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Targeted Relationship Building Pays Off

For the last decade, more and more companies have been seriously looking into programs designed to build relationships with their customers that promote retention, referrals and increased spending. For some products and services, such relationship building activities work well, and can be shown to produce a measurable increase in customer lifetime value (LTV). Lifetime value is used as a measuring tool because it is the one index that combines into a single number the three sought after behaviors (increased retention, referrals and spending) and the key cost item (cost of the relationship building programs). What these companies have failed to do, however, is to take the next step: segmenting their customers by LTV and spending more money on the best customers, and less on the not so good customers. The purpose of this article is to show how this is done, and how to measure the impact of the segmentation.

Relationship Building Works

There is no question that in some industries there is real value to both the company and to the customer in the relationship. This is not universally true. No one wants to build a relationship with the company that makes their paper clips or their light bulbs. Life is too short to be getting communications from the producers of the hundreds of products that we use in our everyday life. Since we don’t want to be bothered, it follows that the manufacturers cannot profit from contacting us. Relationship building only works if the customer feels that she benefits from it in some way.

On the other hand, we can gain by exchanging communications with our favorite airline, automobile manufacturer, bank or insurance company. In many cases, we build up an equity in these relationships. We have spent time training them in our special needs and preferences. We want them to remember these things and to use them in their communications and in the delivery of services. If they please us, then we will reward them in a way that costs us almost nothing: by being loyal and by listening to what they have to say.

What do these relationship building tactics consist of? They can be newsletters, personal communications, surveys, telephone calls, frequent buyer points, gold and platinum cards, or even just plain one-on-one friendships built up between the customer and a customer service rep.

Measuring the effect

Measuring the effect of relationship building is done by lifetime value analysis. A typical LTV chart looks like this:

Base Lifetime Value Calculation Without Relationship Marketing
Revenue Year 1 Year 2 Year 3
Customers 19,984 7,994 3,597
Retention Rate 40.00% 45.00% 50.00%
Spending Rate $1,250 $1,350 $1,400
Total Revenue $24,980,000 $10,791,900 $5,035,800
Direct Percent 85.00% 75.00% 70.00%
Direct Costs $21,233,000 $8,093,925 $3,525,060
Acquisition Cost $20 $399,680 $0 $0
Total Costs $21,632,680 $8,093,925 $3,525,060
Gross Profit $3,347,320 $2,697,975 $1,510,740
Discount Rate 1.00 1.20 1.44
NPV Profit $3,347,320 $2,248,313 $1,049,125
Cumulative NPV Profit $3,347,320 $5,595,633 $6,644,758
Customer Lifetime Value $167.50 $280.01 $332.50

In this chart, a company has kept track of a test group of about 20,000 customers over a three year period. They have determined the retention rate (40% to 50%) and the spending rate ($1,250 to $1,400 per year). The lifetime value of the typical newly acquired customer in second year after acquisition is about $332.50

Let us assume that this company has embarked on a relationship building program with their customers. The cost of the program is $15 per customer per year. As a result of this program, the company is able to increase the retention rate, and the spending rate, and is able to convert a sufficient number of customers into advocates to that their referral rate is 8% going in to the third year. The net effect of all of these activities is to boost LTV in the third year to $398 as shown on the next page.

As you can see, the retention rate increases from 40% to 50% rising to 60% in the third year for those enrolled in the relationship building program, while the spending rate rises from $1,250 per year to $1,700. The $15 per customer per year relationship building program not only pays for itself, it increases the LTV in each of the three years tracked.

Lifetime Value with Relationship Building at $15 per customer
Revenue Year 1 Year 2 Year 3
Referral Rate 5.00% 8.00% 11.00%
Referred Customers 0 999 879
Retention Rate 50.00% 55.00% 60.00%
Retained Customers 0 9,992 6,045
Total Customers 19,984 10,991 6,924
Spending Rate $1,450 $1,600 $1,700
Total Revenue $28,976,800 $17,585,600 $11,770,885
Cost Percent 85.00% 75.00% 70.00%
Direct Costs $24,630,280 $13,189,200 $8,239,620
Relationship Tactics ($15) $299,760 $164,865 $103,861
Acquisition Costs ($100) $1,998,400 $0 $0
Total Costs $26,928,440 $13,354,065 $8,343,480
Gross Profit $2,048,360 $4,231,535 $3,427,405
Discount Rate 1.00 1.20 1.44
NPV Profit $2,048,360 $3,526,279 $2,380,142
Cumulative NPV Profit $2,048,360 $5,574,639 $7,954,781
Customer lifetime value $102.50 $278.96 $398.06

As a result of this experience, the company can project the effect of this effort on the total company Firm Value – a concept pioneered by Behram Hansotia, senior vice president of InfoWorks in Toronto. Behram is also an adjunct professor at Northwestern University. Northwestern is producing more new ideas in this field than any other university. The firm value is the present value of future cash flows. One way of computing this is to multiply customer lifetime value times the number of customers. If the company shown here has 200,000 customers, then we can see the effect of the relationship building programs on Firm Value. It rises from $66 million (200,000 times $332) to $79 million (200,000 times $398) with the new programs – a gain of $10 million – after all relationship building programs were paid for.

Using LTV Segmentation to increase Firm Value

This is the type of gain in Firm Value that many companies have begun to look for in relationship building programs. But if they settle for this, they may be missing the boat. Why? Because they are making the mistake of treating all customers equally. Customers are not equal. Some customers – your top 20% — give you 80% or some other large percentage of your total revenue. Other customers – your bottom 20% — may be giving you less in value than it costs to service them. Why spend money trying to retain these losers? What companies are starting to do is to determine the LTV of customers by groups – such as monetary quintiles – and custom design a group of benefits and perks, plus marketing initiatives designed not only to build relationships, but also to encourage customers to move up to higher plateaus of spending. The picture looks something like this:

Once you have built the database and done the analysis to divide customers into these segments, you can then channel your service and marketing dollars more intelligently. Why spend $15 on every customer? With segmentation, it would be possible to spend exactly the same amount of money — $3 million per year – yet this money would increase Firm Value by another $22 million dollars. Here is the comparison that shows how this is accomplished:

Effect of Targeting Relationship
Building Programs by LTV Quintile
Quintile LTV Equal Mktg New LTV Incr. Targeted Mktg Incr. New LTV
5 $980 $15 $1,175 $195 $40 $519.52 $1,500
4 $425 $15 $509 $84 $20 $225.30 $650
3 $188 $15 $225 $37 $10 $99.66 $288
2 $66 $15 $79 $13 $5 $34.99 $101
1 $0 $15 $0 $0 $0 $0.00 $0
Average $332 $15 $398 $66 $15 $175.89 $508
Firm Value $66,360,000 $79,552,048 $101,538,795
% Increase 19.88% 53.01%

In this example, a special Gold program is set up to spend $40 per customer on customers in the top quintile – who have an average starting LTV of $980. Twenty dollars per customer per year is spent on the second quintile. Nothing at all is spent on the lowest quintile. The overall average is the same — $15 per customer — but the Firm Value rises to $101 million with the more intelligent segmentation of the relationship building expenditures.

Are these examples textbook cases that cannot be replicated in the real world? Not at all. You have to have certain prerequisites, of course. These are:

  • A customer database fed by a system that permits the company to keep track of customer purchases
  • A product or service that where relationship building will be meaningful to the customer
  • An imaginative and resourceful marketing director who can dream up the relationship building programs, and has the authority to get the funding and obtain the cooperation of the many people throughout the company who must carry them out
  • A farsighted management that can see where these programs are going, and is willing to wait a couple of years for the real payoff to come about.

Increasing Firm Value through customer segmentation and targeted marketing – the next step beyond increasing Lifetime Value – is becoming recognized as the next step in advanced database marketing.

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