Net Present Value 

     A business must accurately predict cash flow and profitability? Customer Lifetime Value  or CLV is a method to objectively value the customer relationship based on net cash flow. But a relationship works over time. So to properly count CLV, future cash flows must be discounted. The discount rate is called the “cost of capital”. This is the rate at which a business would need to borrow in order to have cash today. To provide a comparable value in “today’s dollars”, net cash flow from future periods is discounted at the cost of capital to the business.

How to Calculate Customer Lifetime Value

Net Present Value (NPV)  = Valuing cash flow over time in today’s dollars

Expected Value= Probability of Event x Outcome of Event

1.Measuring the expected financial benefits from Retention and Referrals provides for sustained investment in Customer Care.Moves beyond “good will” and “lip service.”

2.Quantifying the expected results provides metrics for measuring the impact of Customer Care programs and actions.Turns data into knowledge that can be acted upon.

Let’s look at the Federal Government Business of ACME, summarized in Table 2.

     The next two examples will demonstrate the calculation of Expected Value and Net Present Value for this segment of Federal Government customers. In the following section, we will look at how CLV can be used to create different activity paths for different segments of customers.

Simple Example I: Calculate Expected Revenue over 2 years from a new customer

     Let’s look at the two-year history of revenue from customers. In the second 40% of customers come back and make a purchase, while 60% of new customers never return. On average, how much revenue do you get from 1000 new customers over 2 years?

     Let’s calculate the profitability to ACME of their customers, assuming that their product margin is 50% of revenue.  Of 100 new customers in year 1, only 40% come back in year 2 to make a purchase.

Simple Example 2: Measure the Profit from increasing Customer Retention

     The Customer Value Model can be used to value Customer Retention. Customer Lifetime Value is the profit you earn from a customer over their lifetime. It is calculated as the Net Present Value of the Expected Value of the profits you earn on sales to that customer in each of the years the customer remains a purchaser. Each customer provides ACME with $1,000 in profit each year that they are a customer. Net Present Value takes into account the “cost of capital” in order to discount future years profits and re-state them in today’s dollars. In this example the cost of capital is 25%.

     One of the great advantages of Customer Lifetime Value is the ability to incorporate probability in the future years. Unlike cost analysis, which is determinate, in that if you do an activity, you will incur a cost, revenue analysis is probabilistic. You can do an activity, but you cannot guarantee that the revenue will eventuate. You can increase the chances of a customer purchasing, but there are factors outside of control of the selling entity that can affect whether or not the purchase will occur. With CLV, you can take these into account.