Tangyslice had a recent post about customer retention metrics. To his list, I would add lifetime value. There are many ways to calculate lifetime value but let me tell you about one way I have calculated it.
A cellular phone company was losing customers due to churn and wanted help to retain their most profitable ones. In other words, they wanted to know the future value of their customers. With a lifetime value model, the company could increase ROI through targeted retention and provide one-to-one marketing.
In the cellular phone industry, most customers sign up for two year contracts. However, some customers default on their contract and others continue their service even when the contract ends. Thus, the lifetime value model in this example consists of two parts:
- survival analysis which predicts survival probability, the likelihood that a customer will remain a customer
- financial data that include revenue and costs used to determine future customer profit
The first step was estimating the tenure of each customer. A proportional hazards model or baseline hazards model can be used to estimate tenure. Once the tenure is determined, the next step is estimating the future value based on past average monthly spending by the customer and the cellular phone company’s costs.
The formula calculates the discounted profit. In the calculation above, i= the cost of capital and the terminal value is an estimate of the revenue beyond the 36th month of tenure.
Does this bring back nightmares from Finance and calculating the discounted present value of cash flow? The same advice applies. Be very careful how you calculate the terminal value because it can account for a large percentage of a customer’s estimated value.