Calculating the Lifetime Value of a Customer

Lifetime value of a customer measures the lump sum dollar value of what a customer is worth to a seller today in terms of lifetime profitability. A brief internet search on the topic gives the impression that this is a fairly easy calculation to make. It really is not. Unfortunately, many examples available online are overly simplified so as to give an incorrect estimate. Additionally, even with the right equation, without using appropriate numbers, one’s estimate could be far from the truth.

To make the calculation, one needs estimates for:

1)    Spending per visit

2)    Visits per Week

3)    Profit margin per dollar spent

4)    Expected Lifetime

5)    Retention Rate

6)    Suitable Discount Rate (cost of capital)

From these estimates, we compute the contribution to the firm’s profits over the customer’s life measured as a lump sum today. For example, suppose the typical customer at a convenience store spends $6 per visit and averages 3.5 visits per week. With a profit margin of 25%, the typical customer will generate $273 in profit this year. Assuming a 20 year lifetime, a 50% retention rate and discounting at the company’s cost of capital of 10%, the lifetime value of a customer is currently $500.

One major implication of the analysis is this – don’t think of the customer as spending just $6. Think of the customer as a person who will add $500 to your profits over the course of their life.

A second major implication of the computation is this– the retention rate is extremely important. Doubling the lifetime value of a customer would require a doubling of some combination of spending per visit, visits per week and profit margin. However, raising the retention rate from 50%to 80% doubles the lifetime value of a customer from $500 to $1,000.

A major omission in much of the marketing literature that focuses on the topic is the lack of a discussion on which discount rate to apply to future values. Or worse, there are website examples that do not even discount future values. Of course, if customers do not stay over a long period, this is a moot point. But if the goal of the firm is to nurture relationships, and management is savvy enough to know it is easier to keep a customer than find a new one, then the customer’s lifetime will be several years. Just keep in mind that a present dollar is worth more than a future dollar.