Peter Fader and Bruce Hardie are experts in understanding the value of customer relationships. They have offered advice on problems with CLV calculations, especially those taught in MBA programs. They ask: “What’s Wrong With This CLV Formula?”
Five Issues
They outline five issues. Many of these are things to bear in mind that we might already know but can forget to clarify. For instance, they note that typically CLV is a projection and so it isn’t a true value but an expected value. The way to cover this point is writing E(CLV), i.e. expected value of CLV, rather than CLV. I suspect their idea won’t stick but I appreciate the clarity.
In a similar vein Fader and Hardie note that we should include the initial period’s margin to be a full lifetime. (I think it is helpful to argue that CLV is exclusively forward looking which means I’d like to be clear that we should only include the initial margin if it is in the future.)
Limited Number Of Periods In A Life
They also talk of the problem with a small number of periods, e.g., three years, being used to calculate a life. This omits the value of the relationship beyond the initial periods so isn’t a lifetime value. The simplest solution is to use a larger number of periods which more closely approximate to lifetimes than a shorter number of periods.
What’s Wrong With This CLV Formula? They Don’t Like Formula
The authors don‘t like assuming a constant retention rate. They argue that this is typically not the case in the real world. (I suspect they are correct but I’m not sure how to ‘prove’ that). Furthermore, they correctly note that many businesses do not observe the time the customer is lost. A retailer never really knows you have ceased to be a customer, the retailer just doesn’t see you for a while and guesses whether you are ever coming back. As such they don’t like the idea of trying to shoehorn a messy customer relationship into a nice neat formula.
The bottom line is that there is not “one formula” that can be used to compute customer lifetime value.
Fader and Hardie, 2014, page 4
It is a good point that life is complex. (That said it this is always true). I’m nervous to fully endorse it, not because I disagree about the principle if we hope for perfection – it is true that the world is complex and no one formula does everything. Still does giving a formula hurt more than it helps? I don’t think they have shown that.
A Test Of What Works?
The worry I have is that we already have loads of CLV variants; I’m hoping to get rid of some of these as just plain wrong. I don’t want to encourage people to come up with their own versions. Advice that refused to give a formula because it isn’t perfect might encourage people to create new ones. That said, Fader and Hardie make some useful points and their advice is worth paying attention to.
For more on CLV see here.
Read: Peter Fader and Bruce Hardie (2014) What’s Wrong With This CLV Formula?, <http://brucehardie.com/notes/033/>