Customer Lifetime Value

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Customer Lifetime ValueCan a Customer Be Worthless to Your Brand?

A few years back, I was living in the UK when my cell phone stopped working.

I went to the store to get a replacement.

I got to the store at 8:55 am to find there was already a long line, and when the store opened at 9, I told them that I had a flight to catch to Madrid and needed a phone.

I was politely but firmly told that I had to wait my turn and it would be 45 minutes before I could see a representative.

I tried to explain that I really needed a phone and had to leave for a flight, but was told -

“But sir, all of these people are ahead of you; they are just as

important.”

I had been a loyal customer for many years and as a result of this interaction, when I got back from Madrid, I canceled my cell service, data plan and other services with the same company.

While the customer service rep in the store had given the “right” answer, the result was the loss of a high-value customer who defected to a competitor.

What went wrong?

Egalitarian – those who believe every customer is equal – marketing & sales are not limited to B2C companies.

We once consulted for a Fortune 500 B2B company with a massive sales force.

The sales force had just done an analysis that showed that 8% of the company’s B2B customers were 93% of its revenues

But the sales force treated every B2B customer equally.

What would happen if one of the 8% were to defect to another

company?

A better approach is to realize that all customers are not equal and develop a marketing and sales strategy grounded in this reality.

Customer ProfitabilityCalculating the Value of the Customer

Companies look at their performance in the aggregate – in other words, past activity.

A common phrase within a company is something like “We had a good year, and the business units delivered $400,000 in profits.”

When customers are considered, it is often an average such as “We made a profit of $2.50 per customer.”

Although these can be useful metrics, they sometimes disguise an important fact that not all customers are equal and worse yet, some are unprofitable.

Rather than measuring the “average customer,” we can learn a lot by finding out what each customer contributes to our bottom line.

Customer Profitability

The difference between the revenues earned from and the costs associated with the customer relationship during a specified period

The overall profitability of the company can be improved by treating dissimilar customers differently.

So when we think about customers, we need to think in three different tiers

Tier One – Reward

Your most valuable customers are the one you most want to retain. They get more attention.

Tier One – Reward

Look for ways to reward them in ways other than simply lowering your price. These customers probably value what you do the most and may not be price sensitive.

Tier Two – Grow

The customers is the middle – with middle to low profits associated with them – might be targeted for growth.

Tier Three – Fire

The company loses money on servicing these people. If you cannot easily promote them to the higher tier of profitability, you should consider charging them more for the services they currently consume.

Tier Three – Fire

If you can recognize this group beforehand, it may be best not to acquire them in the first place.

How do we calculate Customer Profitability?

(Revenue from a customer)- (Cost to serve each customer)

Profitability for the Customer

Now doing this for every customer may not make sense, so you may have to abandon the notion of individual customers and work with meaningful groups of customers instead.

After you calculate the value, you sort the customers based on profits.

Once you have the sorted list, you plot the percentages of total profits vs total percentage of total customers.

Here we have a clear illustration that if they were no longer to serve the least profitable 20% of customers, they would be $28 million better off.

Customer Lifetime Value

This metric is the most advanced that we will cover in this course and value-based marketing strategies often require industrial-strength infrastructure to achieve the strategy.

As a first step, most organizations often start by looking at plain sales revenues so that marketing effort and the sales force are directed at the customers with the most revenues.

The problem is that this does not include the cost of serving the customer, which might be considerable, and the customer’s revenues today do not accurately tell us about the value of the customer in the future.

Customer Lifetime Value (CLTV) addresses both of these issues and is probably the most important metric to learn in marketing.

Even if you don’t use CLTV, everyone in marketing should understand the concepts of value-based marketing.

One of the biggest mistakes marketers make is confusing customer profit with CLTV.

Customer Profit measures the past while CLTV looks forward.

CLTV shapes managers’ decision but is much more difficult to quantify than customer profit.

Customer profit is calculated through careful reporting and summarizing the results of past activity; CLTV involves forecasting future activity.

CLTV is the present value of the future cash flows attributed to the customer relationship.

CLTV – The Math

AC = Acquisition CostMn = Margin Produced by the Customer in each time periodCn = Cost of marketing & serving the customerp = Probability the customer will not defect in a yearN = Total number of years or time periods(1 – r) = Discount rate (because money is worth less in the future)

To best understand this metric, think of CLTV as the Net Present Value of a customer.

Time Period 1 Time Period 2

(M – C) = Margin – Cost in a Specific Time Period (Profit)x (1 – c) = Probability that the Customer Will Stay (c = Churn Rate) (1 + r) = Discount Rate (Profit in the future is worth less)

So how does this work?

Margin is easy to calculate – how much profit do you make on each

product/service you sell?

Cost, on the other hand, is a bit more difficult

On the cost side, we need to understand all touches of the customer with the call centers, web site, customer service, marketing communications, maintenance, and so on…

The Cost of the Customer to the Company in Time Period 0 is the Acquisition Cost. Since they are not a customer yet, there are no margins or service costs – so no profits to calculate.

Once the customer becomes a customer, we start calculating their value to the company. We take the profit generated from the customer (M) and subtract it from the cost of maintaining/serving the customer (C). We multiply it by the probability of the customer leaving within a year (1 – c).

Once we have the top side of the equation, we take the amount that money will devalue over the life of the customer, or discount rate – (1 + r)

Looks really complicated doesn’t it?

CLTV = Margin * Retention Rate (%)1 + Discount Rate –

Retention Rate (%)

Let’s try an example

An Internet Service Provider (ISP) charges $19.95 per month. Variable costs are about $1.50 per account per month. With marketing spending of $6 per year, their attrition is only 0.5% per month. At a monthly discount rate of 1%, what is the CLV of a customer?

Margin = $19.95Cost = $1.50AC = $6/12Churn Rate = 0.995%Discount Rate = 0.01

CLTV = Margin = ($19.95 - $1.50 – 6) =

$17.95Retention Rate = 0.995Discount Rate = 0.01

CLTV = $17.95 * [0.995/(1 + 0.01 – 0.995)]$17.95 * [66.33]$1,191

Remember – we are just taking the profit in each time period for the value of the money.

Now, I am sure you are all asking 1 question –

“What is the correct length of time to use for calculating CLTV?”

I have seen company’s calculate CLTV over 85 years – the natural “lifetime” of a customer, which is wrong.

Customer Lifetime Value is not about the life of the customer, but the length of time that a customer will stay with your brand.

The best practice is 3 – 5 years.

While a customer may stay with a brand much longer than that, it is better to focus on a shorter time period for decision making so that you have reliability, not incredibility.

Cohort & IncubateWhich Customer is More Valuable – New or Existing?

One way to project the value of future customer cash flows is to make the assumption that the customers acquired several periods ago are no better or worse that new customers.

To prove that, we go back and collect data on a cohort of customers all acquired at the same time and break down their cash flows over specific periods.

The next step is to discount the cash flows for each customer back to the time of acquisition to calculate the CLTV and then average the CLTVs together to produce an estimate CLTV of each new customer.

We call this the “cohort and incubate” approach.

How do we calculate Cohort & Incubate?

(Total Cash Flows from the Cohort)/ (Number of Customers)

Average CLTV for the Cohort

If the value of customer relationships is stable across time, the average CLTV of the cohort sample is an appropriate estimator of the CLTV of newly acquired customers.

An Example

In 1993, 6,094 customers of a cruise ship line were tracked (incubated) for a period of 5 years.

The total net present value of the cash flows from these customers was $ 27,916,614.

These flows included revenues from the cruises taken (6,094 customers took 8,660 cruises over 5 years), variable cost of the cruises and promotional costs.

The total 5-year net present value of the cohort on a per customer basis was

$4,581 per customer.

$27,916,614/6,094 = $4,581

Cohort and Incubate works best when customers are stationary – changing slowly over time.

When the value of relationships changes slowly, we can use the value of incubated past relationships as the predictive value of new relationships.

Value Based MarketingMarketing Based on the Value of the Customer

Value-Based Marketing drives significant performance gains and firms that bridge the marketing divide focus on customer value in all marketing activities.

An Example of Direct Mail OffersLow to Medium CLTV + Low to Medium Response Rates are not sent a mailing

From a ROMI point of view, these customers are slow on the take rate, so why waste marketing dollars here?

An Example of Direct Mail OffersHigh CLTV + Low Response Rates are also not sent a mailing

The cost of the mailing is not justified

Our focus, as marketers, must be on the medium to high CLTV + Medium to High Response Rate customers

An Example of Direct Mail OffersNotice

Highest Expected Response Rate + the Highest CLTV get the 2nd most expensive offer

Highest Expected Response Rate + Medium CLTV get the 3rd most expensive offer

While the Lowest CLTV don’t get an offer at all

Why do you think that is?

Those that have the lowest CLTV are coming anyway so they get the lowest, most cost effective offer. They are coming because they value your product but don’t respond to the “offers”; so it would be a waste targeting them.

By focusing this single strategy on a value-basis, we cut our marketing costs in half – since we now focus on less than 50% of the potential customer base, but the impact is significantly higher because we are focusing on profitability.

What Makes a High-Value Customer?

This is one of the most important questions to ask your business and you may need focus groups, surveys and analysis to answer it.

In banking, a high-value customer has a portfolio of services – cash deposits, credit cards, auto loans, and perhaps a mortgage.

To best manage this customer, you have to ensure – first and foremost – that they don’t leave

Secondly, up-sell and cross-sell additional products and services. Sell deep to high-value customers.

Selling bundles of services to high-value customers has the advantage of creating lock-in

What is lock-in?

Lock in means that there is a significant switching cost to the customer if they want to change to a competitor.

But you need to be careful of customer lock in backlash – poor service can result in negative customer satisfaction (CSAT) that results in mass defections when a competitor enters with a low-switching cost alternative.

Customer Service and Service Recovery are extremely important to retain high-value customers.

Customer Lifetime Value

Marketing

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