elements as KPI’s and create a dashboard to track them over time.

Churn is a key indicator for every SaaS business. You can’t manage it directly, but it shows up in other elements of your business.

Customer satisfaction is a leading indicator of churn. Net Promoter Score is a sound methodology for measuring customer satisfaction, and we discussed how Chartio uses NPS and how to link NPS to your customer segments in earlier posts.

Revenue per customer is another element of CLV that it’s possible to influence. We’ll discuss this in a later post, but one indicator of the health of a subscription business is revenue churn.  Revenue churn is the difference between revenue lost from customer churn in a period and additional revenue from existing customers, divided by total revenue at the beginning of the period.  Negative revenue churn means that new revenue from existing customers is greater than revenue lost from churn, and it’s a good indicator of a healthy SaaS business.

Your customer success and account management teams are critical to increasing revenue from your existing customer.  We discussed how to manage revenue churn using customer success in a recent webinar with Lincoln Murphy, Customer Success Evangelist at Gainsight.

CLV is Just the Beginning

Knowing your CLV will help you plan, monitor, and evaluate your marketing and sales initiatives. It will also help you chart the progress and success of your business. It helps determine whether you have a profitable, scalable business or need to reassess your entire strategy.

Understanding how each element contributes to your CLV helps you understand how your business works, identify trouble spots, and improve your relationships with your customers.

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