Why Customer Lifetime Value is So Confusing?

by admin

Why Customer Lifetime Value is So Confusing?

by admin

by admin

In the business world, Customer lifetime value (CLTV) is one of the most mentioned yet also one of the most confusing business terms. The confusions about CLTV mainly arise from its name that is not precisely defined. The same term CLTV may have different meanings for different people using it.

According to the prevailing CLTV definition, CLTV is the present value of future profit attributed to the customer during his or her entire relationship with the business. The main purpose of calculating CLTV is to identify the upper limit of the new customer acquisition cost. Basically, CLTV tells you that if you acquire a customer today, how much future profit this customer will bring to you from the entire relationship with you. With that number, marketers can determine the appropriate amount to spend on customer acquisition. Therefore, a more accurate name for this type of CLTV probably should be something like Customer Lifetime Value for Acquisition, or simply, Acquisition Customer Lifetime Value (ACLTV).

The reason why I wanted to give it such a precisely defined name is that I wanted to differentiate it from another CLTV – the Existing Customer’s Lifetime Value (ECLTV). Theoretically speaking, ECLTV = historical lifetime value of the customer + future lifetime value of the customer. However, since the function of historical lifetime value can be replaced by the total margin amount, therefore, ECLTV sometimes only refers to the projected future customer lifetime value of an existing customer. ECLTV is a very useful metric for marketers to manage customer relationships and improve customer experience.

While both metrics are called CLTV, ACLTV and ECLTV are different in the following four ways:

First, in retail, ACLTV can only be calculated at a group level, but ECLTV can be calculated at an aggregate level or at an individual level as well.

In retail, ACLTV can only be calculated at an aggregate level because there is no way for retailers to collect info about each individual prospect. Therefore, marketers have to use the historical data of existing customers to predict the lifetime value for the to-be-acquired customers that are similar to these existing customers. In the financial industry, however, ACLTV can be calculated at either the individual level or at the group level. For instance, financial institutions predict ACLTV for each individual credit card applicant (prospect) to determine the qualification of that applicant. The reason why financial firms can do so is that they have the privilege to gather enough info about credit card applications such as salary, previous credit scores, past transaction data, home value, etc. even though that applicant had no previous relationship with the company.

Regardless of what types of industries, ECLTV can always be calculated at the individual level or at a group level as well.

Second, the time horizon in ACLTV and ECLTV calculations are different.

The name lifetime implies that the length of ACLTV calculation is a customer’s entire relationship with the company. Theoretically, that is correct. However, in practice, marketers normally use only 3 to 5 years’ worth data to estimate the ACLTV; because any projection beyond 5 years will be deemed as too speculative and not reliable especially in today’s fast-changing business environment. Therefore, the so-called customer lifetime value is only the predicted future value of the 3-5 years. That is another reason why this business term is not precisely defined.

Unlike ACLTV, the starting point of time horizon in ECLTV can be the first purchase date or the earliest purchase date of the customer in the database which could be much earlier than3 or 5 years. In other words, you may use the entire transaction history of the customer to predict his/her future value as long as the historical data avails in the customer database.

Third, ACLTV can be either a forward-looking or a backward-looking metric, while ECLTV is always a forward-looking metric.

Most people know that CLTV is a forward-looking metric. It is true for ECLTV. But ACLTV can be used as a forward-looking tool and/or as a backward-looking tool as well.

When ACLTV is used to determine the upper limit of acquisition spends, it is a forward-looking tool. When ACLTV is used to measure the results of past marketing performance, it is a backward-looking metric. In both cases, ACLTV is calculated based on historical data. The only difference is that when ACLTV is used as a forwarding tool, the ACLTV calculation may need to reflect the planned future marketing endeavors. For instance, if a referral program is going to be launched next year, the company would expect to have more sales from referrals due to the incentives of the referral program; in the meantime, the marketing costs will increase as well for implementing such a program. Therefore, the ACLTV calculation needs to factor both changes into the calculations.

When ACLTV is used as a backward-looking metric to gauge results of past marketing performance, it measures only what already happened in the past, there is no need to consider future marketing changes; therefore, no adjustment is needed.

Fourth, business applications are different.

ACLTV has three major uses. first, it aids marketers to decide the upper limit of the acquisition spend. This is probably the most important and practical application of ACLTV. Second, it helps measure the effectiveness of past marketing efforts when used as a backward-looking tool. And third, when used together with ECLTV, ACLTV helps appraise the value of a company.

ECLTV mainly serves as a customer management tool. When used together with other metrics such as RFM, marketers can develop contact strategies to target each customer in a more personalized manner (See Chapter 2: Developing Actionable Segmentation for details). Another important ECLTV use is in the customer-based corporate valuation model where both ACLTV and ECLTV are needed to estimate the value of a company.

From the comparisons above, you can see that ACLTV and ECLTV are two totally different metrics with different definitions, different calculations, and different business applications. Understanding the nuances between these two metrics is very important, especially when it comes to using customer lifetime value for developing acquisition and retention strategies.

To eliminate confusion, I would highly recommend replacing the current broadly and vaguely defined term of CLTV with more accurately defined terms namely ACLTV and ECLTV instead.

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