{"id":775,"date":"2011-02-11T16:40:50","date_gmt":"2011-02-11T14:40:50","guid":{"rendered":"http:\/\/www.invest-aura.com\/?p=775"},"modified":"2017-01-17T12:27:06","modified_gmt":"2017-01-17T10:27:06","slug":"calculating-your-customer-lifetime-value-correctly","status":"publish","type":"post","link":"https:\/\/www.investaura.co\/wordpress\/2011\/02\/calculating-your-customer-lifetime-value-correctly\/","title":{"rendered":"Are you calculating the Customer Lifetime Value (CLV) correctly?"},"content":{"rendered":"

There are two main mistakes that people do when they calculate the CLV.\u00a0 \u00a0The first one is to simply multiply the customer ARPU by the EBIT margin of the company to estimate the customer profitability in a given month.\u00a0 This is quite bad, but the second mistake is a lot more worse: some people forget about customer churn i.e. they assume that the customer will remain a customer until the end of time.\u00a0 Or if they do assume customer churn, they assume that the probability that a customer churn is constant over time (and independent of the customer); in essence, they use a model of customer lifecycle and customer churn that is totally inappropriate for telecom service providers in a competitive environment.\u00a0 If you want to do better than most, then keep reading until the end of this article.<\/p>\n

In theory, calculating the CLV is easy. \u00a0It is a bit like calculating the NPV (Net Present Value): discount expected future free cash flow to the present.\u00a0 Repeat the calculation for each and every customer and this gives you an indicator of which customers are valuable and which are destroying value.\u00a0 In many cases, you will see that 20% of your customers generate a huge amount of value, 60% of customers are breaking even and neither creating nor destroying value, and 20% of customers are destroying value in a pretty massive manner.\u00a0 A big ‘Aha!’ effect for sure.\u00a0 Show that to your CFO and your COO and they will be…. scared?\u00a0 Intrigued? Questioning?<\/p>\n

All right, but let us return to the CLV calculation.\u00a0 As for the NPV, the problem is that you need to estimate the following parameters:<\/p>\n

    \n
  1. the discount rate<\/li>\n
  2. the expected value of\u00a0 future free cashflows<\/li>\n<\/ol>\n

    and this for all customers!\u00a0 This gives us two problems to solve.<\/p>\n

    So how do you do this?\u00a0 Well, the first simplification is to assume that the discount rate is the same as the discount rate that you use for the NPV calculation, i.e. the weighed average cost of capital (WACC).\u00a0 If you know your company WACC (8%? 10%? 12%?) then you can use the same number in the CLV calculation.\u00a0 Unless you want to treat a customer as a single ‘project’ and wish to calculate a customer WACC.\u00a0 If you are very good at estimating ‘project’ WACC rather than company WACC, then you can do so (most likely using a Monte Carlo simulation).<\/p>\n

    If you do not have a clue what we are talking about here, then forget about it and simply take the company WACC (good to know that you have colleagues in Finance who can calculate the WACC for you!).\u00a0 If you have multiple business line e.g. Mobile, Fixed Line, Internet, TV, and if you want to calculate the CLV of a customer broken-down in its components: the CLV from Mobile, CLV from fixed etc, then remember that it might be more appropriate to take the WACC for each business (fixed, mobile etc) rather than the overall company WACC.<\/p>\n

    But let us not confuse you further – in most cases you will be using one single WACC across the board, for all customers.\u00a0 So problem #1 is solved.<\/p>\n

    The bigger problem is #2: the expected<\/span> value of future<\/span> free cashflows<\/span>.\u00a0 Problem #2 is a collection of three problems: we need the cashflow, in the future, and the expected value.<\/p>\n

    Now we can hear you saying: where the hell am I going to get the cashflow on a customer basis?\u00a0 OK, replace cashflow with NOPAT = EBIT x (1-Tax Rate).\u00a0 So the problem is now to get the EBIT on a customer basis.\u00a0 This is easy if your company has done a Service Costing<\/em> exercice in the past.\u00a0 In which case the EBIT is, for each customer who has an individual traffic profile (call volume per month, split of on-net, off-net, incoming etc) the difference between Call Tariff and Call Cost summed over all call types generated and received by the customer during the month.\u00a0 For the Call Cost you should take the Fully Allocated Cost (FAC) or the Long Run Incremental Cost (LRIC), which is similar to a marginal cost.<\/p>\n

    If the EBIT or EBIT margin is not available at the service (call type) level, then you are unlikely to figure out a meaningful EBIT at the customer level. \u00a0Taking the company EBIT margin and multiplying by the customer ARPU is a very rough approximation, because you are implicitly assuming that all services in your business have the same profit margin (which is very unlikely). \u00a0If it were the case, then your customers would equally be profitable in terms of EBIT margin, and you would probably not worry about the CLV.\u00a0 You would think that customers with a high ARPU are valuable customers and those with a low ARPU are less valuable, so ARPU would be used as a proxy for CLV.\u00a0 Which is also wrong because in that case all your customers are profitable today (unlikely) and you forgot to think about two other issues: expected<\/span> future values<\/span>.<\/p>\n

    Whether you take NOPAT (yes!) or ARPU x CompanyEbitMarging (if nothing else is available), we still have to figured out what their values will be like in the next months and years.\u00a0 So we need to forecast NOPAT<\/em> for each customer in the future.\u00a0 And to get the expected value, we need to take into account the customer lifetime cycle i.e. what the remaining lifetime of the customer is.\u00a0 Which brings us to Churn<\/em>.<\/p>\n

    To forecast NOPAT, you should forecast future tariffs – most likely tariffs will decrease in the future?\u00a0 Also ask your colleagues in Finance who provided the Service costing<\/em> results to generate a forecast of costs for you – if their Service costing exercice is good, then it should not only provide a backward view but a forward view as well.\u00a0 Once you are done with the tariff forecast, the cost forecast and the customer usage forecast (call minutes etc) then you have a NOPAT forecast for this customer.<\/p>\n

    But while doing so, you might have wondered how many years into the future your forecast should go?\u00a0 This brings us back to the customer lifecycle and the issue of churn.\u00a0 You need to calculate the probability that the customer churns some time in the future.\u00a0 To do this, you need a Survival function that reasonably approximates your customer churn behaviour.\u00a0 The Survival function at time t is: S(t) = Pr (T>t) which means that it is the probability that the time of ‘death’ (sorry, ‘churn’) T is higher than t.\u00a0 The Survival function starts at 1 when the customer is activated (t=0) and is a decreasing function of time, converging towards zero in the long term.\u00a0\u00a0 To simplify matters, we will assume here that there is only one Survival function valid for all customers and its profile remains the same over time.\u00a0\u00a0 The Survival function can be estimated from historical customer data and let us assume that you have just done that.<\/p>\n

    Now for the calculation of the CLVi<\/sub> (t0<\/sub>) of customer i <\/em>at time t0<\/sub><\/em> (now), you must multiply the future NOPATi<\/sub> (t1<\/sub>), NOPATi<\/sub> (t2<\/sub>), NOPATi<\/sub> (t3<\/sub>) etc. for customer i <\/em>with the Probability that this customer has survived (i.e. it has not churned) at time t1<\/sub>, t2<\/sub>, t3<\/sub> etc knowing that at time t0<\/sub><\/em> the customer was still alive (i.e. it had not churned).\u00a0 So the factors you need to multiple the NOPAT with looks like this:<\/p>\n

    1-Pr (t1<\/sub>-1<= T < t1<\/sub> \/ T> t0<\/sub>): probability that the customer does not churn during year t1<\/sub><\/em>, knowing that at time t0<\/sub><\/em> the customer was still alive.\u00a0 This factor can be expressed as a function of S(t) as follows: 1 – ( S(t1<\/sub>-1) – S(t1<\/sub>) ) \/ S(t0<\/sub>)<\/p>\n

    To summarise, the CLVi<\/sub> (t0<\/sub>) of customer i<\/em> at time t0<\/sub><\/em> (now) is the sum of the discounted future NOPATi<\/sub>(t), using the WACC as discount rate, and using the factors 1 – ( S(t-1) – S(t) ) \/ S(t0<\/sub>) to weigh the NOPATi<\/sub>(t).\u00a0 The factor used as weight is the remaining portion of NOPATi<\/sub>(t) that is expected to be generated from the customer knowing that the same customer might churn at any time after t0<\/sub>.<\/p>\n

    If you have followed us so far, then congratulations! You should better understand how the Customer Lifetime Value can be correctly calculated and which mistakes can be avoided.\u00a0 We will come back on the issue of the Survival function in a future column on Churn. Keep reading!<\/p>\n","protected":false},"excerpt":{"rendered":"

    There are two main mistakes that people do when they calculate the CLV.\u00a0 \u00a0The first one is to simply multiply the customer ARPU by the EBIT margin of the company to estimate the customer profitability in a given month.\u00a0 This… <\/p>\n

    Read More<\/a><\/div>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"jetpack_post_was_ever_published":false,"jetpack_publicize_message":"","jetpack_is_tweetstorm":false,"jetpack_publicize_feature_enabled":true,"jetpack_social_post_already_shared":false,"jetpack_social_options":[]},"categories":[85],"tags":[9,20,33],"jetpack_publicize_connections":[],"yoast_head":"\nAre you calculating the Customer Lifetime Value (CLV) correctly? | Investaura<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/www.investaura.co\/wordpress\/2011\/02\/calculating-your-customer-lifetime-value-correctly\/\" \/>\n<meta property=\"og:locale\" content=\"en_GB\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Are you calculating the Customer Lifetime Value (CLV) correctly? | Investaura\" \/>\n<meta property=\"og:description\" content=\"There are two main mistakes that people do when they calculate the CLV.\u00a0 \u00a0The first one is to simply multiply the customer ARPU by the EBIT margin of the company to estimate the customer profitability in a given month.\u00a0 This... 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As often in economics in general, and costing in particular, it really depends how you look at costs and value, i.e. whether you focus on the direct costs only, or include the indirect costs as\u2026","rel":"","context":"In "Investaura Analysis"","img":{"alt_text":"","src":"https:\/\/i0.wp.com\/www.invest-aura.com\/wordpress\/wp-content\/uploads\/2013\/04\/churn_simulation_1-1024x473.png?resize=350%2C200","width":350,"height":200},"classes":[]},{"id":1314,"url":"https:\/\/www.investaura.co\/wordpress\/2012\/05\/ibm-whitepaper-quotes-investaura-and-the-work-that-we-are-doing-to-reduce-service-provider-churn\/","url_meta":{"origin":775,"position":1},"title":"IBM whitepaper quotes Investaura and the work that we are doing to reduce service provider churn","date":"May 5, 2012","format":false,"excerpt":"Investaura is pleased to appear in one of the most recent IBM whitepapers: \u00a0Harness the power of data and analytics to maximize the value of each customer [download id=\"3015\"] This excellent whitepaper highlights how mobile and fixed line telecoms service providers can leverage the data that they have about their\u2026","rel":"","context":"In "Whitepaper"","img":{"alt_text":"","src":"https:\/\/i0.wp.com\/www.investaura.co\/wordpress\/wp-content\/uploads\/2024\/07\/Business_Planning2.jpg?fit=1024%2C631&ssl=1&resize=350%2C200","width":350,"height":200},"classes":[]},{"id":831,"url":"https:\/\/www.investaura.co\/wordpress\/2011\/02\/winning-the-churn-reduction-war-how-to-use-churn-prediction-techniques-to-improve-customer-retention\/","url_meta":{"origin":775,"position":2},"title":"Winning the war against churn: how to use churn prediction techniques to improve customer retention","date":"February 21, 2011","format":false,"excerpt":"There is no question that churn is the plague of the telecom industry.\u00a0 In the mobile business, annual churn rate of 20%-30% are standard.\u00a0 In developing countries, churn can be as high as 60% per annum.\u00a0 Do you know any other industry where companies lose 20%-60% of their customers between\u2026","rel":"","context":"In "Insights"","img":{"alt_text":"","src":"https:\/\/i0.wp.com\/www.invest-aura.com\/wordpress\/wp-content\/uploads\/2011\/02\/Churn_prediction_ARPU_boost-1024x588.png?resize=350%2C200","width":350,"height":200},"classes":[]},{"id":1205,"url":"https:\/\/www.investaura.co\/wordpress\/2012\/02\/the-five-reasons-why-your-churn-reduction-measures-are-not-working\/","url_meta":{"origin":775,"position":3},"title":"The 5 reasons why your churn reduction measures are not working, and what you can do about it","date":"February 10, 2012","format":false,"excerpt":"Truth be told, you don't need a Ph.D. in data mining or statistical analysis to reduce churn. 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Churn reduction is a complex\u2026","rel":"","context":"In "Insights"","img":{"alt_text":"","src":"https:\/\/i0.wp.com\/www.investaura.co\/wordpress\/wp-content\/uploads\/2024\/07\/Business_Planning2.jpg?fit=1024%2C631&ssl=1&resize=350%2C200","width":350,"height":200},"classes":[]},{"id":768,"url":"https:\/\/www.investaura.co\/wordpress\/2011\/02\/what-does-service-costing-bring-to-pricing\/","url_meta":{"origin":775,"position":4},"title":"What does service costing bring to pricing?","date":"February 7, 2011","format":false,"excerpt":"Comparing prices with costs is a most enlightening exercice.\u00a0 Unfortunately, service costing being as much an art as a science, many telecom service providers don't do much service costing; and as a result, they don't understand their service costs and their sources of profitability well enough. In many cases, prices\u2026","rel":"","context":"In "Investaura Analysis"","img":{"alt_text":"","src":"https:\/\/i0.wp.com\/www.investaura.co\/wordpress\/wp-content\/uploads\/2024\/07\/Business_Planning2.jpg?fit=1024%2C631&ssl=1&resize=350%2C200","width":350,"height":200},"classes":[]},{"id":5609,"url":"https:\/\/www.investaura.co\/wordpress\/2018\/02\/whitepaper-customer-product-costing-profitability-analysis\/","url_meta":{"origin":775,"position":5},"title":"Whitepaper on Customer & Product costing and Profitability analysis","date":"February 12, 2018","format":false,"excerpt":"Investaura is pleased to present its new whitepaper on Activity-Based Costing and Profitability Analysis, which provides a step-by-step roadmap for a successful implementation over a 5 week period. Service Costing has the reputation to be complicated and time-consuming to implement. It doesn't have to be so. Using the eTOM business\u2026","rel":"","context":"In "Whitepaper"","img":{"alt_text":"","src":"https:\/\/i0.wp.com\/www.investaura.co\/wordpress\/wp-content\/uploads\/2024\/07\/Business_Planning2.jpg?fit=1024%2C631&ssl=1&resize=350%2C200","width":350,"height":200},"classes":[]}],"jetpack_sharing_enabled":true,"_links":{"self":[{"href":"https:\/\/www.investaura.co\/wordpress\/wp-json\/wp\/v2\/posts\/775"}],"collection":[{"href":"https:\/\/www.investaura.co\/wordpress\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.investaura.co\/wordpress\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.investaura.co\/wordpress\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.investaura.co\/wordpress\/wp-json\/wp\/v2\/comments?post=775"}],"version-history":[{"count":8,"href":"https:\/\/www.investaura.co\/wordpress\/wp-json\/wp\/v2\/posts\/775\/revisions"}],"predecessor-version":[{"id":4237,"href":"https:\/\/www.investaura.co\/wordpress\/wp-json\/wp\/v2\/posts\/775\/revisions\/4237"}],"wp:attachment":[{"href":"https:\/\/www.investaura.co\/wordpress\/wp-json\/wp\/v2\/media?parent=775"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.investaura.co\/wordpress\/wp-json\/wp\/v2\/categories?post=775"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.investaura.co\/wordpress\/wp-json\/wp\/v2\/tags?post=775"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}