Customer Lifetime Value – a KPI and its pitfalls

Customer Lifetime Value – a KPI and its pitfalls

What indicators should you focus on if your goal is sustainable success in online marketing and e-commerce?

content image

This and similar problems can be corrected/fixed through KPI models that put important metrics into a logical relationship. A model should represent an important goal or a company’s strategy. One such key figure model is the Customer Lifetime Value (CLTV), which is increasingly becoming a standard model. The CLTV has a lot of potential, especially in e-commerce and online marketing, where unparalleled insights into client behavior can be gleaned via analytics. It is demonstrably the success model for many successful pure players in e-commerce. The CLTV, however – and this is an important part of this article – is by no means the jack of all trades that some marketing experts would make it out to be. Because the CLTV is a composite and therefore a complex key figure, there are many opportunities for errors to arise.

After a short explanation and definition of the CLTV model, I will present two cases of application of the CLTV. The first is the use of the CLTV as a budget estimate for online marketing; the second is the use of CLTV as a general control mechanism. Because certain difficulties can arise in doing so, it is worthwhile to seek out a model for CLTV management. So, at the end I will present a practical example from Amazon and their strategy for customer centricity and will show how even small businesses can follow customer-focused CLTV strategies and models.

1. Customer Lifetime Value – here’s how it works

The Customer Lifetime Value can best be interpreted as an investment in customer relations. The model describes a temporal framework in which, at the present time, customer acquisition is undertaken through online marketing and acquisition costs (AC) are accrued. In comparison, we have future ensuing costs that can be expected over the duration of the client relationship. This length – the Customer Lifetime – gives the model its name. Here it is in no way the biological lifetime that is meant, but the expected timespan of customer loyalty. This can be 90 days or 2 or 10 years, depending on the market and competition of an e-commerce business.

As an investment appraisal, the CLTV requires fairly complex mathematics, but this belongs to the normal canon of business calculations. The CLTV can be defined as follows:

CLTV

Here:

  • AC represents the acquisition costs
  • DB(PM) represents the profit margin for a period
  • MK(MC) represents the customer service costs
  • rr represents the retention rate, from customer retention
  • i represents an internal interest rate, by which the cash value of future revenues can be calculated
  • n represents the number of periods and, thereby, the length of the customer lifetime

This discounting of future revenues is necessary to equal out current acquisition costs and future profit margins. Without the discounting, the model would be too optimistic. The capital cost rate of the business can be used as discount factor. But this factor can also be calculated individually and take certain risks into account.

A simple example shows how the CLTV can be concretely calculated:

Let’s assume a client normally spends $200 per year in an online shop, with a profit margin I of $80. The acquisition costs are a one-time cost of $50, the yearly direct costs for customer service, etc. are $10, and the retention rate is 85%. The Customer Lifetime is assumed to be 5 years, with an interest rate of 5%.

The resulting CLTV is:

CLTV = – 50 $ + 270.48 $ = 220.48 $

The CLTV as a discounted and adjusted value is thus significantly lower than the sum of the gross profit margins, which would be worth $400 for a customer lifetime of 5 years, by taking into account the retention rate, marketing, and customer service costs as well as discounting.

The measurement and determination of the Customer Lifetime Value as the target value is no small matter. The decisive factor here is the allocation of acquisition costs to individual customers or customer segments. The model implies that acquisition costs and income from customer relations must be dependent on each other. Therefore, this relationship must also be identifiable. But how do we handle a situation in which the period between an unregistered customer’s first visit to the online shop and their first order is, for example, 3 weeks?

A complete assessment of the acquisition costs is also not entirely easy. Theoretically, acquisition costs are easy to assess. With the following simple formula, the cost-per-order (CPO) can be used as a rule of thumb for the acquisition costs of an order and thus for a customer:

CLTV

This is only an estimate, however. How can the costs for search engine optimization be quantified? Are search engine costs direct costs or overhead costs? Should acquisition costs be considered for direct accesses or not?

These and other questions are complex and require decisions that must be made on a company-specific basis. It is worthwhile, however, to lay the groundwork for the Customer Lifetime Value, because then every e-commerce company will have a planning and control instrument available that can help increase customer value as a key component of the company’s value.

2. Using the CLTV in E-Commerce Controlling

The CLTV is certainly applicable in the above-mentioned customer investment calculation, but it is not yet clear how it can then be used. There are two basic approaches: on the one hand the CLTV can be used as a planning tool for online marketing and e-commerce, while on the other hand it can be used as a control tool that captures and helps to analyze results.

a. The CLTV as a Planning Tool

The Customer Lifetime Value contains many variables that make it difficult to determine the actual value for individual customers. Therefore, the easiest way to start using the CLTV model is to first use it as a planning tool. The CLTV is used to quantify goals and, in particular, to determine online marketing costs.

Firstly, the average customer retention value, the probability of a relationship, i.e. the retention rate rr, as well as the average expected profit margin, must be budgeted. The discount factor is the result of the internal rate of return with which the invested capital will be paid interest on. Take, for example, the following values:

  • Customer Lifetime: 2 years
  • Retention Rate: 85%
  • Profit Margin: $50
  • Rate of Return: 10%
  • Overheads per customer: $30
  • Profit per customer: $5

This results in a gross customer value of

Gross-CLTV = 0.85 x 50$ + 0.85 x 50 $ x 1.1-1 =81.14 $.

This amount can now be used to determine the online marketing budget (OMB) per customer. This can be determined as a residual value if the overheads and profits are deducted from the CLTV:


OMB = Gross-CLTV – Overheads – Profit

OMB = 81.14 $ – 30 $ – 5 $

OMB = 46.14 $

The value derived from this example provides a framework for determining the costs for initial acquisition as well as for subsequent customer support. Although this budgeting calculation for online marketing is not very detailed, it is constructively based on the idea of the customer lifetime cycle. Within one cycle, the costs for customer service and online marketing should be aligned with the necessary coverage of the overhead costs and the financing of the profit per customer.

b. The CLTV as a Control Tool

The use of the CLTV as a planning tool is strongly dependent on estimates and therefore can only offer a general basis for planning. The CLTV as a control tool, on the other hand, is much more concrete, since it compares the target values in online marketing and e-commerce with actual results that have been achieved. In the mid- to long-term, the basis for making decisions about customer as well as business values will be positively impacted.

The use of the CLTV as a control tool is very powerful, but also quite challenging. Data from almost all parts of the e-commerce system must be accessible and must meet the data validation requirements. The shop system, accounting, Customer Relationship Management (CRM), and Web Analytics data are all involved in this process. The aim is to match individual customer requirements with the actual income generated. The essential prerequisite for this is that customers agree to allow this data to be collected and linked.

content image

If the linking is successful, optimization of online marketing and e-commerce processes can lead to an increase in customer value development. Because the CLTV establishes a relationship between acquisition costs and revenues from customer loyalty, the direction is clearly given: acquisition costs must be reduced and revenues from customer retention must increase. Extending the length of the customer relationship will also optimize the CLTV, assuming a stable customer budget. This generates a special task for the CRM. This compiles qualitative data about customer preferences and makes them available for the optimization of online marketing and e-commerce.

The individualized creation of a customer-based CLTV is often difficult or impossible, however. User access via various technical platforms can often not be recorded or, if it can, only imprecisely. Many customers are also reluctant to register and thereby give access to their data. This significantly limits the use of the CLTV as a control tool. One compromise is to segment customers in order to specify assumptions for the CLTV model. Depending on the question, homogeneous subgroups, for which more reliable claims can be made, can be created from the target group.

3. CLTV as a Customer Loyalty Tool

Customer Centricity has established itself as a central strategy for corporate value development, even beyond such companies as Amazon and Zappos, the leading examples of customer-oriented e-commerce companies. The value of US Amazon Prime customers is currently (as of October 2016) estimated to be $143 billion. If you compare this number with the current market capitalization of approximately $360 billion (Source: Yahoo Finance), the importance of the customer loyalty program Prime for Amazon soon becomes clear. As has been shown, Prime customers spend more and their customer value increases over time.

The Customer Centricity strategy is closely tied to the Customer Lifetime Value as a control tool.

Customer Centricity is not, however, as is sometimes assumed, a particularly intensive kind of customer focus. Customer Centricity is above all a focus on certain, valuable customer segments. And these customer segments are so well cared for that their customer retention period is as long as possible and their customer values are as high as possible. A wide range of media such as Prime Video and Prime Music extends the platform’s service life and above all increases the number of registered customers. This makes it much easier for Amazon to determine and optimize the CLTV of its Prime customers.

CLTVImage 1: Amazon increases the service life of its platform with offers like Prime Music.

Conclusion

Amazon certainly has a market position that makes scaling effects in online marketing and customer acquisition and loyalty significantly easier. However, it should not be forgotten that, until a few years ago, Amazon’s success was by no means a sure thing. Customer Centricity and CLTV orientation should therefore really be viewed as a remarkable success story that is worth imitating.

Amazon’s example might put off many small and medium-sized businesses. Amazon is such an excellent market leader in e-commerce and innovation in so many fields that it is hardly possible for smaller companies to readily imitate Amazon as a whole. But that should not be an excuse not to commit to Customer Centricity and Customer Lifetime Value. The easiest way, which does not require complex tracking methods, is to build up various customer segments using a newsletter, to optimally manage these segments, and to determine Customer Lifetime Value. Because the customers can be easily identified and the acquisition costs for the newsletter are also easily determined, the newsletter segments will be the first case applications for CLTV controlling. Via Analytics they can be assigned unique performance values in online marketing as well as through the online shop so that the control takes place via the CLTV. Try it! It’s worth it.