The Symptoms
The symptoms are often the same. A company achieves early success, growing rapidly, adding products, services, and distribution channels as it reaches scale. Usually, a private equity-backed for-profit company or a dynamic nonprofit, there is intense pressure from the Board for this organization to grow fast. Suddenly, after a few years of rapid growth, the organization starts to founder and, with the entrance of competitors or other changes in the competitive environment, the organization begins to hemorrhage cash. Management doubles down, focusing on improving conversion and lowering acquisition costs. The Board begins to ask questions about the business model, and management is sent off in many directions at once to explore seemingly random options.
What's Going on With Our Profitability?
Sound familiar? What to do? We tell companies to return to first principles. Think back to what made the Company successful. Then, use a per-customer profitability metric called Customer Lifetime Value (CLV) to help diagnose what is going on now. Here are some recent examples where CLV has effectively identified sources of lost profits:
Why CLV Analysis Is Effective
The reason CLV is useful is that it combines five critical elements of customer profitability: 1) revenue, 2) costs, 3) duration of the client relationship, 4) the time value of money, and 5) the value of the client relationship across the entire organization.
By including the duration of the client relationship, CLV is a terrific antidote to what we refer to as the "Fool's Gold" of Google AdWords Conversion Metrics. The daily grind to acquire customers or members cheaply leads Management, over time, to focus on how leads perform in terms of conversion and acquisition cost, as measured only by Google. Rare is the organization that builds the critical analytical bridge from its client acquisition optimization to client profitability optimization. How long do customers stay around? How frequently do they come back? How much additional revenue do they generate once you acquire them?[3]
Lessons from Amazon
Picking up a thread from a previous post, Amazon.com provides a great example of Customer Relationship Management (CRM) and the management of Customer Lifetime Value. A money loser for much of its corporate history, Amazon has grown its per-customer revenue, in part by investing in, and managing CLV across its entire platform. For example, in a 2012 interview, Jeff Bezos admitted that Kindle Paper White Readers and the Kindle Fire were sold at cost to capitalize on future sales of books and other content.[4] The same interdependency applies to its Prime Memberships. (For the uninitiated, Prime members pay Amazon an annual membership fee – usually about $70-$80 to gain access to a yearly menu of free services including free two-day shipping, access to movies and books, and discounts on a variety of Amazon.com products.) A 2013 study by the Consumer Intelligence Research Partners, showed Amazon Prime members spend $1,340 annually -- more than twice as much as non-Prime shoppers, who spend $650 annually. Fool.com investment analyst, Brendan Mathews, made a back-of-the-envelope estimate in a 2014 article showing that the CLV of a Prime Member was approximately 2.5 times that of non-Prime customers or $2,283 for members versus $916 for non-Prime members.[5] No wonder the investment community post-2014 greeted Amazon's strategy to grow the Prime membership base with such enthusiasm! Today, in 2016, when Amazon drives Black Friday promotions to add Prime Members, what does it provide as an incentive? Discounts on Alexa, a voice command-driven device, which, among other things, allows users to purchase audio content quickly, and, of course, facilitates shopping on Amazon.com.[6]
Identifying Technologies That Lock-in Downstream Profits
The Amazon.com example brings to light another critical aspect of CLV analysis: the CLV metric can be used in companies with many different technologies and verticals to manage and grow profitable business interdependencies, which improve lifetime profits for the entire company. Unlike many other more mono-dimensional metrics, CLV analysis can underscore business activities or technologies which lock in benefits for other businesses in the corporate portfolio. So, it is with Amazon: per a 2012 BBC Interview with Amazon CEO Jeff Bezos, Kindle purchasers buy four times more books;[7] In the same way, Kindle Fire owners watch more movies, and Alexa users presumably listen to and buy more music.
How to Make the CLV Calculation
How is the CLV number calculated? To make the CLV calculation, Management needs to analyze client acquisition date, all revenue associated with the client account, the imputed costs related to each client, and the duration of the relationship with each client. For each of the clients, attribute as accurately as possible all costs associated with acquiring that customer. Add in the expenses of servicing that customer. If the organization needs to reacquire the customer through additional marketing to achieve further, repeat sales, the costs of this activity must be added in as well. Use this data to calculate an operating profit for each customer over the life of the relationship.
Once Management has computed an operating revenue for the customer, they use their organization's weighted average cost of capital to discount these cash flows. For most retail organizations, this analysis may go out only a few years; however, financial services firms like the one described above must recover very high costs of client acquisition. For these companies, the analysis will need to go out much further –– as many as seven years or even a decade if the data are available. Many theoreticians will spend a great deal of time and energy debating how this number is best calculated (see our notes to this article for links to authoritative writings on this topic). [8] Our focus (and yours) should be more ongoing through the exercise of identifying costs, how costs are different for different customers, and, most important of all, how long those customer relationships last.
CLV for Nonprofits
Can CLV be applied to nonprofits? Absolutely. Here again, the analyst in the nonprofit setting needs to look at each direct marketing campaign, online promotion, or event as an investment of both money and volunteer time, the fruits of which result in the acquisition of a donor whose contributions hopefully stretch out for years. Except for a few quirks like ascribing a dollar cost to volunteer time and changing around data to show donors as a revenue stream, the CLV math will be substantially the same for the nonprofit as it is for a for-profit institution.[9]
It is in the 'identify customer segments' step where art meets science. After the initial customer lifetime value calculation is complete, segment the customer base into groups. To do this, identify common traits highly correlated with profitable and unprofitable customers. The goal here is to create groups with shared attributes that behave in predictable ways to generate profits or losses to your organization.
Torturing the CRM Data Until the CLV Confesses
It is in this exercise that your CRM truly pays for itself. The more robust your customer database, the better the inferences you will be able to draw from your Customer Lifetime Value analysis. This activity may require some detective work on your part and may require you to obtain additional customer data to test hypotheses about the sources of lost profitability.
When the results come in, be prepared to throw conventional wisdom out the window. Three findings most surprise executives making this calculation for the first time:
Be Prepared to Be Amazed
The results of CLV analysis can be powerful and company-saving. Imagine, for example, the surprise of a CEO of a hospital services company when he realized each new account he added cost tens of thousands of dollars in marketing expenditures to develop and almost two years to reach breakeven. Imagine learning that your best-converting leads are the ones that generate the least revenue or, worse, are the ones causing your company to lose money![10] Imagine being a retail leader and learning, "On top of all the stress of opening up early, paying employees for extra hours, preparing contingency plans if things go awry, and spending a ton on advertising and PR [for Black Friday retail activities] …. it's not even as good as a lottery ticket: at best, your Black Friday sales won't disappoint you."[11]
These examples are just a few of the insights that have come from CLV analyses. They have permitted companies to refocus their activities by focusing on their profitable customers.
What will you learn from CLV analysis?
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[1] See Wharton Marketing Professor, Peter Fader's,2016 article in Forbes Magazine, http://www.forbes.com/sites/groupthink/2016/11/22/is-black-friday-the-best-day-to-meet-your-worst-customers/#4d254ca66dc4.
[2] Ibid.
[3] We hasten to point out that this is not Google's fault. The AdWords toolset provides user plenty of tools to correlate costs of acquisition and other metrics to leads conversions.
[4] See http://www.forbes.com/sites/kellyclay/2012/10/12/amazon-confirms-it-makes-no-profit-on-kindles/#7a2cb2d14dc7 and http://www.businessinsider.com/amazons-profits-what-people-dont-understand-2013-10
[5] See Brendan Mathews 2014 article on Fools.com http://www.fool.com/investing/general/2014/04/21/whats-a-prime-member-worth-to-amazoncom.aspx
[6] See http://www.ibtimes.com/amazon-black-friday-deals-prime-members-get-alexa-exclusive-access-2448067
[7] See again, http://www.forbes.com/sites/kellyclay/2012/10/12/amazon-confirms-it-makes-no-profit-on-kindles/#7a2cb2d14dc7
[8] For a scholarly discussion on CLV and other profitability metrics, see Kumar, V. (2008-01-10). Managing Customers for Profit: Strategies to Increase Profits and Build Loyalty (Kindle Location 677). Pearson Education. Kindle Edition. Also, for those who don't mind wading through an equation of two, a great round-up of different CLV calculation methods may be found in the following 2006 JOURNAL OF SERVICE RESEARCH article: http://www.anderson.ucla.edu/Documents/areas/fac/marketing/JSR2006(0).pdf
[9] See for example a 2007 report by Maria Nobles in the Non-Profit Times online, http://www.thenonprofittimes.com/news-articles/research-examines-true-cost-of-a-solicitation/
[10] See the example of Hubspot Case Study, fictionalized in Harvard Business Review, https://hbr.org/2012/10/target-the-right-market-2
[11] See previously cited article by Dr. Fader, http://www.forbes.com/sites/groupthink/2016/11/22/is-black-friday-the-best-day-to-meet-your-worst-customers/#4d254ca66dc4