New Thinking on Lifetime Value
The foundation for measuring Return on Customersm rests on customer lifetime value (CLTV). Many companies and their C-suite executives talk about LTV and may even think they're doing it, but we find that they're not measuring it in a way that provides an actionable look into the future of how to increase customer value.
We'd like to take a step back and look at just a few of the common mistakes and potential advantages of properly measuring CLTV. Once you have your LTV house in order, ROC can be the next step.
As a starting point, customers who have a high CLTV show some simple, common metrics. They have a high total revenue or profit over their lifetime with your company. They score near the top of your customer value measurements in the areas of recency and frequency. But these metrics are not enough. CLTV also requires complex calculations of cash flow of the customer at present, your company's discounted cash flow rate and the number of time periods in the future being considered. When you actually set it out it looks like this:
CLTVti = Customer Lifetime Value of customer i at time t,CFti = Cash Flow of customer i at time t,r = Discount Rate,n = The number of time periods in the future being considered
Forget the pastC-level executives must understand that CLTV is a forward-looking measure that represents the present value of all future cash flows associated with a customer. It is the value of that customer to the company at a specific point in time. A customer is not valuable because of what they have done in the past. That value has already been realized and booked as income.
They are only valuable due to the possibility of any future behavior. If a customer who had historically spent a lot of money with a company made a statement that they are no longer going to spend anything more, their CLTV is 0.
Still many companies use the amount of money spent historically to measure the value of a customer. This is a useful measure for some general purposes, as customers that have spent a lot in the past usually do spend more than average amounts in the future. But it is not a true measure of CLTV.
Another common approach is to consider recency and frequency explicitly with historical spend (commonly called monetary), which together is often referred to as RFM. This approach is simple and useful for many marketing activities, however for a metric measuring CLTV, it is far too ambiguous. The main shortcoming is that there is no theoretical methodology to combine these individual metrics into one metric that accurately measures the value of a customer.
CLTV is a forward-looking measure that represents the present value of all future cash flows associated with a customer.
Dr. Katherine LemonAssociate ProfessorBoston CollegeRFM is a useful metric in a directional sense. It can show how more recent, more frequent, and higher monetary spend usually indicates an increase in value. But what are we to conclude about two people when one is more recent, but the other is more frequent? Additionally, how do we translate these historical behavior patterns into a future assessment of behavior? RFM metrics by themselves, as we said, may be useful for some marketing activities, like selecting mail lists, or creating reporting groups and loyalty programs. The information in these metrics can be used in the more formal metric of CLTV mentioned above.
All customers with a high CLTV are not created equal. Some customers have high frequency but spend a little each time. Some have low frequency but spend a lot on each transaction, some buy items that are high margin, others buy low margin items. Therefore, CLTV is a function of many dynamics.
Identifying high CLTV customers is the first step, but to have a meaningful relationship with these customers, you need to know why they have a high CLTV. We recommend grouping customers together by their behavior, value, and characteristics.
CLTV in actionSuppose we are trying to communicate with the top 10 percent of our customers according to CLTV. For purposes of discussion, let's also assume we are a cruise company. When we try to understand our top 10 percent CLTV customers, we see that some are people who go on 3-4 cruises a year, go to standard destinations, usually go in our lowest cabin class, and spend very little onboard. There is another group that only goes every two years, but when they do, they live it up, going to exotic locations, on long cruises, buying our Penthouse Suite, and pampering themselves by spending lavishly on board. There is yet another group, who goes about once a year, buying the middle of the road cabins, and spending a respectable amount on board.
It is very possible that these three groups could have very similar average CLTV, but you can see that they are distinct groups. You want to interact with these groups in different ways. Their preferences are different in destinations, cabin class, onboard spending, cruise length, and demographic and lifestyle characteristics.
Therefore, CLTV is used to determine who to target and retain, but we need more to determine how to target and maintain them. Customer segmentation is how we add the necessary information to accomplish this. Many customer segmentation methods can be used, with clustering and decision trees as two leading approaches. These approaches allow you to combine CLTV with many other characteristics to create groups of customers that are alike. Once these groups are visible, it is much easier to devise strategies to acquire, retain, and up-sell, as these groups have similar product preference, lifestyle, and spending patterns.
The ROC connectionOnce you're confident measuring CLTV, it's time to start measuring Return on Customer. ROC is our way of calculating the creation (or destruction) of customer value by measuring the change in a customer's CLTV over time. It's a way of balancing and tracking short-term campaign success with long-term customer value. Calculate Return on Customer to measure the value created by good decisions or sometimes destroyed by bad decisions. Like valuable customers and profits, you really can't have one without the other.
The foundation for measuring Return on Customersm rests on customer lifetime value (CLTV). Many companies and their C-suite executives talk about LTV and may even think they're doing it, but we find that they're not measuring it in a way that provides an actionable look into the future of how to increase customer value.
We'd like to take a step back and look at just a few of the common mistakes and potential advantages of properly measuring CLTV. Once you have your LTV house in order, ROC can be the next step.
As a starting point, customers who have a high CLTV show some simple, common metrics. They have a high total revenue or profit over their lifetime with your company. They score near the top of your customer value measurements in the areas of recency and frequency. But these metrics are not enough. CLTV also requires complex calculations of cash flow of the customer at present, your company's discounted cash flow rate and the number of time periods in the future being considered. When you actually set it out it looks like this:
CLTVti = Customer Lifetime Value of customer i at time t,CFti = Cash Flow of customer i at time t,r = Discount Rate,n = The number of time periods in the future being considered
Forget the pastC-level executives must understand that CLTV is a forward-looking measure that represents the present value of all future cash flows associated with a customer. It is the value of that customer to the company at a specific point in time. A customer is not valuable because of what they have done in the past. That value has already been realized and booked as income.
They are only valuable due to the possibility of any future behavior. If a customer who had historically spent a lot of money with a company made a statement that they are no longer going to spend anything more, their CLTV is 0.Still many companies use the amount of money spent historically to measure the value of a customer. This is a useful measure for some general purposes, as customers that have spent a lot in the past usually do spend more than average amounts in the future. But it is not a true measure of CLTV.
Another common approach is to consider recency and frequency explicitly with historical spend (commonly called monetary), which together is often referred to as RFM. This approach is simple and useful for many marketing activities, however for a metric measuring CLTV, it is far too ambiguous. The main shortcoming is that there is no theoretical methodology to combine these individual metrics into one metric that accurately measures the value of a customer.
CLTV is a forward-looking measure that represents the present value of all future cash flows associated with a customer.
Dr. Katherine LemonAssociate ProfessorBoston CollegeRFM is a useful metric in a directional sense. It can show how more recent, more frequent, and higher monetary spend usually indicates an increase in value. But what are we to conclude about two people when one is more recent, but the other is more frequent? Additionally, how do we translate these historical behavior patterns into a future assessment of behavior? RFM metrics by themselves, as we said, may be useful for some marketing activities, like selecting mail lists, or creating reporting groups and loyalty programs. The information in these metrics can be used in the more formal metric of CLTV mentioned above.
All customers with a high CLTV are not created equal. Some customers have high frequency but spend a little each time. Some have low frequency but spend a lot on each transaction, some buy items that are high margin, others buy low margin items. Therefore, CLTV is a function of many dynamics.
Identifying high CLTV customers is the first step, but to have a meaningful relationship with these customers, you need to know why they have a high CLTV. We recommend grouping customers together by their behavior, value, and characteristics.
CLTV in actionSuppose we are trying to communicate with the top 10 percent of our customers according to CLTV. For purposes of discussion, let's also assume we are a cruise company. When we try to understand our top 10 percent CLTV customers, we see that some are people who go on 3-4 cruises a year, go to standard destinations, usually go in our lowest cabin class, and spend very little onboard. There is another group that only goes every two years, but when they do, they live it up, going to exotic locations, on long cruises, buying our Penthouse Suite, and pampering themselves by spending lavishly on board. There is yet another group, who goes about once a year, buying the middle of the road cabins, and spending a respectable amount on board.
It is very possible that these three groups could have very similar average CLTV, but you can see that they are distinct groups. You want to interact with these groups in different ways. Their preferences are different in destinations, cabin class, onboard spending, cruise length, and demographic and lifestyle characteristics.
Therefore, CLTV is used to determine who to target and retain, but we need more to determine how to target and maintain them. Customer segmentation is how we add the necessary information to accomplish this. Many customer segmentation methods can be used, with clustering and decision trees as two leading approaches. These approaches allow you to combine CLTV with many other characteristics to create groups of customers that are alike. Once these groups are visible, it is much easier to devise strategies to acquire, retain, and up-sell, as these groups have similar product preference, lifestyle, and spending patterns.
The ROC connectionOnce you're confident measuring CLTV, it's time to start measuring Return on Customer. ROC is our way of calculating the creation (or destruction) of customer value by measuring the change in a customer's CLTV over time. It's a way of balancing and tracking short-term campaign success with long-term customer value. Calculate Return on Customer to measure the value created by good decisions or sometimes destroyed by bad decisions. Like valuable customers and profits, you really can't have one without the other.
