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.

 Year 1 Year 2 Year 3 Customers 20,000 12,000 7,800 Retention Rate 60.00% 65.00% 70.00% Orders/year 1.8 2.6 3.6 Average Order Size \$2,980 \$5,589 \$9,106 Total Revenue \$107,280,000 \$174,376,800 \$244,696,480 Direct Cost % 70.00% 65.00% 63.00% Costs \$75,096,000 \$113,344,920 \$161,088,782 Acquisition Cost \$630 \$12,600,000 \$0 \$0 Total Costs \$87,696,000 \$113,344,920 \$161,088,782 Gross Profit \$19,584,000 \$61,031,880 \$94,607,698 Discount Rate 1.13 1.81 2.53 Net Present Value Profit \$17,330,973 \$33,719,271 \$37,394,347 Cumulative NPV Profit \$17,330,973 \$51,050,244 \$88,444,591 Customer Lifetime Value \$867 \$2,553 \$4,422

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.

 Year 1 Year 2 Year 3 Year 0 1 2 Risk Factor 1.8 1.5 1.4 Interest Rate 8.00% 8.00% 8.00% A/R Days 65 85 90 Discount Rate 1.13 1.81 2.53

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.
2. 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%

3. 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.

1. 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%.

Relationship Building Initiatives

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.

What The Website Does

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.

 Order Processing Time* Cost Per Order Phone 28 hrs \$27.00 Fax, Email, Mail 42 hrs \$18.00 Website 1.6 minutes \$1.62 *From order receipt until paperwork arrives at factory

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:

 Year 1 Year 2 Year 3 Old Costs 70.00% 65.00% 63.00% Percent Using Website 10.00% 60.00% 90.00% Net Saving per Order 2.5% 0.25% 1.50% 2.25% New Costs 69.75% 63.50% 60.75%

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

 First Year Incremental Annual Cost Web Site \$1,600,00 \$300,000 IAM \$600,000 (\$100,000) Advisory Councils \$200,000 \$150,000 Total \$2,400,000 \$350,000

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:

 Year 1 Year 2 Year 3 Referral Rate 4% 6% 8% Referred Customers 0 800 828 Retained Customers 20,000 13,000 9,100 Retention Rate 65.00% 70.00% 75.00% Total Customers 20,000 13,800 9,928 Orders/year 1.9 3.4 4.8 Average Order Size \$3,078 \$6,170 \$11,005 Total Revenue \$116,964,000 \$272,714,000 \$480,698,400 Direct Cost % 69.75% 63.50% 60.75% Costs \$81,582,390 \$173,173,390 \$292,024,278 Acquisition Cost \$630 \$12,600,000 \$0 \$0 New Initiatives \$2,400,000 \$350,000 \$350,000 Relationship Building \$96 \$1,920,000 \$324,800 \$953,088 Referral Incentives \$200 \$0 \$160,000 \$165,600 Total Costs \$98,502,390 \$175,008,190 \$293,492,966 Gross Profit \$18,461,610 \$97,705,810 \$187,205,434 Discount Rate 1.13 1.81 2.53 Net Present Value Profit \$16,337,708 \$53,981,110 \$73,994,243 Cumulative NPV Profit \$16,337,708 \$70,318,818 \$144,313,061 Customer Lifetime Value \$817 \$3,516 \$7,216

The effect of these new initiatives is to increase the average customer lifetime value in the third year from about \$4,422 to \$7,216. What does this really mean for Weldon? Assuming that their acquisition program continues to replace the lost customers and that Weldon has a steady customer base of 20,000 customers, the program has increased Weldon’s profits by \$55 million:

 Year 1 Year 2 Year 3 New LTV \$817 \$3,516 \$7,216 Old LTV \$867 \$2,553 \$4,422 Difference (\$50) \$963 \$2,794 With 20,000 Customers (\$1,000,000) \$19,260,000 \$55,880,000

The first year is costly. Introducing these changes reduces Weldon profits by \$1 million, But these figures show that if Weldon were to institute the relationship building programs described here, their profits in the third year would increase by over \$55 million. Business to business relationship building works – and can be shown to work by careful and controlled tests. Where do these figures come from? How do we know that we can increase the orders in the third year from 3.6 to 4.8, and the average order size from \$9,106 to \$11,005? By careful testing using control groups.

Segmentation By Type Of Industry

Another way of segmenting Weldon customers is by type of industry. Here is a possible breakdown:

 Weldon Instruments Corporation Customer Segments Customers Average Annual Total Sales Sales Ranking Lifetime Value LTV Ranking Metal Production 254 \$335,736 \$86,202,044 4 \$145,067 2 Light Manufacturing 15,442 \$13,851 \$213,887,142 1 \$5,914 4 Heavy Manufacturing 44 \$2,314,159 \$101,822,996 3 \$988,146 1 High Technology 612 \$299,007 \$182,992,284 2 \$127,676 3 Others 3,613 \$2,176 \$7,861,888 5 \$929 5 Total 19,965 \$29,695 \$592,857,254 \$12,680

Here the lifetime value is computed for five groups of customers. If you look at Weldon sales, the big money is clearly in Light Manufacturing, with \$213 million in annual sales. But if you look at lifetime value, the 44 Heavy Manufacturing customers account for almost \$1 million a piece. Clearly, any retention strategy should start with Heavy Manufacturers. You are going to get much more bang for a marketing buck. Next would be metal production which is low in overall sales, but clearly high in average customer lifetime value.

This chart represents the ultimate users of Weldon products. Most of the 15,442 light manufacturing firms and laboratories are served through Weldon’s 1,800 independent distributors. That does not mean that Weldon should not cultivate them, but should not try to sell directly to them. By keeping their distribution channel on their database, their efforts can be directed at driving them to visit or call their authorized distributor.

Finally, let's look at the distribution of Weldon customers by total lifetime value. In this chart, we have divided Weldon customers into five, approximately equal groups based on lifetime value.

 Number of Customers Lifetime Value Firm Value Total Percent LTV Platinum 3,967 \$50,410 \$199,976,470 79% Gold 4,004 \$9,603 \$38,450,412 15% Silver 3,881 \$2,903 \$11,266,543 4% Bronze 4,210 \$1,108 \$4,664,680 2% Lead 3,903 -\$309 -\$1,206,027 0% Total 19,965 \$12,680 \$253,152,078 100%

The top group, the Platinum, has an average lifetime value of \$50,410 and represents about 79% of the total customer lifetime value. The bottom group of 3,903 customers are true losers, being responsible for a net lifetime value of minus \$309. What can we do with this chart? It probably should be combined with the previous chart to determine the direction of Weldon’s retention efforts. Why spend money trying to retain customers with a negative lifetime value? Even if they are in a favored group, such as Heavy Manufacturing or Metal Production, if they persistently result in a loss of value to Weldon, the retention effort should be reconsidered.

The relationship building program will probably work best with those customers just below the top. The top group – Weldon’s platinum customers – are probably maxed out. They are loyal customers. Many companies have found that they cannot profitably cross sell or up sell their best customers. In the same way, Weldon probably cannot have this kind of success with its unprofitable customers. Building a relationship with losers is also not a recipe for success. The most profitable group for Weldon’s program are those just below the top – people who are profitable, but probably dividing their spending for Weldon type products amongst a number of different suppliers.

How do you sell management on your plans? You are basically asking for \$7,622,688 to be spent over three years as follows:

 Year 1 Year 2 Year 3 New Initiatives \$2,400,000 \$350,000 \$350,000 Relationship Building \$1,920,000 \$1,324,000 \$953,088 Referral Incentives \$0 \$160,000 \$165,600 Total \$4,320,000 \$1,834,000 \$1,468,688

What will you get for this \$7.6 million? You will get \$55.8 million in three years. You get this by producing an interactive business to business web site and three other strategic relationship-building initiatives. If management asks how did you come up with the \$55 million, you have the figures in detail to prove it.

Arthur Middleton Hughes is Vice President of The Database Marketing Institute. Ltd. (Arthur.hughes@dbmarketing.com) which provides strategic advice on relationship marketing. Arthur is also Senior Strategist at e-Dialog.com (ahughes@e-Dialog.com) which provides precision e-mail marketing services for major corporations worldwide. Arthur is the author of Strategic Database Marketing 3rd ed. (McGraw Hill 2006). You may reach Arthur at (954) 767-4558 .

The articles on this web site are available to the general public to read, enjoy and for limited business use. If you want to reprint more than one or two of them for resale or use in a business or educational environment, send an email to Arthur Hughes at arthur.hughes@dbmarketing.com. He will give you permission by return email. The cost, depending on the number of copies you want to reprint, is very inexpensive.

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