What is Customer Equity?

 CLV, formula  Comments Off on What is Customer Equity?
Feb 222018
 

Defining Customer Equity

Customer equity is the sum of all customer lifetime values for a firm. In other words, we calculate each customer’s lifetime value and we total all of these values together to determine customer equity.

Customer equity, therefore, is the total expected profitability to be generated from a customer base over time.It is calculated using a compounding discount rate which allows us to consider the total expected profitability from our customer base in today’s dollars.

Should we include future customers in a customer equity calculation?

Existing customers are known to the organization – in that we know the current level of profit contribution, and we can estimate their retention/loyalty rate based upon our customer base history and analysis – which means that we can generally determine the customer lifetime value for each customer and then determine overall customer equity for the firm.

When we include customer is likely to be acquired in the future, we may have less information about them, but we can also make certain assumptions about their likely customer lifetime value based upon our existing customer base – which means that we have relatively reliable information to include future customers.

The reality is, that in today’s world of heavy social media usage, many businesses will gain new customers whether or not they engage in marketing-driven customer acquisition activities. This is because new customers will be attracted to the firm through referrals (both online and off-line), information they find online, then knowledge of the brand, independent research, and so on.

This means that, even if a firm stopped all their customer acquisition marketing activities, that they would continue to acquire new customers.

This is a strong case to always include future customers in the overall customer equity calculation, as the firm has earned these future customers due to their previous marketing activities and brand building efforts.

What is the customer equity formula?

Customer equity = sum of all customer lifetime values of the current and future customers

Note: as customer lifetime value should always be calculated using a discount rate, the above sum will provide the total expected profitability from current and future customers on a discounted basis as well.

An example of calculating customer equity

Assumptions for this example calculation

  • We start with a customer base of 1,000 customers
  • We “win” 100 new customers each year, even without customer acquisition actions
  • The profit we make from the average customer is $2,000 per annum
  • A 10% discount rate has been used

Note that we e are calculating customer equity assuming that the firm is NOT continuing to deliberately acquire news customers.

While this would not happen in practice, approaching the calculation in this manner is an effective way of measuring customer equity as it only takes into account marketing activities up until now.

Walk-through of the customer equity calculation

In this example, the retention rate is 60%, meaning that our churn rate is 40% – hence we lose 400 of 1,000 customers in the next year (year 1 of our calculation) and then 40% ongoing. However, this is slightly rectified due to our brand equity and we are likely to acquire 100 new customers each year, even without dedicated customer acquisition programs.

For this calculation, as we have a fluctuating number of customers each year, we can use the average number of customers in the year. In year 1 we start with 1,000 customers, but end the year with only 700 = 850 average customer base for the year.

Our 850 customers are then multiplied by the $2,000 pa per customer profit contribution, which equals $1,700,000 for the entire customer base. This figure is then discounted to 1,545,455 (to equate to a present day value).

We start the next year with 700 customers only (1,000 – 400 lost + 100 acquired) and we repeat the process with the same assumptions (but note that the discount rate compounds each year). This is continued ongoing (I use a 50 year horizon – please see this article on the rationale). And the sum of all the discounted profit contributions (e.g. 1,545,455 +1,008,264 + 700,225…) equals our total customer equity of $7,357,407.

Different customer equity calculations?

Please note that this website has an Excel template for calculating customer equity (available for free download), which calculates customer equity in three different ways.

  1. Customer equity of both current and future customers, assuming continued customer acquisition marketing efforts,
  2. Customer equity of both current and future customers, assuming no customer acquisition marketing efforts but some new customers from brand equity and related word-of-mouth, and
  3. Customer equity of the existing customer base only, with no future customers considered.

Depending upon your measurement purpose, each customer equity calculation method has some merit and value.

The first method is similar to measuring the overall value of a business as a going concern as it is likely that successful marketing activities will be continued.

The second method measures the impact and success of all marketing efforts up to now in creating value and customer profitability for the firm.

And the third method is more suitable for a small business (with limited brand equity) that is unlikely to acquire new customers without any marketing efforts.

Related Topics

The free Excel template for calculating customer equity

Why customer equity is a powerful metric

Customer Lifetime Value (CLV) may be more appropriate than Marketing ROI

 CLV, formula  Comments Off on Customer Lifetime Value (CLV) may be more appropriate than Marketing ROI
Jan 292018
 

Using CLV to determine Marketing ROI

Let’s assume that:

  • the average customer acquisition cost for a company is $100
  • the average annual profit for this customer cohort is $60
  • and the average customer lifetime is three years.

The firm determines that the profit contribution is $180 before consideration of the initial acquisition cost (which means that CLV =$80).

In this case, the marketing ROI is ($80 / $100 = 80%). In other words, the marketing department has turned $100 into $180 by acquiring new customers.

Using Marketing ROI Instead of CLV

This approach may be preferred to the standard marketing ROI calculation because it looks at a longer time horizon. Let’s look at the same situation above, but this time only looking at a one-year horizon:

  • Average acquisition cost = $100
  • Average customer profit per year = $60

BUT the average customer lifetime period of 3 years is NOT considered in marketing ROI, because with a marketing ROI calculation, we generally only consider incremental results on a short-term basis, such as the first year only in this example.

This would mean that the marketing ROI would be calculated as:

  • Marketing ROI =          (Improved profits less marketing costs)/marketing costs
  • Marketing ROI =          ($60 – $100)/$100 = – 40%

When only ONE year is considered in marketing ROI (which is common practice when measuring a campaign with short-term results, then the ROI in our example is negative 40% – that is, we lost money for the firm.

The CLV calculation however, shows that the campaign had a positive contribution because profits from these customers continued for a further two years on average.

This means, particularly for marketing campaigns that deliver long-term results, calculating customer lifetime value will provide a better evaluation of marketing performance.

Customer retention rate should increase over time

 formula, retention  Comments Off on Customer retention rate should increase over time
Jul 232016
 

One of the major impacts on overall customer lifetime value (CLV) is the firm’s ability to retain customers. An increased loyalty rate can substantially increase the average lifetime period of the customer, resulting in a significant increase in customer lifetime value.

However, it is unlikely that any cohort of customers will have a static retention rate. It is likely that retention will increase over time. You should note that the free template provided on this website to calculate customer lifetime value, allows you to modify the retention rate each year.

Obviously, for most firms/brands there is a natural goal to increase retention rate – but this will happen automatically in most cohorts of customers.

Example of increasing retention rate

Let’s assume we have acquired 100 customers in a particular year. Upon their first/early experiences with the firm/brand, they will go through some “customer satisfaction” (post purchase) evaluation. As you probably know, this is aligned to their expectations prior to purchase.

natural customer retention rate over timeLet’s assume that 25% of these new 100 customers are relatively dissatisfied with their purchase, with the remaining 75% relatively satisfied with their purchase.

You would probably guess that many of the 25% dissatisfied customers are unlikely to continue as customers into the second year – and you can probably also guess that a significant proportion of the 75% satisfied customers will remain loyal to the firm/brand.

If we enter the second year, say with a 60% retention rate – with all of these retained customers being part of the original satisfied group – therefore we held 60/75 of these satisfied customers and we lost all 25 dissatisfied customers.

Therefore, as we enter year three, we only have generally satisfied customers. While we had a 40% churn/loss rate in the first year – due to a proportion of new acquired customers being dissatisfied – they have left the firm/brand – and will not impact the retention rate of this customer cohort into year three.

This will mean that we are likely to see a significant jump in retention rate for this customer cohort – perhaps up to 80%. This process likely to continue, with the quite satisfied customers continuing and the less satisfied customers being more likely to drop off. Over time, the firm/brand should be left with a small, but loyal and quite satisfied, customer base – where retention keeps increasing.

Customer lifetime value – does the average lifetime period make sense?

 formula  Comments Off on Customer lifetime value – does the average lifetime period make sense?
Jul 232016
 


Perhaps one of the confusing aspects of calculating customer lifetime value (CLV) is working out the average period that a customer purchases from the firm/brand. Sometimes it seems inconsistent with the percentage of customers retained.

In this article, we will work through why this sometimes seems to be an inconsistency. For this example we will use an 80% retention rate. As we know, as this equates to a 20% churn rate, which is 1/5 as a fraction, making the average lifetime period for customers five years.

However, if we keep decreasing our customer base by 20% (the churn rate) each year, then at the end of the five years we only have around a third of the starting customers – so how can five years be the average period?

Let’s assume we start with 100 customers that are acquired in a particular year and our goal is to track this cohort’s customer lifetime value. With an 80% retention:

  • 80 of them will continue into year two,
  • 64 into year three,
  • 51 into year four,
  • 41 into year five, and
  • by year six there are only 33 of the original 100 customers.

Therefore, the question is given we have only around one third of customers continuing past year five, how can the average lifetime period of this customer cohort be five years?

clv customer contributionIf we use the chart provided here – please note that the lines are mapped onto two different axes – you can see that the red line maps our 100 original customers on a progressively decreasing basis. And by year six there are around one third of the original customers still active with the firm/brand.

The blue line needs some slight explanation. The blue line represents the number of customers who leave in a particular year, multiplied by the number of years that they are a customer. For example, in year one we lose 20% of the 100 customers – and therefore 20 customers – they were only customers for one year.

However, in the second year we lose 20% of the remaining 80 customers – which is 16 customers. But as they were customers for two years, they were equivalent to 32 “single year only” customers. In year three, we lose a further 20% of the remaining 64 customers – which is about 13 customers – as they were customers for three years, they are equivalent to 39 “single year only” customers.

Therefore, the blue line maps the contribution – in terms of customer years – of the customers that are lost in that particular time period. As you can see, the blue line peaks around years four and five, indicating that the average of customers will be dragged towards  four or five years’ worth of value (as opposed to a single year only customer).

The other factor to consider is the long tail of the red line. As you can see, it is somewhat flattening out, meaning that they customers remaining are relatively loyal, and are likely to be long-term customers. For example, in year seven, we only lose 5% of our original 100 customers. These five customers, have been dealing with the firm/brand for seven years. As you can see, we still have 15 to 20% of customers dealing with us up until you 10 – and beyond – which has the impact of extending the average lifetime period (essentially as a weighted average) to five years.

Related topics

Main customer lifetime value formula

Using the retention rate to calculate average lifetime period

 formula  Comments Off on Using the retention rate to calculate average lifetime period
Jul 232016
 

When calculating customer lifetime value (CLV), one of the key inputs is the number of years that the average customer will purchase from the firm. This is surprisingly easy to calculate if you know the loyalty/retention rate of customers.

The formula for average lifetime period of customers is simply 1/(1-retention rate).

You should know that the opposite to the retention (or loyalty) rate is called the churn rate – which is the percentage of customers that are lost in the time period.

For example, an 80% loyalty/retention rate means that 20% of customers are lost (churned). And a 60% loyalty/retention rate means that 40% of customers are lost/churned. In all cases, the retention and the churn rate should add up to 100% to account for all the customers.

If we relook at the above formula for average lifetime period, then it could be further simplified as 1/churn rate. And if we convert the churn rate to a simple fraction, then we can quickly work out the average lifetime period as follows:

20% churn rate = 1/5 = average lifetime period = 5 years

33% churn rate = 1/3 = average lifetime period = 3 years

50% churn rate = ½ = average lifetime period = 2 years

Hopefully what you should notice, is when we convert the churn rate to a simple fraction – where we have 1 as the numerator (top number), we can simply take the bottom number (the denominator) as the number of years.

This occurs because, as we divide the fraction into one, the calculation has the impact of inverting the fraction.

Therefore, if you remember your approach to dividing fractions, you should be able to work out the average lifetime period for any fraction – by inverting the fraction. And you may recall from mathematics, that to divide a fraction you turn it over and multiply it. Because we are dividing into one, we end up multiplying by one – so all we have to do is invert the fraction.

For example, if we have a 30% churn rate, as a fraction that is 3/10. When we invert that we get 10/3 – which is equivalent to 3.33 years.

Likewise, if we have a 40% churn rate, that is equivalent to 2/5 – we then invert it and get 5/2, which is equal to 2.5 years.

Existing Customer CLV Formula

 formula  Comments Off on Existing Customer CLV Formula
Jun 182016
 

A fairly standard CLV formula that you will find for measuring the lifetime value of existing customers is:

CLV = m.r/1+d-r

  • Where m = customer margin (or profit contribution) per year
  • Where d = discount rate
  • And r = retention/loyalty rate per year

Important note: This formula is designed to measure the customer lifetime value of EXISTING customers only. You should also note that there is NO use of an acquisition cost, as existing customers have already been acquired and that expense is now historical (or a sunken cost).

How this CLV formula for existing customers works

To make sense of what this formula is doing, let’s first look at the bottom line of 1+d-r, but remove the discount rate (d) and we are now left with 1-r.

We should know that 1 minus the retention rate is churn (or customer loss) rate. When we use the churn rate at the bottom (denominator) of the fraction/equation, we are actually calculating the lifetime period of a customer in years.

  • For example, a 60% loyalty rate = 40% churn/loss = 1/0.4 = 2.5 years, and
  • An 80% loyalty rate = 20% churn/loss = 1/0.2 = 5 years

Now let’s look at the impact of the retention rate at the top of the equation. At the top of this CLV formula (numerator) there is m times r. This has the immediate impact of reducing the margin (profit) to the likely margin be be achieved in the FOLLOWING year.

This occurs because the formula is looking at an existing customer (already acquired) and estimating their FUTURE value – not their total value over the course of their customer relationship.

comparing clv formulas

Click CLV table to enlarge

To make sense of this difference, let’s compare a new customer’s CLV to an existing customer.

The new customer is shown on the left hand side. As you can see, their acquisition cost was $500 in Year 0, their margin was $300 in Year 1, which then reduces by 60% each year in line with estimated retention rates.

After the 10% discount rate, their CLV (shown as DCF = discounted cash flow) is $160.

On the right hand side of the table, the CLV figures are shown for an existing customer using the above formula.

As you can see, there is NO acquisition cost (as they are already a customer), and we essentially start the customer in Year 2 with a annual margin of $180 (which is 60% of Year One’s $300 – note the two highlighted yellow cells).

In this case, the customer value (after discounting) is $360. This is also what the above formula tells us:

  • CLV = m.r/1+d-r = (300 X 60%)/(1+.1-.6) = 180/0.5 = $360

Limitations of this CLV formula

The main concern with this approach to calculating customer lifetime value is its use of static values. Firstly, it assumes a stable margin (annual customer profit), which is generally unlikely (please see article on increasing customer revenues). And secondly, it also assumes a stable loyalty rate over time, which again is generally unlikely.

That’s why the free CLV Excel template available on this website allows for flexible revenues, costs and margins over time.

So why use this CLV formula?

CLV = m.r/1+d-r is appropriate as a simple estimation of future customer value. It can be easily applied to a customer database (say in a spreadsheet format) where the customer’s profit/margin for the year is listed, along with an estimated loyalty/retention rate.

This CLV value becomes a forward-looking metric that a marketer can use to determine the financial viability of various cross-selling and loyalty focused marketing tactics.

Related Topics

CLV: New versus existing customers

Customer Lifetime Value: Existing versus new customers

 formula  Comments Off on Customer Lifetime Value: Existing versus new customers
Jun 182016
 

Are you measuring the CLV of existing or new customers?

Customer lifetime value calculations, and the most suitable CLV formula to use, will vary depending upon what type of customer that you are attempting to measure. To make this point quite simply, there are two main types of customers that we are seeking to measure for customer lifetime value purposes, which are:

  1. Existing (current) customers, or
  2. Potential (new) customers (which will also include reacquiring lost or lapsed customers).

Key CLV formula differences between existing and potential customers

There is a significant different in the CLV calculation for these two categories of customers. The most significant difference is in regards to the treatment of the acquisition cost. Obviously, existing customers have already been acquired – hence their acquisition cost is essentially a sunken cost that we would not take into account. Whereas new/potential customers still need to be acquired and will incur an acquisition cost.

The second difference is that the loyalty (retention) rate of existing customers is likely to differ between existing and new customers. To make sense of this retention rate difference, let’s consider this graph of customer loyalty over time.

loyalty rate over timeThe first arrow on the left shows the loyalty rate for (new) customers after the first year of just 60%, whereas the arrow on the right shows the loyalty rate of existing customer (in years 7-8) approaching 80%.

So why does this happen? When you think about it, the loyalty rate pattern makes logical sense.

At the start (year 1), new customers are essentially trialing the brand’s/firm’s offering. If they are dissatisfied (or a consumer more prone to switching), then they are more likely to churn (switch or lapse) early in their brand relationship. However, if they are satisfied with their initial purchase and remain loyal after the first year, it is likely that the loyalty rate of the remaining customers will increase over time (as the less satisfied customers decide to discontinue or switch brands).

Example of different CLV calculations: New versus existing customers

To make the customer lifetime value calculation as simple as possible, let’s assume:

  • The acquisition cost of new customers is $1,000
  • The customer profit (revenues less appropriate costs) is $500 per year
  • The loyalty rate of new customers is 60% (as per the above table, which = 2.5 years)
  • And the retention rate of existing customers is 80% (say for year 9 in the table above, which = 5 years)

Therefore, the customer lifetime value of NEW customers would be:

  • $500 X 2.5 years, less $1,000 = $250

And the CLV of EXISTING customers would be:

  • $500 X 5 years = $2,500
What do these CLV results mean?

As you can see, the customer lifetime value for existing customers is 10 times the value for new customers. However, this is to be expected. Due to the loyalty rate pattern for this example (60% increasing to 80%+ retention), there is only a small number of existing customers after ten years.

percentage of customers over timeLet’s now look at the percentage of customers that actually remain loyal for ten years (even with a retention rate of 60-80%). As you can see in the graph, only around 5% of customers are still with the firm/brand at the ten year mark.

These customers are highly loyal (most probably due to choice, rather than habit at this stage) and therefore should be quite profitable ongoing.

And compared to the less loyal newer customer, their CLV figure will be naturally higher. But keep in mind that within every cohort of new customers there will be very short-term low value customers, as well as a small number of long-term high value customers.

Impact on new versus existing customer acquisition strategy

Based on the differing CLV’s of new versus existing customers, there is possibly a suggestion that the best strategy would be to focus on existing customer only. But you are probably aware of the leaky bucket theory – which suggests that even with high retention rates there will always be a drain on customer numbers (as illustrated in the previous chart).

Therefore, the clear strategy should be to continue with new customer acquisition, with the intent of identifying (or creating) the long-term, high value customer than underpins the ongoing profitability of the firm or brand.