Customer lifetime value (CLV) is important because all customers are not equal. In fact, most businesses will find that there is a power law with CLVs. As explained by Wikipedia, a power law is “a functional relationship between two quantities, where a relative change in one quantity results in a proportional relative change in the other quantity, independent of the initial size of those quantities: one quantity varies as a power of another. For instance, considering the area of a square in terms of the length of its side, if the length is doubled, the area is multiplied by a factor of four.” This is how a power law curve looks:
It is not surprising that CLV curves look very similar! This is similar to the 80-20 rule, where 80% of value comes from 20% of the base. (The specifics may vary – it could be 90-10 or 60-20.) For most businesses, a small number of customers account for disproportionate value (revenue and profits).
Power laws are common in product sales. A few “hits” account for the bulk of the sales, followed by the long tail, as shown in this graph below from TechnoLlama:
There is an excellent collection of charts in a post by Michael Tauberg which shows power laws all around us:
Tauberg explains power laws simply: “Basically, power law is like a forest. There are tall trees which soak up the sun and grow to be enormous. Then there are all the shrubs on the forest floor.”
Below is a real demonstration of the power law from one of our customers – the hand-drawn green curve shows the power law at work.
The lesson for business leaders is to recognise the presence of power laws in their revenue charts. Calculating forward-looking and predictive CLV brings this to life. It also leads to another conclusion: businesses and marketers need to take exceptional care for customers who are at the high-end of the CLV charts. Focusing on these customers is what Velvet Rope Marketing is about.
In this context, what Net Predicted Revenue (NPR) does is provide a glimpse into the future. It shows what revenues a business can generate going forward from all its customers. The good thing about NPR is that it is calculated one customer at a time. Making a single customer the unit of analysis takes us to one of the most important ideas from the world of economics.
Tomorrow: The One Number To Predict Revenue (Part 7)