Measuring Customer Value: How BPM Supports Better Marketing Decisions
Ten revenue and cost elements are key to determining the lifetime value of a customer: recurring revenues throughout the customer's lifetime, additional revenues from the likelihood of the customer responding to up-selling and cross-selling, costs to serve the customer, credits and returns, required investment in renewal and retention programs, downward migration to less-profitable channels, the initial cost of acquiring the customer, bad debt and/or administrative removal costs when the relationship is severed, and churn and win-back efforts that affect the other factors (see exhibit 2 below). All variables in this calculation must be considered over the course of the individual's lifetime as a customer. That means the expected timing of future cash inflows and outflows, as well as the cost of capital, must be considered in calculating the net present value of the customer to the business. So, for example, if the financial cost-of-capital rate is 10 percent, then $1.10 a year from now will equal $1 today.
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An individual customer's discounted CLV can be determined by the following equation:
CLV = Net present value [ SUM (Monthly profit margin) ] (sum) M -- Acquisition cost
where M is the probable number of months of retention as a customer. Calculating the discounted cash flow of a customer is not as complicated as one might imagine. Although the top portion of exhibit 3, below, may initially appear intimidating, the bottom section recasts key elements of the equation into a spreadsheet view that most businesspeople will be more comfortable with. The equations basically quantify the price, less the cost, for the expected purchased volume of each product or standard service line, less the cost to serve (including the cost to retain as a customer) for each time period. These costs are calculated for each customer -- or, to make them more manageable for most businesses, for each customer segment -- and then factored for probabilities.
Introducing this type of approach to support marketing decisions offers many benefits for a company. CLV can help the marketing operation contribute to higher company profitability by focusing marketing efforts on the right customers and by winnowing out less-valuable customers with limited potential for financial returns. (Sending an unprofitable customer to a competitor isn't a bad thing.) Approaching marketing investments from a CLV point of view can also be useful in understanding profit momentum because changes in customer behavior are usually not volatile. Unlike financial statement reporting, CLV measures are not interrupted by one-time charges or other short-term but substantial financial statement surprises.
Organizations intimidated by the idea of measuring all the factors that play into CLV may want to begin with simpler equations than that in exhibit 3. They can start by using computer modeling and by estimating the values for some of the elements in exhibit 2. The benefits of such simplified calculations lie in the organization's learning about how to view its customer segments and how to think about the probabilities for elements such as churn and win-backs.
Loyalty + CLV = Shareholder Value
Understanding the loyalty of a given customer is important because loyalty directly affects the amount of marketing spending that is required to retain the customer.
Companies that are advanced in their analytics capabilities use business intelligence software to understand some of the psycho-demographic characteristics of customers and to predict their future behavior. It is not unusual for the customer analytics departments in companies to claim that the accuracy of their customer "survival" projections is reliably high. They can almost predict which customer by name is likely to defect. The question, then, is whether it is worth the extra cost to attempt to retain that customer. Would shareholder value benefit from a marketing investment in that customer?
Excess spending on marketing to any customer segment can lead to shareholder wealth destruction; a company can overspend unnecessarily on profitable but loyal customers to retain their business. For example, bankers are known for lavish dinners or rounds of golf with VIPs, long-term customers who are unlikely to ever switch to another bank. Similarly, insufficient spending can lead to shareholder wealth destruction because an underserved customer may defect to a competitor or reduce spending volume, thus lowering the expected lifetime value for that customer. A company constantly makes marketing-investment decisions, both by actively pursuing customers with new offers or deals and by passively assigning them to a customer segment which is entitled to no offers or deals.
Exhibit 4, below, shows a grid on which a company can plot its customers. Their position on the vertical axis should be based on their lifetime value (i.e., the rank-ordering determined by the customer's distance from the top right corner of exhibit 1), and their location on the horizontal axis should be based on their loyalty. The location of a customer on exhibit 4's grid implies the level to which the company should offer incentives, deals, discounts, and the like to retain the customer's ongoing stream of purchases. The spending budget for sales and marketing is critical, but that spending must be treated as a scarce resource aimed at generating the highest possible long-term profits. This means answering the question: For the types of customers we want to target, how much should we spend attracting, retaining, growing, or recovering each segment?
An organization should calculate how much sales and marketing spending is too much or too little for each customer or customer segment. This is the first derivative of calculus -- similar to acceleration's relationship to velocity. It is about the next increment of change. What impact do I get by spending an extra dollar on each customer or by reducing that planned spending by an extra dollar? Combining customer financial value scores with customer loyalty measures can determine the optimal level of marketing and sales retention spending on each customer cluster.
Most senior managers treat customer intelligence analytics as a harmless curiosity in a permanent phase of development and trials. However, these same senior managers also wonder whether the fact that they do not understand the potential future value of their customers is a matter of "Do we know?" -- or "Should we know?" To optimize their investment decisions, most marketing executives need help from the finance department, from the analysts who have experience in choosing metrics and calculating performance for other areas of the organization. Such collaboration on customer value management initiatives helps a company's marketing department -- and executive team -- navigate shareholder wealth creation based on facts, not on hunches and intuition.
Good customer intelligence software helps companies make smarter decisions faster. To create higher shareholder wealth, an organization must continuously analyze its customer portfolio in innovative ways to discover new profitable revenue growth opportunities. By refocusing customer strategy, retooling measurement mechanics, and taking steps to realign the organization around customers, companies can unlock the vast profit potential of the customer asset. They can retain and grow existing customers and acquire new high-potential customers that will drive the greatest amount of profit today and in the future.
Gary Cokins is global product marketing manager for performance management solutions at SAS and a well-known expert in performance and cost management.
