Product Manager’s guide to Customer Lifetime Value — Part IΙ
Making pricing decisions with CLV
OK, we have seen how CLV is calculated in the previous article, and now it’s time to put it to action. If you are not clear which kind of inputs you can use to calculate Customer Lifetime Value, make sure you read part I and come back to this one:
So why would we want to use CLV to inform our pricing decisions? Like I mentioned in the previous article, the CLV is the foundation of customer value management, so tracking this metric will help us understand how much economic value our product is creating across customer segments. The key here is “customer segments”. Our pricing decisions will affect our whole customer base, in which however, some customers groups will be more sensitive to price changes than others. Undoubtedly, we may lose a percentage of our customer base, but the economic value gained from an increase in price may (or may not) be able to compensate for that loss. CLV can help in this situation by providing a unified view of the economic return from our relationship with customers despite changes in price and volume.
While there are many other factors to consider when making pricing decisions, in this article we will explore a simple example focusing solely on CLV, and how it can be applied to help us understand the trade-offs of two pricing scenarios:
Customer Lifetime Value case example
1. Scenario 1: Current analysis and current CLV
Suppose you are a Product Manager at a music streaming company and are investigating how a change in the price of your current annual subscription of £49.99 to £59.99 will impact your CLV.
Your hypothetical variable costs per customer per year are £32 and include things like cloud services for data streaming and song licensing across geographies.
Since you have a good relationship with Finance, you discuss with the CFO your intention to benchmark your current CLV with an assumed CLV considering the price increase to £59.99. She suggests that an appropriate discount rate to use in your CLV calculation is 10% (more about the discount rate in part I - although - how we derive this number is not essential for the scope of this exercise; your colleagues in Finance should be able to advise).
Finally, from talking with the Head of Operations — and based on data you already have access to (after all, you are the PM for Subscriptions) — you identify that historically your retention rate has been as follows:
Assuming you haven’t done so already (we will talk in a future article about why constantly tracking your CLV is important in product dev), let’s now calculate our current CLV:
a. Considering our CLV equation from part I:
Or:
b. We will use these inputs:
- M (customer margin per customer per period) = £49.99–£32=£17.99
- i (period of time) = [year1, year2, year3]
- n (total of time periods) = our current CLV will be calculated for a 3-year period
- d (discount) = we will use 10% to discount future cash flows
- r (retention rate) = [{afterYear1: 0.42}, {(afterYear2: 0.88)}]
c. To calculate our current 3-year CLV:
d. Which results in CLV=£26.89
Note that in year one, the Net Present Value (our denominator) should be equal to 1 because we don’t need to discount these cash flows since they are coming in at this year’s value. Also, no retention rates apply for the first year. What you see “as retention rate for year 1” on the table above is the percentage of customers that while subscribed in year 1, also stay subscribed in year 2. So we apply the 42% (0.42) to our margins for the second period as only 42% of customers from the first period will give us any cash flows in the second period.
2. Scenario 2: Proposed price increase and impact on CLV
Now let’s see what happens to our CLV of £26.89 if we change our price from £49.99 to £59.99 for the same product. Of course our variable costs and discount rate should stay the same. But we now have an additional input to consider. We need to understand how many of our existing customers will not be willing to pay the new price and therefore won’t re-subscribe to our product in the first place.
To address this, suppose we have already commissioned a targeted market research in collaboration with the CMO. We sampled our customer base through an online survey and a focus-group to understand whether they were willing to pay the higher price. Our results showed that we should expect a 19.2% decrease in our customer base as a result of increasing our price to £59.99. To make the matter worst, our research showed that customers may be inclined to substitute our subscription for a competitor’s who is launching a similar product in approximately 12 months. So the projected retention rates look like this:
Is the price increase to £59.99 still sensible despite the almost 20% contraction in our customer base and the forecasted churn after a year? Things are not looking great but let’s find out how the CLV will be affected:
We will use these inputs:
- M (customer margin per customer per period) = (59.99–32)=27.99
- i (period of time) = [year1, year2, year3]
- n (total of time periods) = our scenario CLV will be done for a 3-year period
- d (discount) = we will use 10% to discount future cash flows
- r (retention rate) = [{afterYear1: 0.32}, {(afterYear2: 0.61)}]
- Only 80.2% of our existing customers may be willing to pay the new price in the first place
To calculate the projected CLV with the relevant price increase, initial loss of customer base and assumption on future churn:
Which results in CLV=£29.69 (a 10% increase from the current CLV). In terms of our economic relationship with the average customer, the price increase to £59.99 is actually worth the contraction of our customer base.
