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Building Successful Retail Strategies Using Customer Lifetime Value

What you use to measure your success often defines your vision and your strategy. If your goal is more customers, you can get them, but they may not be profitable. Fleet Bank discovered that half of their existing customers are not profitable to the bank. If your goal is higher sales, you can boost them – but a what cost? Many retailers have the idea that sales and discounts are the road to success. They may actually be the road to ruin.

Fredrich Reichheld, author of The Loyalty Effect, said that the “net present value of the customer base should be at the top of the measurement hierarchy.” Lifetime value is the net present value of the profit to be realized on the average new customer during a given number of years. It is a wonderful concept, and can be an excellent guide to profitable strategy. The steps you have to go through are these:

  • Get your customers to give you data, and build it into a database complete with purchase history. For a retailer, that means that you have to get your customers to use a plastic member card, or to record their credit cards with you so you can keep track of their spending.
  • Use the data to segment your customers by profitability. You will get a picture that looks something like this:

When you do this, you may discover that your top 20% of your customers gives you 80% of your profits. Everyone else has discovered the same thing. But you may also find, as the Fleet Bank did, that you cannot market profitably to these Gold customers. They are already giving you all their business in your category. They are “maxed out.” What should you do for them? Give them special services and attention so as to retain them. The people you should market to are those just below Gold. They have the ability to move up to Gold, if you will only encourage them.

Building a relationship with customers only works if the customer benefits from the relationship. The trick in retailing, therefore, is to find things that you can do for customers that will modify their behavior in profitable ways. What you provide to customers has to be something that they will appreciate and value, but which do not cost you too much. In retailing, the margins are often thin. Safeway, for example, estimated how much they could afford to spend on customer relationship management. It came to about $2 per customer per month. $2 per month isn’t going to change anyone’s behavior. So what do you do? You concentrate your resources on those customers whose behavior you can most easily change, and whose changed behavior will be most profitable.

If you segment retail customers by frequency of visit, and incremental sales potential, you will notice that your biggest opportunities lie in the second and third quintiles:

These customers probably do a good deal of their buying somewhere else. If you make it worth their while, they could shift to doing more business with you.

The other thing you will discover if you analyze customers by years as a customer, is that long term loyal customers are different from new customers. They tend to:

  • buy more often
  • buy higher priced items
  • are less costly to serve
  • have higher retention rates.

This being the case, retailers have discovered that the goal of their marketing programs should be to build a relationship with customers whose behavior can be modified, to convert them over time into long run loyal and profitable customers. The process can be measured and tracked by using a lifetime value chart. It looks like this:

Lifetime Value Before New Programs
Year 1 Year 2 Year 3
Customers 5,000 3,500 2,590
Retention Rate 70.0% 74.0% 80.0%
Visits/Week 0.64 0.69 0.78
Average Basket $33 $45 $55
Total Sales $5,280,000 $5,433,750 $5,555,550
Cost Percent 83.0% 80.0% 79.0%
Direct Costs $4,382,400 $4,347,000 $4,388,885
Labor + Benefits 11% $580,800 $597,713 $611,111
Card Program $16, $8 $80,000 $28,000 $20,720
Advertising 2% $105,600 $108,675 $111,111
Total Costs $5,148,800 $5,081,388 $5,131,826
Gross Profit $131,200 $352,363 $423,724
Discount Rate 1.00 1.20 1.44
NPV Profit $131,200 $293,635 $294, 253
Cum. NPV Profit $131,200 $424,835 $719,088
Lifetime Value $26.24 $84.97 $143.82

In this chart, we are tracking the performance of 5,000 newly acquired customers over three years. Their initial retention rate is 70%, which means that during the first year, 30% stop shopping with us. The retention rate goes up over time, as loyal customers are sorted out from disloyal ones. Their visits per week also go up with loyalty, as does the contents of their average shopping basket. This retailer spends 2% of his revenue on advertising and about $16 per customer per year on a plastic frequent shopper card system so that he can keep track of what customers are buying.

The lifetime value of these customers is $143 in the third year. We should note that this is based on the net present value of their profits, adjusted by a discount rate. The discount rate is needed because money that you will receive in the future is not worth as much as money that you have in hand right now. The rate discounts future money so it can be legitimately added to current profits to get a valid lifetime value. The formula for the discount rate is:

D = (1 + i)n

Where i = the current interest rate plus a risk factor, and n = the number of years that you have to wait to get your hands on the future money.

The lifetime value numbers are really very powerful measures. They include in a single set of numbers the retention rate, the spending rate, the costs of marketing, and the discount rate. By themselves, however, they are not as powerful as they will be when we use them to evaluate marketing strategies. To illustrate this, look at what Safeway is doing with their frequent shopper program.

By analyzing customer spending patterns, Safeway discovered shoppers who never visited the meat or produce departments. For those shoppers alone, Safeway gave them a coupon for $1 off of anything bought in those departments. Result: meat and produce sales went through the roof. And, more important, these same people returned to shop in these departments two weeks later after the coupon campaign had terminated.

This strategy is targeting certain customers whose behavior you want to change, and giving something only to them that you can afford which helps to modify their behavior. Safeway also experimented with a host of other programs designed to build a relationship with certain targeted customer segments. They offered free ice cream on their birthday, and measured increased sales elsewhere in the store that resulted from this gift. Besides birthday programs, retailers have experimented with:

  • Customer specific pricing, where members get cheaper prices on certain items
  • Rewards for large baskets
  • Rewards for frequency
  • Slow day shopping rewards
  • Personal recognition and relationship programs
  • Reducing advertising to pay for relationship building programs

Suppose that the retailer listed above were to adopt all or many of these programs. What could happen to lifetime value as a result?

Lifetime Value Using Customer Management Program
Year 1 Year 2 Year 3
Customers 5,000 3,750 2,963
Retention Rate 75.0% 79.0% 85.0%
Visits/Week 0,68 0,73 0.82
Average Basket $38 $50 $61
Total Sales $6,120,000 $6,843,750 $7,409,213
Cost Percent 83.0% 80.0% 79.0%
Direct Costs $5,079,600 $5,475,000 $5,853,278
Labor + Benefits 11% $673,200 $752,813 $815,013
Card Program$16, $8 $80,000 $30,000 $23,700
Customer Specific Marketing $61,200 $66,438 $74,092
Advertising 1% $61,200 $68,438 $74,092
Total Costs $5,955,200 $6,394,688 $6,840,176
Gross Profits $164,800 $449,063 $569,037
Discount Rate 1.00 1.20 1.44
NPV Profit $164,800 $374,219 $395,165
Cum. NPV Profit $164,800 $539,019 $934,183
Lifetime Value $32.96 $107.80 $186.84

In this example the retailer has cut his advertising budget in half. With the resulting savings, he has boosted programs for his valued customers. What has he gained by this?

  • The retention rate has gone up from 70% to 75%
  • The visits per week have risen from 0.64 to 0.68
  • The average basket has risen from $33 to $36
  • The lifetime value in the third year has risen from $143 to $186.

What does this really mean for a chain store?

Effect of Adoption of New Programs
New LTV $32.96 $107.80 $186.84
Previous LTV $26.24 $84.97 $143.82
Gain $6.72 $22.83 $43.02
With 200,000 Customers $1,344,000 $4,566,000 $8.604,000

Assuming that the chain has 200,000 customers who are using the frequent shopper card, and getting the relationship building programs described, the profits to the chain in the third year will be more than $8 million. This is real profit, since the costs of the new programs have already been factored in.

These charts don’t tell you that the programs will be a success. Poor execution can ruin any well laid plan. But lifetime value analysis tells you that your programs can be successful. Many programs fail because this type of analysis has not been done in advance. Increasingly marketers are realizing that the techniques used to measure success guide their strategy. Lifetime value, as a measurement, is preferable to basing your strategy on numbers of customers, market share, or total sales.

 

Arthur Middleton Hughes, vice president of The Database Marketing Institute, has presented 28 seminars on database and email marketing.  Arthur has also authored several books includingStrategic Database Marketing 4th Edition (McGraw-Hill 2012). He and Andrew Kordek, chief strategist and co-founder of Trendline Interactive, are hosting a two-day Email Strategy Study Group in Fort Lauderdale  March 26-27, 2013, featuring group competition for email marketers responsible for subscriber acquisition, lifetime value, ratings and reviews, boosting their email budget, and doubling their ROI.  To learn how to attend the Study Group,click here

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