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Extending the CLV Formula, Part 1

Watch Raj Venkatesan explain the impact of time horizon and initial margin on CLV calculations.
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So we looked at the basic CLV model. Now we’re going to extend it a bit, try to see how application of CLV changes, right? How does, when you’re applying in into different context, you may have to make some adjustments here and there? And also, what are some basic fundamental assumptions behind this CLV formula? So that’s what I call as horses for courses. To a large extent, in my mind, CLV is a concept. The actual formula and the actual number are going to be very difficult to accurately get in practical scenarios. But having CLV like we saw in the example comparing the retention spending of Netflix, it allows you to evaluate different options.
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CLV becomes a really good option when you are evaluating different things. It’s a good relative comparison tool, rather than an accurate predictive tool. Now, there are a lot of things that happen when you apply the CLV formula. So the first things are, what is the time horizon? What is this thing about infinity? Is the company going to be the same till infinity? Or, like in Texas, till the cows come home? Or, should we just look at three to four years? How do we know how far ahead to look? Businesses are different when they ask money from the customer. When they first ask the money and then provide the service, or provide the service and ask for the money.
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That makes a difference in the CLV formula.
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I talked about a cohort. We have to see how this cohort system is relevant for a CLV and what this concept of cohort and incubators and why it is important. And then businesses are different. Netflix was a contractual subscription-based model. Does this mean a grocery store like Kroger should not use CLV? Because, in Kroger, nobody signs up a contract saying, I’m a Kroger customer and then whenever they stop buying in Kroger, they have to go and cancel their subscription. No, it’s a non-contractual business so a CLV is applicable for them, too. So we are going to look at these four different major managerial issues that are practical, that come into play when you apply CLV.
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So let’s start with the first thing about time horizon. Infinite or three to four years, what do you think? So my colleagues at here, have developed this table which allows you to assess whether you need to use a CLV formula that leads up to infinity, as we have just seen. Or, can you use a CLV formula that, say, uses only up to five years, that project revenues only up to five years? They say that the best way to do that is to combine retention rate and discount rate. And see, depending on the context, depending on the value of your retention rate and the value of the discount rate, you will be able to tell which way to lean.
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Do you do the CLV up to infinity or can you do CLV up to five years? The concept they use for that is called the percent of CLV accruing in the first five years. What they say is, if most of the CLV that a customer provides a firm comes within the first five years, then it may make sense to just do the first five years. So this table here allows us to do that. So over here we have the retention rate that goes from 40% to 90%. Then you have discount rate that increases from 2% to 20%. So you see here, For a retention rate of 40% and a high discount rate, it’s a very volatile market.
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You get all your money in the first ten years. Money that you get down the road is not making sense because you have a very high discount rate. You’d rather have, in a very volatile market, your money upfront than wait for the future.
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If your retention rate is high, and you have a low discount rate, 90% and 2%. You have high retention rate. You know the customer’s going to stay and it’s a stable market with a discount rate of 2%. You can be fine, you can let the customer be there and keep getting the money over time. So the percent of CLV that accrues in the first five years is only 47%. So, as you see here, the trend you see is as retention rate goes up,
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The percent of CLV accruing in the first five years decreases.
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As discount rate goes up,
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The percent of CLV accruing in the first five years goes up.
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Now, the next thing we talked about was initial margin. So, there are two types of services here. Customers pay before using the service. Or, the customers pay after using the service. Examples would be for the service where customer first pays would be, like we saw with Netflix, Hulu, apartment renters. Vendors or customer pay after using the service, an example is credit cards. So which formula goes where?
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So we so for Netflix, because the customer first pays and then uses the service, we use the same formula, [M- R] x (1+d) over (1+d-r). The customer pays after using the service like credit cards, the CLV formula changes a little bit. It is now going to be [M- R] x [r over 1 + d -r]. So this formula is the same as (M- R) over (1 + d over 1 + d- r)- m. I’m doing the- m here because I’m taking out the first margin that the customer provides the firm. That is gone because the first margin is gone here because the customer first uses the service and then pays.
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So this formula is basically, you take the regular formula like we did in Netflix and subtract out a single repeated margin, then you will get M- R x r/(1+d-r). So we saw two applications scenarios as to how CLV can change depending on the time horizon and the risk of retention rate and discount rate methods. The initial margin, how the arrangement is between the firm and the customer. Do they first pay and then use the service, or use the service and then pay, you have two different formulas here. We’ll look at two more of these application scenarios very soon, stay with me here.

Now that you are familiar with the base CLV model, learn how to adjust the formula based on two factors: time horizon and initial margin. This will help you account for when customers pay and when the percentage of CLV is accrued over time.

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