Weighing up the True Value of a Customer

How much do you value your customers? Understanding the relative value of different kinds of customer can be critical to making informed decisions about your business. In this article we discuss the calculation of Customer Lifetime Revenue and why this is an interesting and useful thing to understand.

In the subscription world there’s a lot of talk of Customer Lifetime Value (CLV). CLV represents the “profit” that results from the lifetime of a relationship with a customer. If CLV can be accurately calculated its a very useful metric. It can be used, for example to determine effective marketing spend per acquisition. If you know that a customer is worth $X over time, then you know that you can spend up to $X to acquire them and still turn a profit. Unfortunately, CLV is a very slippery modeling concept because it requires a model of the cost associated with servicing a customer and this is notoriously difficult to model on a per customer basis. Many of the costs per customer change significantly depending on customer volume  and that is not something that can be captured easily in a per customer model.

On the other hand Customer Lifetime Revenue (CLR) is an relatively easy figure to calculate. CLR represents the total expected revenue generated over the lifetime of the customer. It only models revenue, not profit, but assuming similar delivery costs, it is very useful in understanding things like the comparative value of different products or product versions.

CLR is the sum of the expected revenue generated per month (or year etc.) from an average customer. To calculate it we need to understand the churn rate. For example, suppose that we have a monthly churn rate of 5%. Assuming that the customer pays in advance and that we do not issue refunds for early cancelation, the expected revenue in the first month will be $100. In the second month 5% of the customers that joined will leave so we need to take that into account. So, in month 2 the expected revenue will be $100 – 5% = $95. Similarly, in month 3, 5% of those remaining will leave reducing the revenue to $90.25. This results in a chart like the one above in which every month we take away 5% of the revenue of the previous month. As revenue for the month gets smaller and smaller the 5% we take away also gets smaller and smaller. Because both numbers are reducing a the same time, the revenue never actually reaches zero.  The lifetime revenue of the customer is the sum of the area of this chart. Fortunately there is a simple, mathematical result, the Sum of a Geometric Series, that gives us this area. Customer Lifetime Revenue is simply revenue divided by churn:

CLR = Price in period / churn in period

So, for our example above, the CLR is simply $100 / 5% = $2000.

The CLR metric can be very useful in understanding the relative value of customers over time. Consider the following subscription product which is offered at two tiers, Standard and Premium, and is offered at a Monthly and Annual rate. Each tier and rate has a different rate of Churn as shown below:

 

Standard Premium
Monthly $100 $200
Annual $1,000 $2,000
Monthly 4.0% 6.8%
Annual 35.0% 40.0%

 

Note that we are providing monthly price (MRR) and monthly churn for the monthlies and annual price (ARR) and annual churn for the annuals in this chart. This is not a problem for calculating CLR as long as we are consistent with our periods and divide ARR by annual churn and MRR by monthly churn.

So, using the formula above can use CLR to compare the revenue generated by the different plans. This gives us the following result:

 

Standard Premium
Monthly $2,500 $2,941
Annual $2,857 $5,000

 

In this case we see that for the Standard tier, annual and monthly CLR are unusually close (12%). This is due to the relatively low monthly churn on Standard. With the Premium tier the monthly churn is much higher. Even though annual churn is higher too, we see a much bigger discrepancy (40%) in the CLR between annual and monthly. We can use this data to adjust pricing, sales and marketing to help incentivize the customer to purchase the high revenue products. Or helps expose weaker products where there is the most benefit from decreasing churn.

As with any business modeling metric it is important to be aware of what CLR represents and remember that it does not capture costs. In the example above, there could be a big discrepancy in the cost of providing the Premium tier product over the Standard tier product then we may need to factor in that cost depending on the kind of analysis that we are doing.

In this article we introduced the concept of Customer Lifetime Revenue, described what it represents and how to calculate it and looked at its use for comparing the revenue generated by different product offerings.