Written by Paul D. Berger
A profitable customer is a person, household, or company whose revenues over time exceed, by an acceptable amount, the cost to a company to attract, sell to, and serve that customer. This excess, excluding customer acquisition costs, is called the Customer Lifetime Value (CLV). A major reason for its usefulness is to determine the maximum acquisition cost at which a customer is a profitable one.
While everybody would agree that, of course, we wish to minimize acquisition costs, it may turn out, for example, that a CLV analysis would tell a company that it may be able to increase its profits by spending, at the margin, more to acquire a customer than the profit made on the customer during the first transaction. This was very much the case for a cruise ship company; data clearly indicated a sufficiently high degree of repeat business to warrant an acquisition cost that exceeded the margin from the first cruise. Relatively precise values for this maximum profitable acquisition cost (i.e., CLV) were determined for different cruise destinations. It is not that we know whether an individual customer will become a repeat customer or not. It’s the fact that, given a sufficiently large amount of data (cases), we can, with a reasonable degree of confidence predict whether the repeat rate (or some other factor) is within some tolerance. The tolerance level allows a company to profit by spending money to acquire a customer, without necessarily profiting from the specific initial transaction.
By analyzing past data, we can determine the CLV for customers in general, or for different segments of customers. A segment can be virtually anything that is useful for the company. For a cruise ship company it seemed natural to segment by destination of first cruise; for a financial services company, it was natural to segment by customer asset position or degree of activity (and several other criteria). Segments are usually based on details of past purchase behavior, but can be demographically or otherwise based. In the cruise ship case, A CLV analysis was also done for different age groups, to aid in determining marketing and promotional strategy.
To find the CLV, many different quantities are tracked over time for each customer who starts at a certain time, or has certain demographics, or who buys a certain type of product (e.g., stereo equipment). Indeed, attention needs to be given to the unit of analysis (e.g., “customer” can mean a person, household, or company).
The quantities that are needed fall into two major categories. One category deals with probabilities, that is, the proportion of customers that repeat purchases, how often they do so, and in specific periods. The other category of information deals with revenues, product costs, and promotional costs (the latter often referred to as “retention costs”). These quantities tend to be available, although experience is often necessary to “dig them out,” as well as to identify changes in these quantities, such as increases in revenue due to price increases, or perhaps a pattern of ‘upward buying’ over time.
For a more detailed discussion on the topic of CLV analysis, see Berger and Nasr, “Customer Lifetime Value: Marketing Models and Applications,” Journal of Interactive Marketing, Volume 12, Winter, 1998.