This book explains in analytical detail how companies should assess the value of their customers. Why is this important? This understanding helps provide true value to a company, since the profit-per-customer establishes overall company value
How much should a business school invest in recruiting new MBA students? What about an Internet service provider? The local dry cleaner? A credit card company seeking new clients? A bank seeking new borrowers?
For professors Sunil Gupta and Donald Lehmann (of Harvard and Columbia business schools respectively; for bios click here), the question is of such crucial importance that is has been worth their time to develop a simplified algorithm that helps estimate a core parameter: the customer lifetime value (CLV hereafter). This indicator measures what a typical customer is worth to a company, in terms of a profit stream over her lifetime.
The authors provide many examples of cases when acquisitions went ahead (alas!) without such calculations apparently having been done. Take the example of the AT&T acquisitions of MediaOne and TCI in 1999 and 2000. By acquiring the two companies, AT&T expected to enter the broadband segment and hopefully control a portion of the ‘last mile’ access to households. That would give AT&T access to juicy sales of different varieties of digital services to homes (broadband, but also video on demand, etc.). But was an acquisition cost of $4,200 per household justifiable?
Similarly, the authors invoke research on customer acquisition costs for a variety of industries: German utilities, Internet music sales start-ups, even luxury automotive manufacturers. For professors Gupta and Lehmann, the guiding philosophical outlook is that “it is better to be vaguely right than precisely wrong”.
The focus on customer lifetime value (CLV) may seem self-evident, yet the authors emphasize numbers of cases where such common sense was absent or was flawed in its calculations. That is why they propose a simple – indeed a purposefully simplified – algorithm to assess CLV.
A good part of the formula’s attraction is that it only requires limited data (and therefore limited analysis) by company managers. The basic approach requires only two bits of data: estimates of the profit margin per customer and the retention rate of customers over time. Although a discount rate for the cost of capital is also required, that element is typically given by the company’s financial backers (e.g. banks, investors, etc.).
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Although the formula is simple, it reflects the authors’ conviction that a more complex formula (that they provide in one of the book’s appendices) would be counterproductive, since it would discourage managers from actually estimating what their CLV is.
Why calculate your CLV?
The simplest answer is that the CLV is the maximum allowable marketing investment to recruit new customers (or acquire them via a merger or buyout). Returning to the AT&T acquisition, analysts at the time estimated that a suitable value-per-subscriber would be closer to $3,000.
The beauty of the CLV model is that it turns the focus of the managers on two key metrics that are worthy of constant management attention.
Firstly, the profit margin of the product or service. An evaluation of this metric is critical since it has the biggest mathematical impact on the CLV. Putting it bluntly, every dollar improvement in the product margin will go directly to the company’s bottom line – and better yet, to the company value since margin improvements carry over the full lifetime of the customer.
The second key measure is the retention rate. Or how many customers remain loyal every year (or month). Just as the margin forces managers to reflect on the current value of a customer, the retention rate provides impetus to reflect on future trends and competitive pressures. The retention rate can be affected by variables such as customer satisfaction, pricing by competitors, the degree to which customers are ‘locked in’ (e.g. mobile phone contracts with guaranteed pricing), or simply special offers at renewal time. Part 2 of this series will delve into those considerations in greater detail.
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Within their analysis, the co-authors introduce an intermediary variable that they call the margin multiplier; this is simply a mathematical factor that depends on the retention rate and the discount rate. The impact of the retention rate on the margin multiplier can be seen via the chart. This illustrates vividly why managers should focus more time on increasing their retention rate!
Assumptions that hold?
Like any mathematical model, the simple CLV model proposed by Gupta and Lehmann relies on several assumptions. Are they trustworthy and reliable? The three main assumptions are:
- That the profit margin is constant over time
- That the retention rate is also constant
- That the time horizon is infinite
By relying on various studies and published research, the co-authors demonstrate that changing the assumptions has a limited impact on the overall CLV.
In other words, the proposed simplification is vaguely right and not precisely wrong. In the next installments on this book (click here for box), we will examine how the CLV algorithm can be applied so as to help improve management decision making.
Published in June 2010.
The next installment will appear on June 23 and will cover customer-based strategy.
Just use the university ones.
Customer lifetime value in five sets
We examine “Managing Customers as Investments”, written by professors Sunil Gupta of Harvard Business School and Donald Lehmann of Columbia Business School.
Discover the algorithm that every company should use to assess the true value of its customers, and therefore how much it can afford to invest in marketing operations in order to capture new clients.
We cover this book in five parts:
Part 1 – June 9
The algorithm to evaluate customer lifetime value. How to calculate its value and what precautions to take.
Part 2 – June 23
Customer-based strategy: key drivers of customer profitability and their impact on marketing strategy.
Part 3 – July 7
Customer-based valuation: how the customer lifetime value can be used to value companies, namely in acquisition settings.
Part 4 – July 21
Customer-based planning: how planning with customer objectives in mind (retention, acquisition, etc.) varies from product-based planning. How effective can it be?
Part 5 – August 4
Customer-based organization: how a customer-based focus affects ideal corporate structure.
Michael and Chris Fodor