Lifetime Value is Used to Evaluate Customer Relationship Management
During the last decade, lifetime value (LTV) has become the standard method for measuring the success of Customer Relationship Management programs. Return on investment (ROI) is used for campaigns, and profitability is used, particularly in banks, to take a snap shot of the performance of existing customers. Lifetime value, unlike these other measurements, predicts the future performance of a group of customers, based on their past and current spending behavior. It also permits you to evaluate the performance and value of the firm as a whole.
Lifetime value is the net present value (NPV) of the future profits to be received from a given number of newly acquired or existing customers during a given period of years. To compute lifetime value, you have to have a customer database that includes purchase history. LTV is used, of course, in both business to business and consumer marketing. It is used for all sorts of products and services in all industries. For this article, we will take a retail store as an example of the principles involved.
Let us assume that we have a chain that has issued a proprietary card which is used by shoppers when they visit the store. Some of the customers may also use VISA or Mastercard credit cards which may be registered with the chain, or which may be tracked with reverse appending. By a combination of these three methods, the chain is able to track most of the purchases of those shoppers who do not use cash in their transactions. The data is stored in a database.
With a little more than one yearís worth of data, it is possible to create a LTV portrait of a group of 5,000 customers which could look something like this:
The Retention Rate
Year 1 in a LTV chart is the year of acquisition. Year 2 is the year after that. The chart, therefore, pictures the lifetime value of newly acquired customers. Year 1, therefore, includes customers acquired in different years, such as 1996, 1997, 1998, etc. Year 2 is their second year with the chain. Looking at this chart, you can see that of 5,000 customers acquired, only 3,500 are still shopping with the chain a year later. That means that their retention rate is 70%. The retention rate is the most important single number in a LTV chart. It tends to go up, over time, as disloyal customers leave the store, and those enthusiastic about the store remain. By Year 3 the retention rate is up to 80%.
The chain is able to monitor the visits per week, and the average shopping basket. As a result, they know the total sales from these customers each year.
Variable costs have to be included in a LTV chart. The direct costs can include anything that can be measured, including the costs of goods sold, the cost of serving the customers, etc. Costs tend to go down over time, since loyal customers are easier to serve than new customers. In this chart, the costs drop from 83% of revenue to 79% of revenue in the third year. Other costs listed include the labor and benefits, advertising, and the cost of the card program. Typically, stores that have a card program include some communications with customers to maintain their interest in and use of the card.
Profits, of course, are sales less costs. Future profits must be discounted by means of a discount rate. This discounting is necessary because money to be received in the future is not as valuable, today, as money in hand right now. The formula for the discount rate is:
D = (1 + i) n
Where i = the market rate of interest plus a risk factor and n = the number of years that you must wait to receive the money. As an example, suppose that the market rate of interest that the store must use to borrow money is 8% and the risk factor is 2, then the rate of interest is 16%. The formula for the discount rate in the third year is:
D = (1 + 0.16) 2 = 1.3456
Dividing the gross profits in each year by the discount rate, produces the net present value (NPV) profits. When all profits have been reduced to NPV, they can be added together to get the cumulative NPV profits. These numbers are then each divided by the original 5,000 customers to get the lifetime value of newly acquired customers in Year1, Year 2 and Year3.
Measuring the effect of new CRM strategies and tactics
To see how lifetime value is used, letís assume that the store chain we are discussing has decided to adopt a number of new CRM marketing strategies. We will measure their effectiveness using lifetime value. As an example of these strategies, letís take those adopted by Safeway Stores for their frequent shopper program. They developed a variety of special rewards for shoppers that included:
They proposed to pay for these programs by cutting their advertising expenditures in half. The principle here is this: we all know that it is more profitable and easier to increase spending from existing customers than to beat the bushes for new ones. Few companies actually act on these principles. They continue to stress acquisition, and to ignore retention. Safeway put their money where their mouth was, and slashed advertising (acquisition) and put the money into these programs. These are actual Safeway programs. Lets see how Safeway went about measuring the impact on customer lifetime value.
The first result of the program was an increase in the retention rate. As you can see, it went up from 70% to 75%. These are not actual Safeway numbers, which are proprietary. The numbers, however, are typical of what many companies have experienced. Visits per week increased, as did the amount of the average basket. In all, the programs increased the annual sales to these 5,000 shoppers by a million dollars.
Measuring the costs
The customer specific marketing programs were pegged to be funded by one half of the advertising expenditures. For the first year, they amounted to $61,200. The total impact on the customer lifetime value is shown on the bottom line. Comparing the LTV before and after the adoption of the proposed strategies shows a significant gain:
From these numbers, you can see that the programs will result in an $8.6 million increase in profits in the third year, across a chain in which 200,000 shoppers used the proprietary store and registered credit cards.
Lifetime value analysis like this does not guarantee the increased profits detailed here. The programs could be hamstrung by weak execution. What these LTV charts indicate is that the programs have the potential to be highly profitable, if they are executed properly.
The same type of analysis is done for banks, insurance companies, credit cards, cellular phones, hotels, airlines and hundreds of other businesses. Lifetime value has become a highly useful CRM measurement technique.