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Customer Lifetime Value for CFOs

An Enterprise Metric

It has often been said that marketing means putting the customer at the center of everything a business does. A customer-centered company is therefore one that continually learns how to find out what it can do for customers at a profit. To the customer-centered organization the biggest question that must be answered and tracked over time is: how are we doing at improving our predicted profit per customer? This ought to be at least one key criterion for measuring success in the organization. The bad news is there is no standard way to do this and report it to directors and shareholders. The good news is that this challenge can be overcome and tried and true techniques already exist. The profit value of customers is different from either product profitability or contribution from advertising and other communications but is related to both. As a distinct metric, Customer Lifetime Value (CLV) is the net present value of expected cash flows earned by, and expended on behalf of, a given customer for his/her relationship over a projected time-scape. We will come back to what this means and how to obtain it, but first it is necessary to review how companies usually try to measure the value of what they do to attract and retain customers.

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Marketing Return on Investment (ROI)

Increasingly, marketing managers are expected to justify their efforts by showing the ROI of advertising efforts. There are a variety of ways to determine if programs produce response, customer interest or intent to purchase. These methodologies mostly have to do with asking a group of people who may or may not be customers what they intend in one way or another. An assumption seldom stated in the analysis or presentation of findings is that the main priority of any company is to acquire customers or to convert prospects to buyers. About seventy cents of every marketing dollar is currently spent to do this, even though evidence mounts that keeping customers is more cost efficient and more critical to both current results and long term growth. At the same time, people dont do what they say they might in a survey. Instead, their past behavior tends to predict their future behavior. If the behavior that is tracked is not matched back to individual customer records, it is difficult, if not impossible to accurately gauge the actual results of a program. Direct businesses have always done this, but companies that build brands and sell through others have always had a tough time getting sales transaction data from their trade partners. Because of the difficulties associated with this, various heuristics (rules of thumb) are used with assumptions that build on assumptions to arrive at some sort of result. These aggregations are usually not confidence inspiring. One can get a directional sense for marketing effectiveness by aggregating campaign metrics based on assumed values and surveys, but it is a stretch to say this accurately captures whether, for example, brand advertising is enhancing or diminishing profit. Better would be an algorithm that

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accurately captures and predicts profitability at the customer level, but this would not entirely replace campaign metrics. This is because the ability to drill down and across data elements for analysis is improving but still far from perfect. CLV is predictive and powerful, but changes take time to show up and cant always be drilled down into specific campaigns. The bias of CLV analysis is that marketing efforts should drive profitability, not exclusively sales or customer acquisition, and should be evaluated based on their ability to do this. Success is not therefore about measures of reach as has been the historical norm in gauging media effectiveness. The need for more accountability in marketing is indicated by the shift in allocations toward internet advertising. Even where actual results are unknown, the appearance of marketing accountability based on individual click behavior is preferred to general assumptions about purchase intent based on self-reported advertising recall. At some point, the analysis of marketing

performance breaks off into at least these two dimensions:

What can we say about campaign/program success at growing or retaining customers or driving sales? What can we say about the changing customer profitability over time?

While measures of campaign or marketing program success are of great interest to the marketing department, they are seldom strategic in the sense that the outcome is mission critical. On the other hand, Customer Lifetime Value is too strategic to be treated as an afterthought to campaign or programmatic communications or branding initiatives.

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Additionally, the challenges in obtaining this measure require cross functional expertise within the organization.

What is the Point of Marketing Research?

Marketing research is what represents the voice of the customer and the memory of what they say both by their words and actions. While many great organizations try to manage portfolios of customers and deliver what they can at a profit, not a few still see marketing as the job of finding and convincing customers to buy what they make. Marketing research is there treated as the rubric for scientific support to buttress beliefs held by management about who will buy ACME Widgets and how to convince them to do so at reasonable cost and a good price. The results of this latter type of information may be used to guide product development and pricing. Information that has to do with the real conversation a company has on an on-going basis with its customers is often embedded in call center applications and is the purview of operations functions. Marketing and product development routinely ask questions of some purportedly representative groups of customers but what all the customers are saying and doing that could inform their decisions is as often as not left out of their decision process. This may be tactical or strategic in importance, depending on whether the results of research are programmatic and within budget or have to do with broader and bigger changes and resource allocations. For strategic level decisions it is well to ask what the impact is likely to be on strategic or enterprise measures of value, such as the profitability of the customer base whether or not the absolute number of customers changes. CLV can be used as a

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scorecard device in budgeting and planning resources, not just for marketing spend, but for executive decisions that may be sensitive to or driven by perceived customer impact. Most executives would agree that the process of building a business case for large cash or capital outlays to change or elevate a companys position in the marketplace ought not to be justified on the basis of what eight guys in a focus group said. A variety of

approaches exist to find out why customers do what they do. Ethnographic research is a holistic method that has gained popularity. Statistical methods such as conjoint analysis can also provide excellent insights when evaluating customer attributes. However a firm tries to understand the why of customer behavior, it is a good idea to place insight within a context of customer profitability. While CLV does not provide all the answers, it does provide a reliable guidepost.

How is CLV calculated?

CRM gurus Don Peppers and Martha Rogers recognized that traditional financial metrics often do not sufficiently capture the value of the customer base, or how management decisions can alter the value of the franchise. They have proposed an alternative called Return on Customer (ROC), which is calculated as the firm's current-period cash flow from its customers, plus any changes in the underlying customer equity, divided by the total customer equity at the beginning of the period. Customer equity is the net present value of all the cash flows a company expects its customers to generate over their lifetimes. Peppers and Rogers are on to something. At the same time, questions about how to get there with confidence immediately arise, including:

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How do we know how long customers last? What do we include in positive and negative cash flows? When evaluating investments a positive NPV is a good thing but the absolute value doesnt mean much. How can we evaluate the relative value of customers? The interest rate in an NPV calculation is the required rate of return or cost of capital or hurdle rate. What interest rate is appropriate in evaluating customers?

One wishes to avoid commitment to an exercise reminiscent of the proverbial chalk filled blackboard with a long formula pointing to a space where it says a miracle occurs here. What follows are some comments on how to get there from here.

CLV Elements & Process

An NPV calculation is pretty straightforward and can be done on my venerable HP 12-C. The hard part is getting the inputs ready. Broadly this means answering these questions: How do we define customer? How long do customers last? What does it cost to acquire them? What does it cost to keep them? What do we earn from them?

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As might be expected, the questions are simple but answering them can be complex. Lets look at each in turn.

How do we define customer?

To most sales people, everybody in their target group is a customer, whether they happen to realize it or not. However, most companies can only legitimately claim as customers those who buy from them (whether they are end users or not) and who have relationships based on recent, frequent and or high value purchases (RFM). RFM was an early customer value metric developed by catalog retailers that is still in use today. The reason to go beyond this and calculate customer lifetime value is that while RFM does index customer profitability, it doesnt do a very good job of prediction and doesnt establish a scorecard metric the way CLV can.

Customers are identifiable units with purchase behavior not abstractions existing in theory. This can mean individual consumers, families or purchasing agents. For consumer household it is relatively easy to group attributes by a single mailable address, which is usually the place of residence, the billing location and the shipping location. All of these identifiers help to tag the identity and behavior of that customer or household. For businesses, things get more complex, but the idea is the same. If you know where they live and to whom they report you pretty much know who they are.

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For customers buying and shopping online there are additional challenges but essentially the same rules apply. If you can identify individuals and tag their purchases and other profile information to them by address or other unique identifier than you have established customer identity. Good manners in communication and increasingly the law require that companies obtain permission to solicit customers or use information about them. This means that creating profiles of customers and their communications preferences is a business requirement. Accordingly, rather than a luxury, it is becoming a necessity for a company to know who their customers are in ways that would help them index profitability for each individual.

Companies disagree internally and externally on the definition of customers. While technology professionals often have to compensate for these disagreements, definitional differences are not only an IT issue. However a customer is defined within an enterprise, it is important to have a common language lexicon that will become the standard for evaluating customer value. Ultimately, the group that works on this should have the authority to bring critical systems into agreement on definitional elements.

Some of the variables considered in defining customers are: B2B2C who are the customers customers and how do we roll up that information? When did they buy something? became a customer, before that a prospect or lead. Also important to retain limited history to see if companies are paying to re-acquire customers. Who owns the customer?
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How long do customers last?

The lifetime used in a CLV calculation can be crudely estimated as the average duration (days/months/years) between first purchase and last purchase for the customer population. A single measure of this may be useful for a division or channel, but may lose value if aggregated at the corporate value. Additionally, to be defined by the enterprise is what rule will be used for last purchase and what to do with lapsed customers who reactivate later. Factors affecting the lifetime include:

Moving Re-acquiring Lapse rates (when does a customer stop being a customer?)

It is usually advisable to create an index value using a statistical model. This is especially important if the CLV is going to be used with RFM to sort individuals or groups of customers to determine an appropriate communication strategy. One shouldnt assume that the mean value of a group applies equally to each member of the group. Using models and indexes helps avoid this.

What does it cost to acquire them?

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The real cost of acquiring a customer is everything a company spent to get them to say yes and make a purchase the very first time. This may include advertising of various types. In the case of Starbucks it is likely to include the ubiquity of their stores and word of mouth more than brand advertising (since they invest little or nothing in this activity). A difficulty then presents itself how do we include the cost of capital expenditures and other costs of doing business along with non-capital expenditures like advertising? Where does this stop? A fully allocated cost of acquisition would include the CEOs stock options. I am unaware that anyone actually goes that far, but the point is, marketing effectiveness really cant be all about measuring success at acquisition because nobody would be able to afford to do it on a fully allocated basis. Thinking this way does tend to push in the direction of comparing all customer related costs to the positive cash flows generated by customers, but for the present, acquisition is about short term payback. If we take the unit cost of each marketing activity ($/new customers) we get a cost to acquire. Those involved in branding may say this is incomplete because the effect is a long term one (back to the Peppers & Rogers point) and the benefit in branding is felt by people who may not buy during the period analyzed. Also, this acquisition cost ignores the lift provided by other forms of influence. All this may be true, but increasingly, finance will have to give extra weight to the acquisition methods where a benefit can be confidently established. The time when large marketing expenditures can be made based on a leap of faith is drawing to a close. The burden of proof must be on marketing to show the benefit. CLV might help, since it is not a campaign metric but does benchmark whether customer value is growing. The value of branding may ultimately be subtracted from what is left after known factors are accounted for. This becomes easier if

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it is possible to establish a control by blacking out dates and prospect groups/geographies and accounting for expected decay of awareness.

Factors to be analyzed and unitized include: Quantifying other marketing (e.g. billboard effect of Starbucks location/logo) Coupons and trade support Brand advertising Direct advertising

What does it cost to keep them?

As mentioned earlier, the cost to get a customer can include the expense of putting a store in her face on the way to work. If acquisition program managers want to justify efforts based on an expected break-even when the ongoing purchase stream pays back the initial cost of advertising or promotion they can be surprised to learn the payback might be never on a fully allocated basis. However, fully allocating the cost of operations against the initial outlay is not really fair. A separate measure of cost of carry is appropriate, but begs the question, how much of this is legitimate to balance against cost of acquisition and or branding? Wouldnt it be better to compare more fully loaded costs (with or without fixed/indirect costs as deemed appropriate) to all expected cash flows? Yes it would. This is precisely what CLV does and why it is so important.

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Factors to consider when developing the negative cash flows: Cost of carry not just advertising all operations that affect the customers Whether or not to include fully allocated costs (e.g. the CEOs pay) Advertising & promotion Communication (such as monthly statements) and the cost of inbound call centers that are not mainly there for sales purposes

What do we earn from them?

The positive cash flows we obtain from customers include gross or net sales. We need to be sure we are not double counting costs captured elsewhere. Acquisition costs are properly counted as negative cash flows. Here is where it is so critical to have our customer definition in order. Decisions need to be made how far we want to aggregate (or parse) data and how we want it done. If we want enterprise customer value then we have to be consistent all the way down. If we have trouble connecting the dots between items or amounts sold to subsidiaries or connecting bill to information with ship to information with parent company, then we need to address those issues first. If we are confident that we have customers and all related transactions attributed to them then we can proceed to a determination of projected value for a likely lifespan having done all we can to eliminated guesses and mismatched data.

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Factors to consider in evaluating earnings: Aggregated sales Not a campaign metric includes all sales for the period, not just what came in response to a given treatment

CLV Process

Doing the work of CLV requires a detailed project plan and project management. Before the process begins, and at touch points along the way, it is imperative that executive level management stay involved to check on progress and communicate the importance of the work to the wider organization. There may be times when executives need to provide air cover with managers who dont see why they should make resources or information available to the CLV team.

A high level work plan will include major milestones such as these: Cross functional team leader/sponsor assigned and partners/vendor(s) selected JAD session/kickoff (facilitator) to define program goals, obstacles, participants and parameters Develop project plan and responsibility matrices and obtain signoff from key constituents Business Requirements Document authored and approved Data cleansing process performed and programming requirements defined logically

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Metadata (including common language lexicon) the rules or data about data that will under gird the CLV process Modeling statistical model development and validation to predict lifetimes and other modeled attributes for inclusion in CLV Infrastructure development to operationalize CLV going forward and measure change Deployment of operational CLV model and report of initial findings to senior management Measure/repeat and improve (test & learn)

Conclusion

Now more than ever, companies are realizing that better ROI measures are necessary to provide accountability for marketing expenditures. Less well understood is the applicability of tested metrics for marketing effectiveness in determining and reporting enterprise value to those who have a legitimate need to know. The value of a companys franchise can be captured and benchmarked using Customer Lifetime Value metrics.

CLV can show which customers are the most costly to lose and deserve more careful attention. This means a shift in emphasis away from spending the most on new customers where cost is high and benefit is uncertain. Using CLV as an enterprise metric is consistent with being a customer-centered organization. We are what we measure.

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While the work is not easy, the rewards can be a fuller and more satisfying connection between the metrics that govern the enterprise and how the enterprise goes about getting and keeping profitable relationships with customers. The requirements for doing CLV are increasingly available in already deployed and integrated systems because of the widespread adoption of ERP systems (such as Peoplesoft and SAP) and requirements for transparency and assurance mandated for US based companies by Sarbanes Oxley. Marketing departments can no longer avoid accountability metrics but to a great extent executives are focused on branding and PR assignments. They may have sophisticated analytical capabilities available to them but they tend to be buried in the organization.

The time has come for Finance to take a strong and consistent hand in measuring how all the efforts made to keep and grow customers pay off. Customer Lifetime Value is a tool that can provide an important guidepost on this journey. It is ready at hand and worth the effort to deploy.
Andrew Talbot comes to ATwork, LLC as a seasoned marketing manager and consultant. With over twenty-three years of experience, his background comprises direct marketing, integrated marketing and e-commerce in various industries with a concentration in financial services. His work for Fortune 100 firms has included CRM process consulting, developing insight from data mining and statistical modeling, sales process improvement and allowing the facts to drive branding. He is a graduate of Gettysburg College with a BA in Philosophy. For more information, please visit: ATworkllc.com

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