In the 1980s the focus was on 'getting close to your customers.' Today the push is to measure the 'lifetime value' of existing and future clients. We look at what LCV means, why it's a hot buzzword and what it means to your business.
By ANDREW WILEMAN, a strategy and organisation consultant; e-mail: firstname.lastname@example.org.
What is the main idea behind 'lifetime customer value'?
The value of a business is the sum of the value of its current and future customers. Some customers are profitable and have a positive value; others are loss-making and destroy value. Lifetime customer value is calculated using discounted cash-flow and net present value analysis.
What are its key drivers?
First, customer acquisition costs. For example, a direct marketer funds 1,000 mailings to arrive at one new customer conversion; a consulting firm invests in research, sales calls and several proposals before it wins its first project from a new client; a mobile phone operator gives away headsets.
Second, annual customer profitability - or revenue, less cost-to-serve.
In some businesses, customers have only one supplier (for example, mobile phones or internet service providers). In others, several competitors fight for share of spend by an individual customer (for example, grocery retailers or fast-food chains).
Third, churn or switching rate - what percentage of the customer base switches to a competitor in any year, and therefore, how long an average customer is retained.
Combined, these factors drive lifetime customer value (LCV or LTV). So, the LCV for a cable or internet service provider might comprise: pre-tax customer acquisition cost: £250; pre-tax annual customer profit contribution (50% of revenue): £200; annual churn: 20%; undiscounted sum of future annual customer profit streams: £1,060; discount rate: 8%; pre-tax net present value (NPV) of future annual customer profit streams: £780 - in which case, pre-tax LCV will be + £530.
Why is it such a hot topic right now?
It is a key management metric in some of the hottest, highest-growth sectors - particularly telecoms and e-commerce.
For example, mobile operators are investing billions in building networks and in acquiring customers, and customer value analysis offers a way of evaluating the possible returns on that investment. It also provides early indications of which competitors are winning, and where. For example, Orange's subscriber acquisition costs and its share of new subscribers are similar to Vodafone's, but its average annual customer profitability and retention rate has been higher - so its overall business value per subscriber is 40% higher.
Customer value is the only possible approach to take in valuing many new internet/e-commerce businesses, given the absence of profits today and (often) for the foreseeable future. But justifying current market valuations requires making some heroic assumptions about long-run customer value. Yahoo!, with sales of $200 million ( £125 million) and $26 million profits, is valued at $35 billion, with 35 million registered users - or $1,000 per customer, despite having no direct way of extracting revenue from its customer base. Amazon, with a market cap of $20 billion and six million customers, is valued at over $3,000 per customer, in a retailing business that will be competing on very thin margins in the long run.
What are the practical applications - for managers rather than stock analysts?
Too many businesses waste time and money, and destroy value, pursuing and keeping unprofitable customers. Customer value analysis helps them focus on market segments and customers that can generate an adequate return on investment.
It also helps determine where and how a business is under or overperforming, compared with the competition. Is it over or underinvesting in customer acquisition or retention - and are its investments effective? Is it extracting maximum annual profit per customer, or can it generate higher revenue and reduce cost-to-serve?
One last question. Is lifetime customer value different from brand value?
A strong brand's value derives from its power to generate higher customer revenue, profits and loyalty. Coca-Cola and P&G tend to talk about brands; AOL and Orange talk more about customers and subscribers; grocery retailers talk about both. But it's the same issue and soon Yahoo! and Amazon will be arguing for the capitalisation of customer value on their balance sheets.