The challenge of customer lifetime value is getting all of the customer interactions in one place so you can truly understand their costs and benefits.
Before Customer Relationship Management was what we know it to be today, the focus of marketing was to make the sale. To try and entice the customer with offers or promotions to get them to buy the product. Sometimes they would try to take into account the margin on the product before discounting, but many times, especially during the dot.com bubble, the focus was to get the sale no matter what the cost in order to take market share from competitors. The idea was that the company would be able to make it up later when the customer became loyal to them.
Obviously, that whole process never worked. First, the assumption that the customer will remain loyal to you once they make that first purchase was very naive. Secondly, gaining market share for that sake alone was a faulty strategy because if you compete on price, the relationship with that customer will never be profitable. Additionally, if you planned on gouging your customer later on to make the money back, that market share will just as quickly shift back to the competitor. The only market share that matters is the market share that is sustainable.
You can see how some of these decisions that were made were qualitative in nature. Metrics were based on making the sale only. Later on, new metrics-backed ways of truly understanding the value of a customer, both present and future, started making the promotion and discounting decisions more quantitative.
The premise of lifetime value is to take the sum of all of the company's interactions with that customer, both revenue and cost, and begin to develop strategies to grow that relationship to be profitable. The key is that the relationship by its true nature, must be profitable for both the company and the customer. The company gets its revenue from sales to the customer and the customer gets the company's products and services at a price he or she believes is worth the money.
As an example, Sarah, Bill and Jane are all customers of Acme Widget, Co. Sarah likes the "super-widget". She purchased the top of the line widget on the company's ecommerce website. She called the support number once after the widget arrived to activate the "super widget service" with all the bells and whistles. She liked the product so much that she wrote a nice review on the website and every year she renews her "super widget service". Acme Widget Co. knows that she likes the pink super widget, so when some pink accessories come out, the company markets those products to her via some email marketing campaign. Sure enough she purchases all of the accessories for her super widget and continues to be a very happy customer.
Bill on the other hand doesn't need all the glitz and glamor of the super widget. He found a coupon in the Sunday paper for the "economy widget" for 20% off at the Acme Widget, Co. branch store. He went to the retail establishment with coupon in hand and purchased the economy widget with the economy service plan that goes month to month. When the service plan lapses, Bill waits for an incentive to renew his service plan. Maybe a coupon for Buy One Get One (BOGO) month for free. Additionally, Bill constantly (about 10 times per year) calls the contact center with really dumb questions that are already published in the published website FAQ. Attempts at up-selling or cross-selling only work if there is an accompanying discount.
Jane is somewhere between Bill and Sarah. She buys the "average widget" with the average service plan. She also sets up auto-renew on the plan. Jane doesn't call the support line. She manages to do everything online including visiting the FAQ. If she needs direct support, she usually just emails the support center maybe once a year. Jane responds to flyers that come in her mail box. She is usually enticed by discounts, but if she wants an accessory for her widget, she will buy it at full price about 30% of the time.
If we take these three customers and look at the value each one brings to Acme Widget, Co. we see three different pictures:Sarah: She buys the high-margin products and will by anything associated with pink "super widgets" that we send her, discounted or not. She wrote positive reviews of the products. She only called support once. We know that for every dollar Sarah spends, Acme gets 35 cents. Lets assume that this equals $350 per year profit from this customer. Subtract the one call center support call per year at $15 per transaction and the ecommerce channel cost of $2 per transaction for 10 transactions a year and original customer acquisition cost of $500 and we get Sarah's value to the organization after 3 years is: Product margin ($350 + $350 + $350) + Reviews that have helped future sales per year ($1000 + $1000 + $1000) - less customer acquisition cost ($500) - less support costs ($15+$15+$15) - less transaction costs ($20 + $20 + $20). Sarah total value to Acme is: $3,445 if we keep her happy and more if we can grow the relationship further with new products and services. Bill: He buys the lowest-margin product and is only motivated with a discount. For every dollar Bill spends on these products, Acme gets 3 cents. Lets assume that this equals $30 per year. Take into account the same call center support costs of $15 per and the transaction cost of going to a retail store of $15 per transaction. Customer acquisition costs are the same: $500. Bill's value to the organization is: Product margin ($30 + $30 + $30) - less customer acquisition cost ($500) - less support costs ($15*10) - less transaction costs ($15*10). Bill's total value to Acme is: -$710 Jane: She buys the average products and services and uses a cheaper support channel, email at $4 per support incident. Acme gets 20 cents for every dollar that Jane spends. Jane's value to the organization is: Product margin ($200 + $200 + $200) - less customer acquisition cost ($500) - less support costs ($4*3) - less transaction costs ($20*3). Jane's total value to Acme is: $28.
So we can tell by these customers how quickly (or slowly) the break even cycle comes for each type. Sarah has almost an immediate return where Jane takes about three years and Bill will just continue to cost the company money. When we look at these numbers, we also need to understand if we can influence these customers. Maybe the right offer to Bill will turn him into a Jane? Maybe a little TLC with Jane and she can become as valuable a customer as Sarah? Large companies use append data to try and determine similarities or trends, but I'll save that discussion for another post.
The other value of a Lifetime Value calculation is how long your customers stay with you. How long can you count on that revenue. Maybe the average Sarah lasts five years and the Jane's of the world last ten. These statistical trends can be used to look at ways to incent these customer to stay on to insure a consistent revenue stream. This is a lot cheaper then spending $500 for every new customer. Regardless, understanding how long you can count on that revenue allows for wise investments in product development and investments in plant and property. There are always things that can cause hiccups such as the current economic climate or a highly publicized product recall, but for the most part, you can begin to view customer purchasing behaviors as somewhat predictable.