Lifetime Value of Customers The Key Financial Metric for Customer Focussed Businesses
WHITEPAPER This white paper covers the topic of lifetime value of customers as a critical financial metric for customer focused businesses to guide their investment in customers. Specifically it covers: 1. The compelling reasons for its use 2. The approach to be taken and its challenges 3. A simplified formula for calculating lifetime value of customers 4. The action steps required to get started at a high level www.MarketCulture.com
What is the Best Financial Metric to Guide Investment in Customers? If you could chose only one financial metric to measure the strategic health and value of your business it should be: lifetime value of customers. Why? There are four compelling reasons: 1) It is the best means of measuring the changing value of your business over and above its tangible assets. 2) It provides a financial pulse of the success of your market driven strategy and market-‐centric culture. 3) It reinforces market-‐centric behaviors in the business consistent with generating both value for the customer and value for the business over time. 4) It gives a clear guide to the allocation of marketing and sales resources to different market segments, geographies and individual customers. Most executives believe customers are critical to the survival and growth of the firm. However disconnects occur when discussions begin relating to the levels of investment required to satisfy customers. How much money should a company spend on acquiring new customers? How much should be spent on improving customer satisfaction? How should sales resources be allocated? Without a clear understanding of the value of customers to the business over time it is very difficult to answer these questions with any confidence. The customer lifetime value metric gives clear direction to those decisions.
What is the Lifetime Value Approach?
This approach begins with a bottom up approach by starting with the value of a single customer. Consider a customer who walks into a BMW dealership. For the salesperson the value of this customer depends on which model and accessories the customer is interested in purchasing. The owner of the dealership however is less concerned with who gets the sale so long as the sale gets made. The owner is interested in the customer returning for service and future purchases. This example highlights the difference between a transaction focus versus a relationship focus. The sales rep is focused entirely on getting the deal done and gaining this month’s commission. In contrast the owner is interested in the longer-‐term relationship and the ongoing potential profit of each customer. The value of a customer is therefore viewed differently by different members of the organization. This disconnect can be overcome by realigning incentive structures which is a discussion beyond the immediate scope of this paper. An additional challenge highlighted by this example is how much should the owner be willing to spend to develop longer-‐term relationships with customers? www.MarketCulture.com
Hence the need for a metric that will assess the longer term value of customers, a metric known as Lifetime Value of a Customer (LTVC). The LTVC is simply the present value of all current and future profits generate from a customer during the life of his/her business with the company. Before we get into calculating the metric lets take a look at some of the challenges to be aware of going into any project designed to calculate LTVC. What are the Measurement Challenges? Companies face a number of challenges in implementing this concept which stem from 3 main areas: 1. Getting the Right Data a. Most companies have a snap shot of customer data but do not necessarily track it overtime. Ideally we need an understanding of the average tenure of a customer with the company b. Getting data on customer profits and estimating future profits from new products, cost savings and the impact of word of mouth can be a challenge for many companies c. Understanding defection rates is often the most difficult data point to find. This is easier for companies with contractual agreements like telecommunication firms that can accurate measure things like “churn” (customer’s leaving during a specific period of time). 2. Complexity of getting into the weeds a. Metrics need to be clear, concise and generally understandable. The desire to build complex models in minute detail has meant that the metrics have been confined to campaign level tactics. b. While this may help direct marketers make decisions on which customers should received the next mail piece this detail does not translate well to senior executives. 3. Desire for Absolute Precision a. Calculating any lifetime of a customer metric will require assumptions because it involves a forecast of future customer behavior. Company experience with past and current customers can be a useful guide. b. Costs are also challenging to allocate. We can easily allocate the cost of goods sold to a customer, however other costs are more difficult. i. How do we allocate advertising or service costs? ii. What about employee costs? To what extent can these be allocated to customer accounts or segments? c. These decisions will require some subjective decision making. Regardless of these challenges it is worth pursuing this metric to gain a better insight into how customers impact profit and growth potential and provide a broad strategic metric to align company activities around the customer.
How is Lifetime Value of Customers Measured? In order to simplify this discussion we need to make a some assumptions: 1. Profit Margins remain stable over the life of a customer with the company 2. The retention rate is constant 3. The lifestime of the customer is infinite (rather than make a subjective or artbitrary choice for simplicity’s sake we can assume customers will stay indefinitely). Note the retention rate allows for the fact that some customers will always switch eventually and the discount rate means that the distant future cash flows will have less and less impact on the LTV number we calculate. We therefore arrive at the following formula:
LTVC = M
R 1 + D -‐ R
M – is the margin from a customer per period R – is the retention rate expressed as a percentage of the customer base D – is the discount rate or cost of capital used to discount future cash flows This simple formula would allow the BMW Dealership owner to make a few quick calculations of the LTV of his or her customers. For example let’s assume a discount rate of 10% and a customer retention rate of 80%. If the average customer’s annual margin from purchases is $5000 then the formula would look as follows:
LTVC = $5000
80% 1 + 10% – 80%
LTVC = $13,333
Based on these assumptions, every customer is worth on average $13,333 to the firm. If all staff new this, how would that affect the way they treat individual customer interactions? Chris Zane, the CEO of Zane’s Cycles, North America’s largest Trek Bicycle dealer has used the calculation of his customer’s lifetime value to shape the way his 60 staff interact with customers. Instead of “nickel and diming customers for small parts he empowers to his staff to give away parts that cost less than $5 to customers. This has allowed him to maintain a very high retention rate and grow year on year for the past twenty years by more than 23% www.MarketCulture.com
annually. How much would the BMW dealership owner be prepare to invest in each customer to retain them? That is still a somewhat subjective decision but at least there is a stronger basis upon which to make that decision. For example, if the BMW dealer could increase retention rate over time from 80% to 90% the LTVC becomes $22,500 (assuming the same profit margin) – up from $13,333, a 68% increase. This basic formula can be adjusted for changes in margin and time horizons as well as retention rates. More importantly it can also be used to assess different groups of customers. Is the lifetime value of customers in one geography different from another? Can we differentiate between “good” (high profit and LTV) customers and “unattractive” customers (less profitable lower LTV). This is where the LTV metric can be a very powerful input to strategy and decision-‐making.
What Action Steps are Required?
To calculate your Lifetime Value of Customers begin with a simple calculation at a high level. • Step 1: Average the Key Purchase Variables o How many customers do you have? o How often do they purchase? o How much do they purchase on average? • Step 2: Calculate the Lifetime value of these customers o Gather the following data points: Average lifespan of a customer Average customer retention rate Average gross margin per customer per lifetime o Use the simple Customer Lifetime Value Equation • Step 3: Gain buy in and agreement from the executive team on a number that represents the value of a customer. This can and should be review annually • Step 4: Use this number as the number to align around and motivate all staff to execute their roles in a manner that maximizes the value they deliver customers.
Should you Invest in this Approach in your Business?
Those companies committed to creating a customer-‐focused business and implementing market driven strategies measure the lifetime value of their customers. They use this one financial metric to guide, strengthen and reward customer-‐centric behaviors, They use it to guide investment decisions in marketing, sales, customer service, customer satisfaction and targeting new customers for acquisition. They use it to monitor the changing value of their businesses. If you are leading one of those companies committed to being a customer-‐focused business you should make that investment.
