Feb 112016
 

The accounting challenge of customer lifetime value

One of the key challenges with communicating the benefits of customer lifetime value (CLV) as a key marketing metric is its alignment (or perceived lack of) with the firm’s overall profitability.

Take for example, a marketer who has determined that the firm’s CLV is $300 (before taking into account the initial $200 acquisition cost) and the marketer has also worked out that the average customer retention rate is 75% (or four years on average). The marketer could then argue that an acquisition cost of $200 per new customer (leaving a net CLV of $100) would be quite acceptable and would actually deliver a good marketing ROI of 50% ($100 profit/$200 acquisition cost – not including a discount rate).

Enter the accountant: who then points out that the firm made $2 million last year and that the firm has a customer base of around 40,000 customers – which clearly shows that each customer only makes $50 per year for the firm ($2m/40,000). Therefore, according to the accountant it doesn’t make sense to acquire customers at a $200 each – when they only make $50 per year and last only four years – “the firm would be lucky to break-even doing that“.

This would not be an uncommon situation for a marketer – so how do we reconcile the $100 customer lifetime value with the average $50 profitability quoted by the finance expert? Let’s have a look in the next section.

Aligning CLV to Overall Profitability

The problem with the above discussion is that the position is confused by the firm’s fixed costs and the overall acquisition (marketing/promotion) budget. So let’s reconcile customer lifetime value and the accounts.

  • The firm made a profit of $2 million last year
  • The firm had fixed costs of $800,000
  • And they had a marketing/acquisition budget of $200,000
  • Therefore, their profit BEFORE fixed costs and new customer acquisition costs was $3 million

So what does this $3 million profit represent? This is the profit generated by the current/existing customer base for the year. We have removed the fixed cost component and we have removed the investment in new customers. Therefore, this is the key financial number to get to = which is profit contribution of the existing customer base. So now we can continue our accounting and CLV connection.

  • The profit contribution of the existing customer base was $3 million
  • The firm has a 40,000 customer base
  • This means that each customer contributed $75 in profits (on average)
  • The average customer lifetime is 4 years
  • $75 (per customer profit) X 4 years = $300

Yes, we are back to the $300 customer lifetime value amount quoted by the marketer initially. So the marketer is right, the firm can spend $200 on customer acquisition, as they will make $300 back – every new customer is worth a net $100 to the firm.

An approximate customer lifetime value metric

Given this reconciliation of profits and CLV above, we should be able to work backwards as well and construct a ball park estimate of customer lifetime value using the firm’s top level financials (although I would suggest that you use the Excel template on this site to ensure greater accuracy).

As an example of this approximate CLV metric:

  • A firm made $10 million in profits
  • Add back their fixed costs, say $4m = $14 million
  • Add back their marketing budget, say $1m = $15 million (profit from existing customers)
  • Divide by their customer base, say 100,000 = $150 (profit per customer)
  • Multiply by average customer lifetime, say 5 years = $750 (CLV before any acquisition costs)

This is possible metric that you could use to:

  1. Verify/ball park check your own CLV calculations
  2. Set targets for improving CLV – e.g. if profits are to increase by $1m, what does CLV need to get to?
  3. Estimate competitor customer lifetime values

Help in setting CLV targets for increasing profitability

If you look at the 2nd way you could use the CLV “appropriate” metric above, you can see it can be used for setting a customer lifetime value goal/target. Let’s continue with the above example and figures to see how that would work.

  • Firm’s profit of $10m, with a goal of increasing to $11m
  • Without any other major changes, this would mean that the profit contribution from the customer base would need to increase from $15m to $16m
  • If the customer base remains at 100,000 – then profit per customer per year needs to go from $150 to $160
  • With the 5 year average lifetime, total CLV (before acquisition costs) needs to increase from $750 to $800 (assuming acquisition costs per customer remain the same)

As you can see – the $10 increase in profit ($150 to $160) X 100,000 customers = $1 million profit increase. But that’s just a guide – our task, as the marketer, is to increase CLV from $750 to $800, and that increase could be achieved by:

  • Increased revenue per customer
  • Decreased costs of supplying/servicing the customer
  • Decreasing retention costs per customer
  • Increasing loyalty (lifetime) per customer
  • Decreasing the acquisition cost (more customers/same spend)

And, of course, we could grow the customer base instead – but the purpose of this article is to discuss CLV considerations.

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