Customer lifetime value model input parameters

The CLV per customer is calculated as follows (Gupta et al., 2006:141):

𝐶𝐿𝑉 = ∑[𝑃𝑡− 𝐶𝑡]𝑟𝑡 (1 + 𝑖)𝑡 − 𝐴𝐶 𝑇

𝑡=0 where:

 Pt is the price a customer pay at time t,

 Ct is the direct cost of the product or service at time t,

 i is the discount rate at time t,

 rt is the probability that a customer will return to the organisation at time t,

 AC is the acquisition cost of the customer, and  T is the lifetime period of customer engagement.

Each input parameter within the CLV model should be carefully examined and calculated to give an accurate representation of the market environment. The CLV model can be disaggregated into five parts: how much return the organisation makes from each customer per product, how long the customer uses the product, the organisation’s discounted rate, the probability that the customer will return to the organisation after using the product, and how much it costs the organisation to acquire the customer. The CLV input requirements are briefly reviewed below; thereafter the methodology for obtaining the input parameters from the product lifetime uptake model is explained in detail.

5.2.1.1 Profit per product

Pricing forms an integral part of the product’s customer value proposition statement. Pricing is one of the fundamental Ps of marketing, and it should be in line with the customer value propositions. The integrated value proposition design framework will suggest a pricing strategy that is aligned with the organisation’s objectives. The price should either be maintained at the industry standard or reduced below the industry standard. Either way, the pricing strategy identifies the optimal price of

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the product and the cost of the product, which in turn is used as input parameters in CLV calculations.

5.2.1.2 Time period

This refers to the time period that a customer is classified as being actively involved with the organisation. The regularity of customer purchases depends on the type of product and its billing arrangement. Products associated with contract subscription payment agreements are generally easier to use in CLV calculations, as such agreements guarantee regulated cash flow. The data obtained from subscription agreements has short feedback loops, and therefore offers a good premise for customer behaviour analysis. For transaction-based product payment agreements, the retention rate is used to calculate the time period of customer engagement.

5.2.1.3 Discounted rate

The discounted rate is the net present value interest rate that compares the organisation’s current expenses with all future income streams. The discounted rate is used to compare the desirability of the organisation’s investments. A customer-centric organisation manages customers as investments; therefore the discounted rate is an indication of the attractiveness of having that customer active in the organisation. Making use of a discounted rate, the CLV calculation shows an organisation whose customers will generate profits in the future; and in that way the organisation can channel its marketing spend.

An organisation’s discounted rate is determined by a weighted average cost of capital (WACC) methodology. The WACC is a combination of the cost of equity and the after-tax cost of debt. Cost of equity (Re) is what it costs an organisation to maintain a share price at an acceptable level. The cost of debt (Rd) is the effective rate an organisation pays on its current debt (McClure).

The cost of equity is calculated as follows:

𝑅𝑒 = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓) where:

 Rf is the risk free rate;

 β is the rate of how the organisation’s share price performs in comparison with the market as a whole; and

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The risk free rate Rf represents the amount of equity the organisation obtains from risk free investments such as government bonds. A β rate of 1 indicates that the performance of the organisation is in line with the other competitors in the market; if β is greater than 1, it indicates that the organisation’s share price performance is better than the competitors; and contrariwise if β is less than 1. Equity market risk premiums are the rate on returns expected above the risk-free investment rates.

The final input parameters to calculate the discounted rate are the total equity over total organisation value (equity + debt) ratio, and the total debt over total organisation value ratio. From these, an organisation’s discounted rate is calculated as follows:

𝑊𝐴𝐶𝐶 = 𝑅𝑒𝐸

𝑉+ 𝑅𝑑(1 − 𝑐𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)

𝐷 𝑉

5.2.1.4 Customer retention rate

Customer retention rate is the ratio of the number of retained customers from one period of time to another. In other words, it represents the probability that a customer will be an active customer at a certain time, given that he or she was an active customer at a previous time. The customer retention rate is calculated as follows:

𝑅𝑅 = 𝐶𝑇− 𝐶𝑛 𝐶_𝑠 where:

 CT is the total number of customers at the end of the period,

 Cn is the total number of new customers at the end of the period, and

 Cs is the total number of customers at the start of the period.

5.2.1.5 Acquisition cost

Customer acquisition cost is the cost associated with acquiring a new customer. The modelling approach within the integrated value proposition design framework uses a high-level calculation of customer acquisition cost, which can be calculated either by adding all the marketing expenditure of a period of time, divided by the number of customers over that period of time, or by multiplying the direct marketing cost aimed at a customer by the probability of the response rate of the customer.

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𝐶𝐴𝐶 = 𝑀𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔 𝑠𝑝𝑒𝑛𝑑

𝐶𝑛 or

𝐶𝐴𝐶 = 𝑀𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔 𝑆𝑝𝑒𝑛𝑑 × 𝑟𝑒𝑠𝑝𝑜𝑛𝑠𝑒 𝑟𝑎𝑡𝑒

The marketing spend used in the customer acquisition cost calculation is the direct marketing cost aimed at acquiring new customers – for example, call centre costs or direct messaging costs.