Concepts behind a Customer Lifetime Value formula - Part 1 of 4
This is the first in a series of articles on Customer Lifetime Value (CLV). CLV is an important predictive metric, at the intersection of marketing and finance, providing business managers and senior decision makers with forward-looking information on customer relationship performance. Customer relationship performance is a key driver of firm value, risk management and profits. In addition, a focus on CLV enables a customer centric business culture and is the core of customer value management.
This article provides a definition of CLV, grounded in finance, accounting and marketing theory.
What is customer lifetime value?
There are many variations on the definition of Customer Lifetime Value (CLV). Central to all definitions of CLV is the idea that it is an economic value derived from the firm’s relationship with its customers.
Inside the concept of economic value is the notion that money has a time value. Economic value also includes the idea that value is based on what someone would pay “today” (in the present) to consume or own something.
The firm’s relationship with its customers is an economic relationship. Economic relationships are evaluated based on the value exchanged over time periods. While past transactions maybe a predictor of future transactions, by definition, past transactions have no present value. For example, you can’t consume the same piece of cake twice. Eating a piece of cake may be a predictor that you will consume a piece of cake in the future, but, once the present piece of cake is consumed, it cannot be sold or consumed again. The present value (what someone would pay today) for an eaten piece of cake is zero.
As a consumed piece of cake has no economic present value, past customer transactions have no economic present value for the customer relationship. However, past customer transactions may be used as a predictive driver of the economic value of a firm’s customer relationship. For CLV, the economic value of this relationship is measured over future time periods.
Within this economic value context, Customer lifetime value (CLV) is defined as a measure of the “present value of future cash flows attributed to the customer relationship”. It is a forward looking concept, and as such can be considered a leading indicator of financial performance. This definition is grounded in the finance theory concept of “value”, the accounting concept of “going concern” and the FASB characterization of “assets”. All three concepts apply on a look-forward basis. On this foundation, a focus on three key aspects of this definition will deepen the understanding of CLV: present value, future cash flows, customer relationship.
In the next part of this series, we will explore in more detail the basics of finance theory which impact customer lifetime value calculations. We will provide a usable customer lifetime value formula and provide specific instructions on modeling customer lifetime value in practice.
 Robert M. Conroy, Mark E. Haskins, and Phillip E. Pfeifer, “Customer lifetime value, customer profitability, and the treatment of acquisition spending,” Journal of Managerial Issues Spring 2005: p17.
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