Increasing Customer Lifetime Value

What's the difference between customer lifetime value and customer
loyalty programs?

Customer loyalty programs are designed to retain as many customers as possible,
regardless of their real value. The customer lifetime value calculation indicates the
contribution individual customers make to profitability.

Why are lapsed customers important?

If they can be "revived," they tend to behave like new customers and become regular
buyers once again, with good potential lifetime value.

Is customer retention more important than acquisition?

Acquisition should never be neglected, because existing business may decline for reasons
outside your control. Industry experience indicates, however, that existing customers
make a comparatively greater contribution when marketing costs are taken into
consideration.

Do we want to retain all our customers?

Not necessarily. Some customers may not be profitable. Using customer lifetime value,
you can calculate the cost and contribution of each customer.

Apply the Customer Lifetime Value Concept

Customer lifetime value is a way of measuring how much your customers are worth to
you, over the length of time that they remain your customers.
The lifetime for customers will vary from industry to industry, and from brand to brand.
The lifetime of customers should come to an end when their contribution ceases to be
profitable unless steps are taken to revitalize them.

Benefits from Customer Lifetime Value

Industry experience indicates that a number of benefits apply.

• A 5% increase in customer retention can create a 125% increase in profits.


• A 10% increase in retailer retention can translate to a 20% increase in sales.


• Extending customer lifecycles by three years can triple profits per customer.

Identify Categories of Customer

Before calculating customer lifetime value, it is possible to analyze your customers
according to four key attributes. This can help to clarify analysis and act as the basis for
marketing activities to improve customer lifetime value:

• frequency—how often they purchase (regular customers are more likely to
  purchase in the future)


• recency—how much time has elapsed since the last purchase (recent customers
  are more likely to purchase again)


• amount—how much they spend (higher-spending customers are likely to be more
  committed)


• category—what sort of product they buy (some products will be more profitable
  than others and some may be one-time purchases)

Calculate Lifetime Value

In a consumer business, customer lifetime value is calculated, in practice, by analyzing
the behavior of a group of customers who:

• have the same recruitment date;


• are recruited from the same source;


• bought the same types of product.

In a business-to-business environment, a similar approach can be used.

• Isolate particular customers, and examine them individually.


• Analyze the behavior of different groups, segmenting your customer database by
  factors such as industry, annual turnover, or staff numbers.

The basic calculation has three stages:

• Identify a discrete group of customers for tracking.


• Record (or estimate) each revenue and cost for this group of customers, by
  campaign or season.


• Calculate the contribution, by campaign or season.

Refine the Calculation

Other factors can be introduced to make the calculation more relevant. In a business-to-
business environment, for example, it may be the sales representatives who generate sales.
In this case, the calculation should include the representative's "running costs" and the
cost of any centrally produced sales support material.

Evaluate a Campaign

The table shows the calculations for a group of customers who were recruited through a
direct response advertising campaign that ran in the spring of year 1. The table tracks
their expenditure over a five-year period.

Divide the total contribution by the number of customers in the group. Say there are one
thousand customers: the average lifetime value per customer is $7. But this compares
favorably with a short term analysis which, in the first year, would show a loss of $3 per
customer recruited.

Analyze the Results

A company may offer different products or brands, which are marketed under different
cost centers. If a customer is a customer of more than one cost/profit center, there is a
choice of approaches:

• Examine customers of each brand and ignore multipurchases.


• Build a more detailed model that combines and allocates the cumulative costs as
  well as the cumulative profit in the appropriate proportions.

Use Customer Lifetime Values to Improve Marketing Performance

There are four important applications:

• setting target customer acquisition costs


• allocating acquisition funds


• selecting acquisition offers


• supporting customer retention activities

In the example above the decision was taken in Year 4 to reduce marketing costs on this
group of customers. Equally valid may be an increase in expenditure aimed at
reactivating customers—this is a classic retention activity.

Set Target Customer Acquisition Costs

If a customer is expected to generate more than one sale, the allowable cost can be
greater than the cost allowed for the first sale—the classic loss-leader approach to
customer acquisition, illustrated in the example table above. However, overspending on
customer acquisition can also be ruinous. A reasonable calculation is to recruit only from
those sources that yield new customers at less than half the estimated lifetime value. On
that basis, the worst sources will have a cost per customer close to a lifetime value, while
the average cost per customer should be far lower.

Allocate Acquisition Funds

Different recruitment sources will provide customers with different lifetime values. After
identifying those values, spend more on the best sources.

Select Acquisition Offers

The lifetime value of a customer may depend on the type and value of their initial
purchase. In turn, this can lead to decisions about which products and offers to use when
advertising externally, or when considering how to upgrade existing customers.

Support Customer Retention Activities

Once the typical lifetime value of a group of customers is known, companies can decide
how hard to work at retaining them. It is not a foregone conclusion that all customers are
worth having. Activities should be tailored to the customers who are most valuable.

A financial services company can increase customer lifetime value by cross selling a
variety of products and services.

Trying to Retain the Wrong Customers

Customer retention costs money in terms of sales and marketing funds, so do bear in
mind that not all customers are worth keeping. You should carefully select the customers
who are likely to yield the highest returns over a period of time and prioritize the
allocation of marketing resources to these.

Offering Customers a Limited Range of Products

When you have identified the most valuable customers, you need to have a wide variety
of products or services to offer them. Cross-selling and up-selling are the best ways to
increase customer lifetime value, but this can be difficult with a limited product range.
Customers are your company's most valuable asset; think about "share of customer
wallet" rather than just share of market.

Spending Too Much on Acquiring New Customers

Customer lifetime value analysis reinforces a traditional marketing rule of thumb, that it
costs less to retain existing customers than to acquire new ones. Overemphasis on new
business development could be a bad move, since existing customers are easier to sell to.

Books:

Reichheld, Frederick F. Loyalty Rules! How Today's Leaders Build Lasting Relationships.
Boston, MA: Harvard Business School Press, 2003.
Peppers, Don, and Martha Rogers. Return on Customer: Creating and Maximizing Value
from Your Scarcest Resource. New York: Currency, 2005.

Web Site

Peppers+Rogers: www.1to1.com