How to Calculate Customer Lifetime Value
Investing to earn the loyalty of your customers often requires trade-offs—you must decide which of the many investments you could potentially make will result in the greatest return. A clear understanding of your company’s loyalty economics will help you make those decisions. It will give you a quantitative basis for investments in long-term customer assets and provide a defense against the short-term, sub-optimal, "quarterly earnings" mind-set that often tempts leaders to generate "bad profits."
It is possible to calculate loyalty economics with great precision, if you have the resources and the tools to do so. If not, you can also make rough estimates that can help guide decision-making. This page describes a relatively simple way to get reasonable, rough estimates of the potential value that can be created by improving your company’s Net Promoter Score® and earning the loyalty of more of your customers.
(Note: the calculations presented below are simplified versions of the work that Bain does with clients. To learn more about how Bain can help your company calculate customer lifetime value and referral value, contact us.)
Loyalty economics quantify the differences in customer lifetime value between promoters, detractors and passives. The first step to understanding those differences is quantifying the lifetime value of your average customer. From this average customer, you can then estimate the differences for promoters, passives and detractors. The simple formula for estimating the lifetime value of a customer is:
The number of years a customer remains active describes the average duration of a customer’s relationship with your company. (For some companies, it may be easier to think in terms of churn or attrition rates. For instance, if you have a 5 percent annual churn rate, the average customer remains active for 20 years.) Typically, you will find that promoters have lower churn or attrition rates than detractors and therefore have more active years. Each business and each customer segment will show different variations between promoters, passives and detractors.
The annual variable contribution per customer can get a bit more involved, if you don’t have a reasonable handle on which of your costs are fixed versus variable. Nevertheless, for many purposes, a simple gross margin can suffice. To calculate the annual variable contribution per customer for your whole customer base, on average, you would simply divide your annual variable contribution (or gross margin) by the number of customers on the books. To get an estimate of how this differs for promoters versus passives or detractors requires understanding three key elements that will drive differences:
- Share of wallet and number of products purchased: calculate how the annual purchases of your promoters, passives and detractors vary. This will help you estimate revenue differences. If you have actual revenue per customer, you’ll be able to estimate more precisely, of course.
- Cost to serve: calculate how the costs to serve customers vary among promoters, passives and detractors. At its simplest, you could use the percentage of your average gross margin multiplied by the revenue per customer. Of course, if product mix varies among these groups, you’ll want to use a prorated variable cost estimate, based on how costs and margins vary by product. And if you wanted to get even fancier, you could factor in differences in customer tenure, which are often quite different for early tenure customers than for customers who have been buying from you for a long time. The cost to serve will be subtracted from the revenue calculated in the first step.
- Cost to acquire: calculate the cost to acquire each group of customers. The simple version of this uses the average cost to acquire a new customer (perhaps by adding up all the sales and new customer marketing and on-boarding costs, and then dividing by the number of new customers acquired) and amortizes it over the life of the customer. Because promoters, passives and detractors have different expected number of years as active customers, you would amortize over different periods, resulting in a different annual cost to be subtracted. A more sophisticated approach might also take into account other factors, such as the cost of selling different products or the differences in customer acquisition costs for promoters versus detractors, based on the mix of market segments represented among each group. These annual cash flows should be discounted appropriately to reflect their present value.
Value of a referral
Many companies fail to take into account one of the most important sources of value differences between promoters, passives and detractors: the value of the positive and negative referrals they make.
The value of referrals can be difficult to estimate with precision. Nevertheless, you can make reasonably accurate estimates. The formula is:
Many companies estimate the “percentage of new customers coming via referral” and the “number of referrals made,” based on surveys of new customers (for example, they may ask a sample of customers to name the most important reasons they chose to buy from their company). With those estimates in hand, and the lifetime value calculation from above, you should be able to calculate the value of a referral. Then you can use referrals as the positive baseline for estimating the impact of negative comments (generally three to four times the power of a positive). The final step is to estimate the number of positive versus negative referrals made by promoters versus passives and detractors so that you can then add up all the referrals and their value, and add those in with the customer lifetime value for each.
With a solid understanding of the critical differences in lifetime value for promoters, passives and detractors, you can make investment trade-offs built on a more solid understanding of the potential value that could come from turning more detractors into passives or promoters.