Using Lifetime Value in Business to Business Marketing
by Arthur Middleton Hughes

Lifetime value has become a highly useful method for directing marketing strategy. We want to develop strategies that increase customer lifetime value. We want to retain customers that have high lifetime value, and reprice or discard customers with negative lifetime value. This article explains how to use this valuable tool in a business to business situation.

Lifetime value tables for business to business customers are easy to develop. To show how this is done, let’s develop the lifetime value of customers of an artificial construct: the Weldon Scientific Company, that sells high tech equipment to factories and laboratories.

Let’s explain some of these numbers. Year 1 represents the year of acquisition, rather than a calendar year. Year 1 thus includes people acquired in several different years. Year 2 is everybody’s second year with Weldon. We are assuming that Weldon has acquired 20,000 business customers including a number of independent distributors. A year later, only 12,000 of these customers are still buying. That means that Weldon’s retention rate is 60%. Over time, the retention rate of the loyal Weldon customers who are still buying goes up.

The average customer placed an average of 1.8 orders in their year of acquisition, with an average order value of $2,980. As customers became more loyal, they placed more orders per year, of increasing size.

The acquisition cost was $630 per customer. The cost of servicing customers came down substantially after the first year. Most interesting in this chart is the discount rate, which is developed in a separate table. The discount rate is needed because to compute lifetime value we will have to add together profit received in several different years. Money to be received in a future year is not as valuable as money in hand today. We have to discount it if we want to compare and add it to current dollars. That is the purpose of the discount rate.

The formula for the discount rate is this:

Discount rate = ((1 + interest rate) x (risk factor)) ^Year+AR/365

It includes the interest rate, a risk factor and a payment factor. In the first year, Weldon tries to get new customers to pay up front, relaxing to a 60-day policy with subsequent orders. For established customers, ninety days payment is customary. The risk factor drops substantially with long term customers. The combination of all of these factors gives Weldon a sophisticated discount rate that is responsive to the business situation that they face.

When The Repurchase Cycle Is Not Annual

The retention rate is typically calculated on an annual basis. A 60% retention rate means that of 10,000 customers acquired on Year 1, there will be only 6,000 customers still remaining as active customers in Year 2. This is easy to compute if customers buy every month or once a year. But what is the annual retention rate if 50% of the customers buy a product only every four years? This is true in many business to business situations. Here a formula is necessary. The formula is this:

RR = (RPR) ^(1/Y)

Where: RR is the annual retention rate, RPR is the repurchase rate and Y = the number of years between purchases. We can illustrate this with automobile purchases. Here are several examples of the use of the formula.

1. Automobile Purchase By One Segment.

A segment of Buick owners buys a new car every four years. About 35% of them buy a Buick, and the balance buys some other make of car. What is their Annual Retention Rate?

RR = (RPR) ^(1/Y)

RR = (0.35) ^(1/4)

RR = 76.9%

2. Automobile Purchase By Several Segments

Buick owners can be divided into four segments: those who buy a new car every one year, two years, three years, and four years. Their respective repurchase rates are:

Segment	Years Between Purchase	Repurchase Rate	Annual Retention	Acquired Customers	Retained Customers
A	1	55.00%	55.00%	90,346	49,690
B	2	45.00%	67.08%	170,882	114,631
C	3	40.00%	73.68%	387,223	285,308
D	4	35.00%	76.92%	553,001	425,347
TOTAL			72.83%	1,201,452	874,976

This chart provides some interesting information. The repurchase rate of those who buy a Buick every year seems much higher than that for those who wait four years between automobile purchase. Their annual retention rate, however, is far lower.

3. Restaurant Patrons by Week

A businessman’s restaurant had a regular clientele of patrons who ate there almost every day. They decided to try database marketing. They set up a system to gather the names of their customers, and gave points for each meal. They discovered that they were losing about 1% of their clients every week. What was their annual retention rate? The formula is the same:

RR = (RPR) ^(1/Y)

In this case, the repurchase rate is 99%, and the period involved is 1/52 of a year. So the formula becomes:

• RR = (.99) ^(1/(1/52))

• RR = 59.3%

This tells us that the restaurant’s annual retention rate was 59.3%.

Lets suppose that Weldon has decided to experiment with database marketing. They may take the following steps:

• Build a web site with distributor and direct customer access by means of a PIN number. The site will include all of their products, which prices shown based on the customer’s volume situation. Distributors and direct customers can place orders directly on the web site, or by phone, email or fax, as they prefer. Distributor’s customers can use the Website, with shipment directly from the distributor. All of this is controlled by the PIN number.

• Set up an integrated account management (IAM) team that contacts all medium sized and large customers at least six times per year, learning the names of the decision makers, influencers and actual users of Weldon’s products. Annual sales agreements are negotiated with volume discounts. There is a special team to work with the 1,800 independent distributors that handle the Weldon line. The other teams work with end user accounts. IAM is expensive to set up at first, but once in operation should be less expensive than previous methods of reaching customers.

• Creating an advisory council for each of their six major customer groups, complete with a newsletter which is published on the web, and prizes given at professional trade shows for the best use of Weldon’s products.

• Design of a series of communications to each identified Weldon contact in customer firms. Each new customer receives a welcome letter with a survey form and thank you letters for large orders. During the year other communications are developed describing industry developments and new products of interest to the particular customer, based on the survey results. If the survey is not completed, a phone call is made to get the survey information. Weldon averages 92% response rate to their surveys, although only 24% come in by mail or fax in response to the first welcome letter.

The Website could make the largest change in the way that Weldon does business. Before the Website, let’s assume that orders arrived in four ways: phone, mail, fax and email. Because of the detailed nature of Weldon’s products, the order processing is complicated, requiring skilled people who look up each product in the catalog to verify the part number, price, shipping method and regional specifications. The Website could create a revolution. Each customer will have their own PIN number, which triggers software that determines the correct price for each item, the shipping method, the distributor, if any, and the regional specifications. With some exceptions for custom items, all products could be ordered from the Website with the click of a mouse. If the customer enters a part number by typing, the software could verify the entry, and refuse incorrect part numbers.

In time, all distributors will develop their own Websites. When a customer wants to order a Weldon product, he will click on that product on their distributor’s Website display, and will be shifted immediately to the Weldon Website where the order is processed. The codes transferred in the link inform Weldon that this is a distributor customer with a unique PIN number. Arrangements with the distributor dictate whether the order will be filled out of the distributor’s warehouse, or directly by Weldon, with the distributor getting a commission. If the order is to be fulfilled by the distributor, the Weldon Website will transmit the order electronically to the distributor.

What is the advantage to Weldon and the distributor through having the Weldon link? The customer may want some Weldon item that the distributor does not have in stock or on display. Weldon can show the customer everything in the line, with the distributor making a commission no matter where the product is actually shipped from. Also, by browsing the wider and up-to-the-minute Weldon product display, the customer may order additional items, supplies, refills, etc., with credit going to the distributor. It is a win-win situation for both. In some cases, distributors may become "virtual distributors" with no inventory at all, but simply a highly productive web site listing the products of many manufacturers in a given field.

The result, in terms of order processing time can be amazing. Whereas phone orders typically require an average of 28 hours, and mail, fax and email require 42 hours from receipt of phone call until the completed order arrives in Weldon factories in Taiwan or Singapore, the web orders can arrive in the factory in an average of 1.6 minutes. This mirrors experience in the Panduit Corporation where order processing time was cut to 1.5 minutes using electronic data interface, and Intel, which saved 75,000 faxes to Taiwan per month after their Website became active in July of 1998.

The savings cost from the Website is larger than the time saved would indicate. Because orders are processed so much faster, and without human intervention, personnel are saved in the order-processing department. In addition, by cutting more than a day from each order processing time, customers get their products faster, which gives Weldon an edge over its competitors. Finally, by getting bills out one day earlier, Weldon’s cash flow is improved by a measurable amount. In all, use of the Website ordering system can cut costs by 3% per order. The problem, is that in the beginning, only about 10% of Weldon’s customers might use the Website to place their orders. To change this, Weldon could give a discount of ½ of one percent for all orders placed on the Website. By the second year, the percentage of customers using the Website could grow to 60% and by the third year it could be close to 90%. The cost savings could look like this:

Let’s assume the cost of the first three initiatives is as follows:

The relationship-building communications to customers, based on their preferences as shown on the survey have an average annual cost per person of $40 each. The average customer has about 2.4 people that Weldon needs to contact, so the average cost per company of the relationship building program is about $96. For each customer that recommends a new customer who becomes a Weldon customer, Weldon provides a reward worth $200.

The result of the initiatives is a major change in customer lifetime value, as shown below: