Customer lifetime value has intuitive appeal as a marketing concept, because in theory it represents exactly how much each customer is worth in dollar terms, and therefore exactly how much a marketing department should be willing to spend to acquire each customer. In reality, it is difficult to make accurate calculations of customer lifetime value due to the complexity of and uncertainty surrounding customer relationships.
The specific calculation depends on the nature of the customer relationship. Customer relationships are often divided into two categories. In contractual or retention situations, customers who do not renew are considered "lost for good". Magazine subscriptions and car insurance are examples of customer retention situations. The other category is referred to as customer migrations situations. In customer migration situations, a customer who does not buy (in a given time period or from a given catalog) is still considered a customer of the firm because she may very well buy at some point in the future. In customer retention situations, the firm knows when the relationship is over. One of the challenges for firms in customer migration situations is that the firm may not know when the relationship is over (as far as the customer is concerned).
Most models to calculate CLV apply to the contractual or customer retention situation. These models make several simplifying assumptions and often involve the following inputs:
- The percentage of customers who end their relationship with a company in a given time period. One minus the churn rate is the '''retention rate'''. Most models can be written using either churn rate or retention rate. If the model uses only one churn rate, the assumption is that the churn rate is constant across the life of the customer relationship.
- The Cost Of Capital used to discount future revenue from a customer. Discounting is an advanced topic that is frequently ignored in customer lifetime value calculations. The current Interest Rate is sometimes used as a simple (but incorrect) proxy for Discount Rate .
- The amount of money a company has to spend in a given time period to retain an existing customer. Retention costs include customer support, billing, promotional incentives, etc.
- The unit of time into which a customer relationship is divided for analysis. A year is the most commonly used time period. Customer lifetime value is a multi-period calculation, usually stretching 3-7 years into the future. In practice, analysis beyond this point is viewed as too speculative to be reliable. The number of time periods used in the calculation is sometimes referred to as the model '''horizon'''.
- The amount of revenue collected from a customer in the time period.
- Profit as a percentage of revenue. Depending on circumstances this may be reflected as a percentage of gross or net profit. For incremental marketing that does not incur any incremental overhead that would be allocated against profit, gross profit margins are acceptable.
- Bauer, Hans H. and Maik Hammerschmidt (2005), "Customer-Based Corporate Valuation – Integrating the Concepts of Customer Equity and Shareholder Value," Management Decision, 43 (3), 331-348
- Berger, Paul D. and Nada I. Nasr (1998), "Customer lifetime value: Marketing models and applications," Journal of Interactive Marketing, 12 (1), 17 - 30
- Haenlein, Michael, Kaplan, Andreas M., Schoder, Detlef (2006), "Valuing the Real Option of Abandoning Unprofitable Customers When Calculating Customer Lifetime Value," Journal of Marketing, 70 (3), 5 - 20.
- Jonker J.J., N. Piersma and Dirk Van den Poel (2004), " Joint Optimization of Customer Segmentation and Marketing Policy to Maximize Long-Term Profitability ," Expert Systems with Applications, 27 (2), 159-168.
- Pfeifer, Phillip E., Haskins, Mark E., and Conroy, Robert M. (2005), "Customer Lifetime Value, Customer Profitability, and the Treatment of Acquisition Spending," Journal of Managerial Issues, 17 (1), 11-25.
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