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Tying the Knot
Is lifetime customer value the key to long-term profitability, or a numerical mirage?
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Any good microeconomics primer includes an overview of the significance of money over time through the concept of present discounted value. In short, a dollar tomorrow is good, but a dollar today is even better.

The amount of money your customers will spend throughout their relationships with your company, discounted by interest and inflation rates as appropriate, is the measure of lifetime customer value (LCV), a metric that has gained popularity as CRM adopters try to quantify the benefits of reorganizing around the customer. Encourage a customer to upgrade their relationship with you, and their LCV will increase. Alienate the customer to the point that they threaten to reduce or withhold their business in the future, and the LCV will decline.

"This is the ultimate goal of a well-implemented CRM system," says Paul Rodwick, vice president of market development and strategy for CRM solution developer E.piphany. "It has to do with getting the right customers, not wasting resources on the wrong customers." In short, LCV can help a company understand who its most valuable customers are, not through crude measures, such as current gross revenue or current profitability, but by their remaining profitability. That way, marketing and service efforts do not focus on past glories, but the best future prospects.

"We can ascribe costs to customers much more perfectly than we could in the past," says Harris Gordon, a partner in the CRM practice of PricewaterhouseCoopers Management Consulting Services. "It's a more nuanced, more sophisticated way to measure the value of customers."

Greater emphasis on LCV is also an offshoot of the loyalty and retention movement, which in turn was spurred by the realization that customer retention is considerably cheaper than customer acquisition. "If we can just keep them here, it's worth a lot in the long haul--you don't want to give them a reason to switch," says Mike Kozub, chief marketing officer for CRM developer Marketsoft. "Business isn't just about making a sale and moving on, it's about understanding where the first sale will lead, one customer at a time."

No Winning Formula

Kozub recommends a simple probability study as the basis for understanding lifetime customer value. When customers reach their repurchase decision point, "what percentage do you lose? What percentage will re-up with you at the same level? What percentage will re-up at a higher level because you've been able to cross-sell or up-sell?" Companies that understand their customer lifecycles know to a certain degree of accuracy when these events occur, and with an understanding of behavior patterns, as well as the overall health of the relationship working to make reasonable predictions on the likelihood of each event. The result is the expected future value of that customer.

Rory Byrne, manager of market research for CRM vendor Altitude Software, says that what you learn from the ongoing exercise of measuring LCV is more significant than actually generating a new column in your ledger. "It's impossible to accurately quantify, but it's important to strive towards it," he says. "You can tell if [a customer] is going to be a transactor or a revolver based on performance...but you don't know what business you're going to be in in five years."

Gordon cautions against reading too much into the literal interpretation of the term, however. "The word 'lifetime' suggests our lifetime, but 'lifetime' on average is about five years," he says. Beyond that, the predictions tend to become hazy due to changes both in business and in a consumer's life.

The differences in opinion and approach are not surprising, given the history of similar attempts to gain deeper insight into the true mechanics of corporate profit and loss. "For the last 15 years, companies have played with the concept of cost-based accounting (an attempt to break down the component costs of business activities), and every single company has a different take on that," says Rodwick. He believes LCV measurement, which is in an early stage of development, is bound to have similar growing pains.

"There are cultural and organizational [roadblocks] in the way of using lifetime value," says Pierre Charchaflian, director of CRM solutions for Boston-based consultant firm DiaLogos. "You have to get various business units and functional organizations to work together to improve [LCV], but it becomes a measure one unit uses for revenue-generating purposes. They don't use it as an enterprise-level metric to optimize business performance."

Chasing Value

The trouble with understanding LCV is that customers may be unconsciously conspiring to become more expensive to service. A recent Deloitte Research report, Digital Loyalty Networks, describes a "customer paradox" in which the only reward a company receives for expanding its customer service is even loftier expectations, despite the fact that not all of those being served "really matter." Deloitte Research interviewed more than 850 manufacturing executives about their supply chain and CRM systems and concluded that "fulfilling those demands for all customers most often proves to be too costly and unreachable."

still, some customers are worth the increasing costs. The trick is knowing enough about them to identify tomorrow's winners. "If you have a customer in the MBA program at Harvard, maybe they're not a very valuable customer now--they're just a student. But if they're going to get a big-time job in Silicon Valley, that helps you project their lifetime customer value," says Jon Diorio, strategic marketing manager for E.piphany. By the same token, he says, smart brokerages treat their retiring customers well, even though their incomes tend to fall--"you may be a more active [investor] because you've got time."

Consider the approach United Airlines took to address last year's unquestionably bad service. The airline apologized to just about everyone who came near an airport in 2000. But they apologized to some more than others--Byrne, for example, was part of a customer group that got a 25-percent premium on his frequent flyer miles last year, and he knows that customers even more valuable than he fared even better. Everyone at least got a solemn vow to do better, but the customers generating the profits were incentivized for their continued patience.

CRM vendors often boast, explicitly or implicitly, that they help companies boost LCV by making the sales experience more personalized, generating more effective marketing campaigns, or generally making a company more pleasant and attractive to do business with. "The biggest weakness [with this argument] is that companies don't act in a vacuum. You tend to get inwardly focused when spending all this money [on CRM], and you don't think about what competitors are doing at the same time," says Chris Selland, vice president of marketing for CRM supplier eSupportNow.

It's the "customer paradox" again--what appears to be groundbreaking improvement today simply catches up with, or even lags, the expectations and standards of tomorrow. That's why Selland strongly emphasizes the importance of cost savings for companies looking to boost LCV. "No matter what your competitor does, saving money is saving money."

Charchaflian warns that such a view might be too simplistic. "If you decrease the marketing budget, there's a chance fewer people know about your product. If you lower customer service costs, you might decrease satisfaction," he says. "It's a very complex measurement to understand."

Unprofitable At Any Price?

Deloitte Research puts it simply: Not all sales are necessarily good sales.

"If you're a lost cause, there's not much point in investing more money in you," adds Byrne. "I can save money by not trying to sell to you, and not including your name in mailing lists, targeted mailings and sales calls."

Such conclusions are dangerous, however, if they do not accurately reflect a customer's overall lifetime value to the company.

"When you start to organize everything around the customer, you can understand what they're worth," says Selland. "If you haven't, it's next to impossible." Without a customer-centric view, these measurement efforts end with departmental and parochial notions of LCV, and are just another self-defeating weapon for divisions looking out only for their own P&L concerns, rather than the overall state of the customer relationship.

Charchaflian points to the insurance industry as fertile ground for improvement through a better understanding of LCV. By taking a parochial view of individual policy lines of business, companies may push away customers who happen to be bad risks in just one area, such as auto coverage, sacrificing a larger and ultimately profitable stream of home and life insurance proceeds. "Lifetime value changes the underwriting process--it's based on all the products you own with them," he says.

LCV and "Benign Neglect"

No one in the industry seems willing yet to seriously discuss the possibility that a careful interpretation of LCV has curious consequences, such as a rational decision to behave like a con artist in certain circumstances. For a low lifetime value customer, who only influences other low lifetime value customers and prospects, it could be financially optimal to try to induce a single, relatively profitable purchase up front and then cut service and support to zero. Any future (discounted) revenue stream from that customer is likely sacrificed as a result, but if those future transactions would have been unprofitable anyway, and any unpleasant word-of-mouth effects are restricted to a similarly marginal group, how can such a strategy be faulted? On a similar token, the elderly should rationally expect to receive little service, as their already limited lifetime value is nearly depleted.

Simply put, such approaches may not generate a very positive aura. "You don't want to antagonize anyone for being unprofitable," says Byrne. "You generate a lot of bad publicity for that."

Employees must still be driven to go the extra mile for customers, but must make choices about when it is most beneficial to do so, writes Deloitte Research. Some things are easier said than done.

Customer care agents clearly understand the difference in service and satisfaction protocols if they are part of a "gold customer" service group, but such broad, traditional divisions may not be enough. Some companies are finding it necessary to become more granular in their internal customer quality ratings in order to help service agents make these judgment calls.

In the past, some in the industry have recommended that front-line staff be shielded from the more intimate details of LCV. At iSKY, a Laurel, Md.-based customer service outsourcer, however, disclosure is in. "When an inbound call comes in from a customer with a history... literally flashing on the screen is the value of this customer," he says. Although the raw data is still obscured, customers are given a rating in smiley faces or stars, guiding the agent as to the proper balance of accommodation and what Richard Hebert, president and CEO of iSKY euphemistically calls "benign neglect." That same system will determine how much a customer is encouraged to stick with self-help options, and how long they may have to wait on the phone for live assistance. Such is life in the lifetime value-driven world.

"There are, I think, the beginnings of understanding the concept of lifetime value," says Rodwick. "Customers really do appreciate the concept of getting differentiated service," at least on the favorable end of the equation.

Charchaflian advises that stratification based on lifetime value measurements can result in an unconscious transformation to niche status. "If 80 percent of your revenue comes from 20 percent of top customers, do you only want to serve 20 percent of the market? If you want to do that, that's fine, but it prevents you from growing fast," he says. "The rest of the 80 percent does huge volume for you. They give you coverage and market share."

Here's the real question: is LCV a valid financial metric, or a convenient fabrication by the CRM industry? Will your chief financial officer laugh you off the executive floor as soon as they hear the words leave your lips?

"This is something that a fair amount of dot commers were using to justify huge investments in marketing," says Hebert. "When dot com busted, along with it went a lot of the legitimacy."

Ellen Masterson, a partner with PricewaterhouseCoopers, as well as a former CFO, believes that it can be a legitimate business valuation when put to good use. "The measure is not of tremendous value in and of itself. It's what you do with it," she says. Treating LCV not as a statistic in isolation, but as a benchmark for setting customer relationship goals and gauging the effectiveness of marketing and service efforts, can provide a great deal of insight for executives and shareholders.

The trouble, as Masterson sees it, is that there are few accepted standards for defining even a valid time horizon for lifetime value, to say nothing of proper, robust measurement techniques. "To the extent companies do use some form of lifetime customer value to manage their businesses, they also ought to be disclosing what the lifetime customer value is, how they have increased it, and how they have managed it so investors can see what this means to the business," she says. She also stresses the importance of fully disclosing the methodology used to arrive at the LCV readings, and keeping that methodology consistent from quarter to quarter so it provides a meaningful view over time.

"We're at least four to five years away from making the lifetime customer value standard a metric to use day in and day out," says Charchaflian. In his view, just as cost-based accounting (also known as activity-based costing) gained exposure through the maturation of ERP (enterprise resource planning) systems, so shall LCV have to wait for a more complete and thorough understanding of CRM.

Many companies cringe at the mere thought of disclosing any cost, revenue or customer performance data they are not explicitly forced to publish by law. By extension, LCV could become a closely guarded secret--what could be more intimate than a raw view of the profit and loss, down to the penny, created directly by a company's customer base, not only today, but for the forseeable future?

Some companies, such as Outpost.com, have started to loudly trumpet measurements, such as repeat purchases and average order size, but few have taken the steps to quantify and disclose the long-term net value of their relationships. "They don't want to expose that. It would give their competitors better insight into what's going on," says E.piphany's Rodwick.

According to Masterson, such reluctance is misguided, especially as the concept may become an inevitable part of accepted financial reporting and valuation.

"Early adopters in each industry have the edge on creating the [measurement and reporting] standards," she says. "The first bank, the first energy company that gets out there and begins to disclose this will likely drive the standards." In Masterson's view, the long-term alternative is to force the market to start guessing, which could lead to inaccurate and possibly damaging interpretations of a company's worth.

In the near future, a proper understanding of LCV will be a dangerous weapon. Careful analysis and application will help build a more profitable business overall, but it should not be allowed to become a divisional distraction or a bludgeon for loyal customers.

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