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Article Excerpt
Loyal customers cost less to serve, pay more than other customers, and attract more customers through word of mouth. If you agree with these three claims, it is time to revisit them and find out why they may not be true.
Our research has shown that loyal customers know their value to the company and demand premium service, believe they deserve lower prices, and spread positive word of mouth only if they feel and act loyal. Then why do companies pursue the claims listed above, and what is their logic in doing so? The answer lies in the premise that loyalty equals profitability. With this premise as the base, companies maximize backwardlooking metrics such as RFM (Recency of purchases, Frequency of purchases, and Monetary value of purchases), PCV (Past Customer Value), and SOW (Share of Wallet). Managing customers for loyalty, however, does not amount to managing them for profitability. On the contrary, the loyalty-profitability link must be managed simultaneously. How is this achieved?
We propose that measuring and maximizing Customer Lifetime Value (CLV) will help companies address this issue. When using the CLV paradigm, companies can make consistent decisions over time about which customers and prospects to acquire and retain, as well as those not to acquire and retain, and also determine the level of resources to be spent on the various micro-segments. Further, we have found that selecting and nurturing customers based on the CLV approach increases future profitability of the customers.
CUSTOMER LIFETIME VALUE: A FORWARD-LOOKING METRIC
What is CLV, and how can we measure it? CLV can be defined as:
"The sum of cumulated cash flows--discounted using the weighted average cost of capital (WACC)--of a customer over his or her entire lifetime with the company."
Although a true CLV measure implies measuring the customer's value over his or her lifetime, for most applications it is three years. This time period is due to three reasons--product life cycle, customer life cycle, and an 80% of profit that can be accounted for in three years. Figure 1 explains the approach to measuring CLV.
The CLV framework can be modeled using three main components: contribution margin, marketing cost, and probability of purchase in a given time period. Each of these models has a set of drivers and predictors, and the models are estimated simultaneously. By applying this modeling approach, managers can estimate the CLV for each customer of the firm. The calculation of CLV for all customers helps the firm rank customers on the basis of their contribution to profits. This would help firms in developing and implementing customer-specific strategies that can maximize customer lifetime profits and lifetime duration. In other words, CLV helps the firm treat each customer differently, based on his or her contribution, rather than treating all customers the same.
[FIGURE 1 OMITTED]
To test if CLV is really better than the backwardlooking metrics, we rank-ordered customers of a large high-tech services company from best to worst according to each metric (RFM, PCV, and CLV) using the first 48 months of data from one of our studies. We compared the total revenue, costs, and profits from the top 15% of the customers. For the next 24 months, the net value generated by the customers who were selected based on CLV score was about 45% greater than that generated by customers selected based on the traditional metrics. This shows that using CLV to select customers is far more effective than using the traditional metrics.
Having identified CLV as the best metric to manage customers profitably, let us try to answer the three important questions virtually all firms in every industry typically face:
1. How do we determine which types of customers and future prospects to retain, grow, acquire, or win back?
2. How do we determine which types of customers and future prospects not to retain, grow, acquire, or win back?
3. How much should be spent on the various microsegments to retain, grow, acquire, and win back these customers?
1. How do we determine which types of customers and future prospects to retain, grow, acquire, or win back?
In an effort to identify the types of customers and prospects to acquire and retain, we need to determine whom to acquire and retain, how to make customers profitably loyal, how to grow customers by managing their life cycle, and how to retain customers and prevent churn.
Whom to Acquire and Retain?
This is a fundamental question to which every company seeks a response. The CLV metric suggests that retaining profitable customers increases the firm's overall profitability, and it advocates that acquiring and retaining profitable customers should be the guiding principle. When companies pursue this approach, however, they encounter three common pitfalls:
* Considering the customer acquisition rate and customer retention rate as principal metrics of marketing performance,
* Focusing too much on the current cost of customer acquisition and retention and not enough on a customer's long-term value, and
* Treating acquisition and retention as independent activities and attempting to maximize both rates. In the first pitfall, companies often consider the customer acquisition rate (the percentage of people targeted by a direct-marketing effort who actually become customers) and customer retention rate (the duration of a customer's relationship with the firm) as the principal metrics of their marketing performance. This is because the two metrics are easy to understand and track, and companies have had a long-standing attraction toward garnering more market share.
While concentrating on these two rates may be valid in a contractual setting, such as in magazine or cable services subscription, using acquisition and retention rates as measures of overall performance may lead to the problem of diminishing returns. Every firm needs to understand that, as acquisition rates and retention rates increase, profits do not always increase beyond a certain point. Therefore, firms should make decisions to acquire or retain the next customer only if the cost of doing so is less than the value the customer brings back, either through his or her own future purchases or through positive word of mouth and referrals. Many firms have realized this and have taken steps to reward managers who are profitable--and not the ones who only maximize metrics such as acquisition and retention rates. This leads directly into the next pitfall of balancing acquisition and retention: focusing too much on short-term profit.
In the second pitfall, managers look to get the most out of each customer by focusing only on the short-term profitability or the next transaction and not on long-term profitability. This problem occurs when companies group their customers into one of the following four buckets: those customers who are easy to acquire and easy to retain; those who are hard to acquire but easy to maintain; those who are easy to acquire but hard to retain; and those who are hard to acquire and hard to retain. Such a classification makes managers target only those customers who are easy to acquire and easy to maintain as per the false assumption that acquisition costs and retention costs are the major drivers of customer profitability. This would not be a problem if each classification of customers were equally profitable, but that often is not the case.
By studying a catalog retailer, we analyzed the relationship between acquisition costs, retention costs, and customer profitability. In this study, a cohort of customers was tracked over a three-year time period. This cohort was split into one of four buckets based on the cost to acquire and retain the customers. Then, based on the transaction behavior of these customers, we determined how much each of the four customer groups contributed to the overall profitability of the cohort. Figure 2 shows the results of this study. The largest segment--the Casual customers (32%)--was easy to acquire and retain, but they...
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