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Evaluating Strategy Using Lifetime Value

Most people have heard about the concept of customer lifetime value, but few have actually computed it for their own customers. They feel that they lack the data needed to do the computation. Even if they were able to create produce a number, most people don’t know what to do with it once they have it. After you finish reading this article, you should be able both to compute customer lifetime value, and use it in your marketing strategy.

To understand lifetime value, let’s take a hypothetical situation. Let’s compute the lifetime value of a group of newly acquired Hertz car rental business (not consumer) customers. (Note: the numbers are illustrative and not derived from Hertz. Hertz is used here as an example of how a well known and well run company would go about this process.) To determine lifetime value, you have to create a database which enables you to track customer purchases from year to year. If we can assume that Hertz has done this, they can look at their database after a couple of years, and create the following table.

Hertz Business Customers
Revenue Year 1 Year 2 Year 3
Customers 100,000 50,000 30,000
Retention Rate 50.00% 60.00% 70.00%
Spending Rate $160.00 $200.00 $240.00
Total Revenue $16,000,000 $10,000,000 $7,200,000
Variable Costs
Direct Percent 60.00% 57.00% 55.00%
Variable Direct Costs $9,600,000 $5,700,000 $3,960,000
Acquisition Costs $20 $2,000,000 $0 $0
Total Costs $11,600,000 $5,700,000 $3,960,000
Profits
Gross Profit $4,400,000 $4,300,000 $3,240,000
Discount Rate 1.00 1.20 1.44
NPV Profit $4,400,000 $3,583,333 $2,250,000
Cumulative NPV Profit $4,400,000 $7,983,333 $10,233,333
Customer lifetime value $44.00 $79.83 $102.33

We are assuming that Hertz has spent about $20 per person (in general advertising and promotion) to acquire 100,000 customers. Of these newly acquired customers, only 50,000 (50%) rent a car from Hertz in the following year. Of these remaining 50,000, only 30,000 are still renting cars in the third year. We have just determined the Retention Rate — a key component of customer lifetime value. For Hertz it is 50% in the first year, rising to 60% in the second year year. This is an important number which we will refer to later when we plot Hertz marketing strategy.  It is projected above that the retention rate will rise to 70% in the third year.

These newly acquired customers spend an average of $160 each in their first year. Those who remain for subsequent years (the loyalists) increase their spending to $200 and $240. TheSpending Rate is the second component of lifetime value. Putting these numbers together, you can see that Hertz gross revenue from these 100,000 new customers is $16 million the first year, $10 million from those who remain in Year2 and $7.2 million from the remaining loyalists in the third year.

The cost of servicing customers tends to go down over time. The first year, it costs Hertz about 60% of revenue. For those customers who last into subsequent years, it goes down to 57% and 55%. If we include the initial acquisition cost ($20 per new customer), we can then determine the total costs in each of the three years. Profits, of course, are equal to revenue minus costs. Looking at the gross profit line, we can see that these 100,000 customers produce a gross profit of $4.4 million in Year1 and $3.5 million in Year2. We need a way of adding profits from different years together if we are going to compute lifetime value. The method is to use a discount rate.

The discount rate is used to reduce assumed future profits down to their net present value. The discount rate is based on the rate of interest, and is usually doubled to include a risk factor. The formula is D = (1 + i)n where i = the annual rate of interest including risk, and n = the number of years. To compute lifetime value, we have to determine the net present value of the cumulative profit from each customer over each of the three years. This cumulative profit is then divided by the original 100,000 customers in each case to determine that the lifetime value is $44 the first year, rising to $103.33 in the third year.

Taken out of context, this number $102.33, has little meaning. To understand how we can use this number to guide Hertz marketing strategy, we have to make some strategic assumptions. Let’s assume that Hertz is trying to determine whether to set up a Number One Gold Club which will provide super services to its members, designed to make them loyal. I am, in fact, a Hertz Number One Gold Member. When I use a Hertz car, the Hertz bus at each airport drives me to an arcade where my name appears in 8″ high lighted letters. My car is waiting with the motor running. It is warm (in winter) and cool (in summer). I don’t wait in lines. I don’t have to sign a rental agreement form. I just show my driver’s license and go. The question which Hertz must answer before deciding to spend the money to set up such a club is, “How will this club affect customer lifetime value?”

Any strategy, such as this one, has both benefits and costs. The benefit of such a club is that it should increase the retention rate and the spending rate. It should also create a referral rate — encouraging some customers to become advocates, recruiting their friends and relatives to the club. At the same time, the club is not free. It costs money to put members names up in lights when they land at each airport, to get the car motor running in advance, to provide other benefits and services for club members. Will the costs exceed the benefits? In such a case, lifetime value will actually go down. To decide what to do, Hertz should compute a second lifetime value table: one which includes the costs and benefits anticipated from the proposed club strategy. Here is what it might look like:

Hertz Number One Club Gold Customer Lifetime Value
Revenue Year 1 Year 2 Year 3
Referral Rate 8.00% 10.00% 12.00%
Referred Customers 0 8,000 8,300
Total Customers 100,000 83,000 74,700
Retention Rate 75.00% 80.00% 85.00%
Spending Rate $210.00 $250.00 $280.00
Total Revenue $21,000,000 $20,750,000 $20,916,000
Variable Costs
Direct Percent 60.00% 57.00% 55.00%
Variable Direct Costs $12,600,000 $11,827,500 $11,503,800
Club Acquisition Costs $40 $4,000,000 $0 $0
Database Costs $5 $500,000 $415,000 $373,500
Special Services $20 $2,000,000 $1,660,000 $1,494,000
Referral Incentives $20 $0 $160,000 $166,000
Total Costs $19,100,000 $14,062,500 $13,537,300
Profits
Gross Profit $1,900,000 $6,687,500 $7,378,700
Discount Rate 1.00 1.20 1.44
NPV Profit $1,900,000 $5,572,917 $5,124,097
Cumulative NPV Profit $1,900,000 $7,472,917 $12,597,014
Customer lifetime value $19.00 $74.73 $125.97

This chart is similar to the last one, but it has significant new features. In the first place, the retention rate is now 75%, instead of 50%. This is a typical result of a successful marketing strategy — it should improve the retention rate. If your strategy does not increase the customer retention rate it is probably not a very good one. In addition, the spending rate is much higher: $210 instead of $160. Why? Because with a successful strategy, you are likely to get a much higher percentage of your customer’s business, instead of just a portion of it. How does Hertz determine what the new retention rates and spending rates are going to be? They make a guess, based on tests. One of the advantages of database marketing is that you can experiment and subject the planned changes to small scale regional tests that provide valuable insight without alerting your competition of what you plan to do on a larger scale.  Hertz certainly tried this strategy out before going national with it.

There are two new lines added: the referral rate and referred customers. Almost any worthwhile strategy that you can dream up — if it is working and popular with customers — will lead them to recommend your company to their friends and relatives. I have told hundreds of people about the Hertz Number One Gold Club. You can even incentivise your customers to enlist others as Verizon Wireless does by offering free in-network calling.

The combination of increased retention, spending and referrals has greatly increased the profits from the new strategy. The costs have also risen. It takes real dollars to put signs up with customer’s names in lights, to start the car engines when the planes land, and to provide all the services that go with a successful Gold club. We are assuming here that the database costs $5 per person per year, special services $20 and that the acquisition cost has risen from $20 to $40. The net result is that in Year1 the customer lifetime value has fallen to $19.00. But, on the other hand, lifetime value in Years 2 and 3 is greatly enhanced by the Gold club. To see what this means to Hertz, look at the following chart:

Hertz Gain from Gold Club Membership
Year 1 Year 2 Year 3
Before Club $44.00 $79.83 $102.33
With Club $19.00 $74.73 $125.97
Difference ($25.00) ($5.10) $23.64
With 200,000 Members ($5,000,000) ($5,104,167) $23,636,806

The lifetime value in Year3 has risen from $102.33 to $125.97 What this means to Hertz is an increase in profits due solely to the new strategy by nearly $23.6 million after all expenses have been paid if 1,000,000 customers become club members.

This chart does not prove that the club will be a success. It might fail through poor execution. What it proves is that the club might be a success. Many such tables have been drawn up which prove that proposed strategies could not succeed, no matter how well they are executed, because the costs exceed the benefits. This is the purpose of performing a lifetime value analysis and constructing such tables.

The lesson: before you embark on any new marketing strategy, first build or tap an existing customer database, and then create a base lifetime value table. When you know the base lifetime value, you should then use your imagination, and some carefully constructed tests to create a new lifetime value table assuming that your strategy is successfully implemented. You will soon see that there are only five ways in which database marketing strategies can increase lifetime value. They can increase the retention rate, the spending rate and the referral rate. They can also reduce the direct costs (in some cases) and the marketing costs. Use your new lifetime value table to evaluate your strategy. Don’t spend any serious money on a new project until this analysis shows that you have the potential for success.

Arthur Middleton Hughes is Vice President of The Database Marketing Institute that does research and consulting for e-mail and database marketing companies. He would love to hear about your problems. Perhaps he could help.  He can be reached at Arthur.hughes@dbmarketing.com or 954 767 4558. His new book Strategic Database Marketing 4th Edition is due out from McGraw-Hill in 2011.

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Arthur Middleton Hughes has published over 200 articles on Database and E-mail Marketing. Click Here to read them.

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