Product Manager’s guide to Customer Lifetime Value — Part I
Calculating Customer Lifetime Value (CLV)
The CLV is an important metric in modern product development, but sadly, it often gets overlooked. Most likely because it’s often thought of as a metric reserved for sales and direct marketing functions. In a nutshell, the CLV forms the foundation of Customer Value Management, so tracking this metric can help product managers understand how much monetary value is created across customer segments as a result of new product releases and fixes.
The best cross-functional product teams will refer to quarterly/yearly CLV as part of their KPIs in order to gauge value created for specific segments. After all, modern product development is all about maximising customer value. As per the Scrum Guide, “ the Product Owner is responsible for maximising the value of the product”. In practice, the Product Manager/Owner should be able to track and use the CLV to monitor effectiveness and even inform key product decisions such as backlog and roadmap prioritisation.
I’ll talk more about how PMs and Scrum teams can make use of the CLV in an upcoming article. For now, let’s focus on understanding and performing a CLV calculation. (In part II we will put these calculations to action to reach a product pricing decision).
Let’s break down each element of the equation. In reality, it’s more straightforward than the equation shows:
t for a period of time:
t denotes a time-period. In practice, this will typically indicate a month or year. t = 1 is essentially the time of acquisition, for example, the first period during which a particular customer paid for a subscription product or made a first one-off purchase.
M for margin:
This is the average margin we make per period (t) for a customer of a particular product. It’s how much money we make per customer having subtracted variable costs. M is also often written as CM — Contribution Margin.
r for retention rate:
The retention rate is the probability that at any given time period, the customer will also remain our customer for the subsequent period. Past data is an accurate enough way to calculate this percentage.
d for discount rate:
Since this is called a “Lifetime-Value” calculation, we need to take into account the time value of money. In other words, money that a customer gives us in the future (if they are still our customer ) will not be worth the same as today. As such, we need to discount future cash flows at a particular rate. We call this action “finding the present value of future expected money” or the Net Present Value (NPV).
The reason we are even talking about NPV is that the whole denominator of the Customer Lifetime Value(CLV) is the equation for the NPV (Net Present Value). It’s worth taking a moment to breakdown the NPV with a simple example as it will help us better understand the role of the discount rate (d).
Net Present Value explained
Consider the following example cashflow projections:
The NPV uses the discount and retention rate to better represent future cash flows in today’s monetary terms. For this example, the discount rate will be 10%. We consider t=1 to be the time of the acquisition, so we don’t need to apply a discount because the customer has paid us in present value.
Let’s have a look at the retention rate. In month one, we know that only 90% of our customers stay with us for a subsequent month. So projecting this effect further in the future, we get an exponential retention rate of 0.9²( = 0.81) by month two, and a 0.9³ (=0.66) by month three. Together, the retention and discount rates allow us to discount future margins to match today’s monetary value as follows:
Notice that we are adding the 10% discount percentage to integer 1. This is because we need a number larger than 1 to divide our numerator with and thus achieve a decrease (discount) to the value of M (so add 1 to each discount rate).
Now let’s consider a practical example. Let’s assume that in our NPV scenario, the 10% discount rate represents the current interest rate reward for saving our money at our bank. If we were to save the same amount of M today, it would be worth more money than if we were to wait and receive M in two years. This is because during the elapsed time we could own M plus 10% in annual interest. This is why the value of current interest rates is often used as the discount rate as it reflects the monetary opportunity-cost of not having the money today and therefore not being able to invest it under a positive interest rate. Now that we know more about the elements of the NPV equation let’s see how it looks in English:
This NPV equation is exactly what we use in the denominator of our Customer Lifetime Value (CLV) calculation:
Final word on NPV: Why is our exponent t-1? Remember that exponent represents the time period. As you can see from the example forecasts above, t=1 is the time of acquisition when no discount rate applies. In month one this will evaluate our exponent to 1–1 which is 0 and anything with a 0 exponent equals 1. This makes sense because at the time of acquisition there is no reason to discount the cashflow. The customer is paying us in present value so we don’t need to discount our Margin (M).
Back to our CLV; we now know what’s happening at the denominator (it’s the famous NPV) so let’s have a look at the numerator:
Here, we are multiplying our customer margin for the given period (which is our revenue from a particular customer minus all variable costs) with the retention rate for that period. Just like with NPV, at t=1, the retention rate will be 0.⁹⁰, which equals 1. Again, this makes sense because, at the event of an acquisition, the retention rate doesn’t apply.
Putting it all together, we can think of CLV like so:
Read on in part II how we can calculate the CLV to inform pricing decisions.
