A customer can be thought of as an intangible asset belonging to a company, and as such, you should be able to attach a value to a customer. Given that you will spend money acquiring customers, you need to know how much they are worth, so that you can determine the exact price you are willing to spend on their acquisition.
Components
CAC = Customer Acquisition Cost. The money you spend on getting a customer. Remember that for every successful customer you acquire, you will have spent money trying to acquire others who did not become customers. The correct way to calculate CAC is therefore
m = Margin. This is the marginal profit per customer, across your entire company. It does not take into account fixed costs, so is calculated by subtracting variable costs (COGS + SG&A) from revenue, and dividing by the number of customers. We are assuming a constant average margin.
i = Discount Rate. Due to factors such as inflation and risk, £100 in the bank today is worth more than a promise of £100 in a year. A company’s cost of capital will decide the discount factor it must apply; for example, if i = 10%, then £100 in 1 year is worth £90 today. £100 in 2 years is worth £81 today.
t = Time Period. For example, t = 3 means the third year (or whatever unit is appropriate).
r = Retention Rate. If you have 100 customers sign up now, and of them 5 leave in a year, r = 0.95. We assume this is a constant rate (it isn’t in reality, but is hard to find out).
Customer Lifetime Value
The value of one extra customer is the revenue from him or her, minus the variable cost involved in serving the customer. The more years in the future this value is being calculated for, the more it must be discounted by the discount rate. Furthermore, the likelihood of a customer remaining must be factored in- not all who join in year 1 will still be customers in year 2.
For any given number of years, n,
However, it is hard to know exactly when a customer will stop being a customer, and therefore what n is. Retention behaves more like a probability curve. So we can model for all customers generically, for an infinite time period:
This gives us a simple equation into which we can put the margin, retention rate, and discount rate, to get the CLV as an output. The equation can be thought of as the margin multiplied by a factor called the Margin Multiple r/(1+i-r).
Therefore, if
Then
CLV = m x MM
Note that the drivers of MM are the retention ratio and the discount rate, whereas the drivers of the margin are revenue (price received per unit sold) and variable costs.
Acquisition Costs
The present value of any given customer can then simply be determined by deducting the CAC from the CLV, giving
For more detail on the above equations, read this article by GUPTA and LEHMANN.