Loyalty Management

CUSTOMER LIFETIME VALUE (CLV) Part 5.

Retention and the Net Present Value (NPV)

Retention is one vitally important factor affecting a company’s profitability. MBNA bank announced that a 5% increase in its retention rate resulted in a 25% increase in profits.   

Most managers instinctively know that the longer a good customer is retained the more the company profits are likely to increase however, and sadly, many managers do not measure the affect of retention rates on profits. The table below measures the increasing margin contribution made based on how long the customer stays with the company.

The figures here are just examples; your basic data will be different. A 10% per year sales increase is used the future value of which is discounted to get the Net Present Value (NPV) (see posting Aug 18) assuming a 6% interest rate and no risk factor.  Usually the 1^st year of activity generates a slightly lower margin on sales because of some one time costs such as credit checking, providing samples, training and so on. The new customer acquisition cost is derived by taking the total marketing expenditures for the period (usually the past year), deducting that part of it devoted to activities with existing customers and dividing the result by the number of new customers – if proof of the value of customer retention is needed then repeat this calculation but divide the cost by the number of new customers, minus those acquired through referrals.. The yearly retention cost is the expenditure on programs for existing customers, divided by the average number of customers over the period.

It should be clear that the worst possible combination is to have a low retention rate and a high acquisition cost. It is not unusual, in some companies, for the acquisition cost to exceed the 1^st year’s margin – clearly companies with high customer acquisition costs must pay particular attention to the retention rate.

The table shows clearly that the longer a customer is retained the more margin contribution he or she makes.

CLV of the average customer based on years with the company
Years	Sales	Sales	Margin			Acquisition	Retention	NPV
	per year	discounted	%	$	Cum	cost	cost
1	1000	1000	48	480	480	100	50	330
2	1100	1037	50	519	999	100	100	799
3	1210	1076	51	549	1548	100	150	1298
4	1331	1119	51	571	2119	100	200	1819
5	1464	1162	51	593	2712	100	250	2362
6	1610	1205	51	615	3327	100	300	2927
7	1772	1251	51	638	3965	100	350	3515
8	1948	1299	51	662	4627	100	400	4127
9	2142	1346	51	686	5313	100	450	4763
10	2357	1398	51	713	6026	100	500	5426

 

Frank Friend  email. friend@ffauk.com

Next posting “The importance of referrals” Sept 5 2008

CUSTOMER LIFETIME VALUE (CLV) Part 4.

Customer data

Calculating the CLV requires that you have detailed customer data and this presents a problem for many companies – they don’t have much information beyond the absolute basics.

Peter Drucker, the management guru said “If you don’t measure it you can’t manage it” and this certainly applies to customer activities.

The extent and type of customer data that are collected will vary from company to company and from B2B to B2C business models. For some customer retention is all important while for others, for example, a custom builder, referrals are the key to success. Whatever the differences the key point is that the more customer data that is collected the more successful will be the company.

Collecting customer data doesn’t come free – some will judge the expense as reducing profits and so will collect as little as possible, others will judge it as an investment and collect as much as is appropriate. Companies with the latter belief will prosper; those with the former opinion will just have to get lucky!

What’s appropriate? It’s a judgment call but basically the goal is to collect data that can be of practical value to help measure and increase;

·         Retention

·         Referrals

·         Purchases

·         Margins

If you sell an expensive high margin product then you will benefit from collecting as much customer data as possible, if however you sell an inexpensive low margin product then your customer data can be less detailed.

All companies need to identify their most profitable customers (80/20 analysis) plus those thought to have potential to join that group. It is important to collect more data on these “A” customers, even for low price, low margin product companies. These customers must be retained and the more you know about them the more likely it is that this will occur.

Most companies will have basic customer data: sales history showing purchases by date, product(s) purchased and margins generated on the purchases.

Thereafter the information about customers that can be collected is almost unlimited, some of it valuable to develop customer profiles to assist in new customer acquisition and some directly related to calculating and then increasing the CLV, including the following.

Retention

The CLV is dependent on the length of time (usually years) that the average customer continues to buy from the company. The current figure, to act as a starting point, can be determined by tracking all, or a representative number of, customers for each of the market segments for which the CLV is to be calculated, by going into historic customer records. New or start-up companies will not have historic customer records so judgment must be used to estimate a figure (to be refined as data becomes available) for most B2B companies a 3-5 year time scale can be used.

Interestingly many companies do not know when, or if, a customer has defected – much less why. It’s necessary to know when a customer has defected so that retention rates can be monitored. If, for example, a company’s usual customer purchase frequency is every 30 days then it would be reasonable to assume that a customer has defected if there has been no purchase for 90 days – different companies will have different purchase frequencies and so defector dates, but the method used to calculate it is the same.

Clearly the CLV will increase if the retention rate improves (less defectors) so trying to spot a potential defector is a worthwhile endeavor. Generally there will be changes in a customer’s purchase habits – lower purchase frequency, smaller orders, some products not purchased and so on, that hint at the prospect of defection. Knowing this allows the company to take action to try to prevent the customer leaving. Even though a customer has defected it doesn’t necessarily mean that all is lost. Some defectors can be reclaimed; studies have shown that it is less expensive to reclaim a lost customer than it is to acquire a new one.

Retaining customers is best achieved by converting simply satisfied customers into loyal ones (see August 18 post) and companies that buy into this strategy will have dedicated programs in force to achieve this. These programs will be discussed in a future posting in this series.

Referrals

In most cases the best customer is one referred by an existing customer, they come largely pre-sold and their acquisition cost is low, or none.

The average CLV is increased if existing customers can be encouraged to refer more potential customers – to become advocates for the company. Again one way to do this is to convert simply satisfied customers into loyal ones.

It is vital that referral statistics are collected so that the changes in referral rates and the affect on the CLV can be monitored.

The source of each enquiry must be noted and the progress of each tracked. This will show the increase/decrease in referrals and their conversion rate to actual customers. Ideally details of their purchases would be collected.

Purchases

Loyal customers are more likely to be accepting of new products, they will tend to commit more of their purchases to the company (“share of wallet”) and react more positively to cross-selling. The average customer purchases by customer segment is easy to calculate and trends in average customer purchase is an important control metric.

Cost of acquiring a new customer and programs to retain existing ones

Determining the CLV requires that the cost of acquiring a new customer is calculated. This is a hidden figure in most companies. The calculation is simple enough, take your entire new client acquisition budget and divide it by the number of new clients acquired, not counting those that came from referrals. Then take the annual cost of all internal customer satisfaction programs and divide it by the total number of customers to get a rough cost per customer.

Frank Friend     Any questions? Contact me at Email. friend@ffauk.com

 

   

 

 

CUSTOMER LIFETIME VALUE (CLV) Part2.

 

The definition of the CLV given in Part 1 is useful for expressing the principle and explaining the concept but things are a little more complex in the “real world” so a couple of comments are in order.

We calculated the CLV in the example used in Part 1 as $3,300. This assumes that future dollars are as valuable as today’s dollars but they aren’t so the future dollars must be discounted to establish their current value. This is especially important if the CLV is to be used to justify expenditures based on future gains, for example, how much can be invested to acquire a new customer.

The formula used to convert the value of future dollars into their current value is;

Discount rate = (1 + ab)ⁿ

Where a = interest rate   b = risk factor, and n = number of years into the future.

We’ll use the formula later when we do the maths to calculate the CLV but a brief discussion prior to that is useful.

The interest rate is usually the current commercial rate (possibly modified for guesses of future changes). The risk factor is difficult to estimate, but because looking into the future is fraught with danger it’s wise to assess the risk of things happening which could reduce the Customer Lifetime Value, loosing customers for example. 

Determining the risk factor is a subjective decision usually based on a company’s own historic experience or on industry data. For example, if your company sells a product or service where your customers are tied by contract, then the future risk is small. If you sell a product or service that is complicated to install making it difficult for the customer to switch suppliers then the risk will be greater than the contract situation but much less than say for a company providing high fashion apparel. Hair salons have a lower risk factor than, say, hardware stores because their customers often develop  strong attachments to the stylist (called “stickness”) and are loath to switch. Most managers are conservative when assessing risk since it’s safer to have a low rather than high expectation of future benefits.

Reducing the risk factor is at the heart of customer loyalty programs and this will be discussed in the section devoted to ways to increase the CLV.

Another point to bear in mind is that very few companies have just one product sold to the same type of customers in one location - so while calculating a global CLV is interesting it has limited value as a management decision making aid.

The ideal position is to calculate the CLV for each distinct product/customer combination – market segmentation in other words. Doing this requires that the company has detailed customer data, unfortunately not too many companies do. Companies using good contact management systems such as ACT! or better still CRM systems such as Sage CRM have a tremendous advantage. That said companies that do not have these systems can collect enough customer data to calculate the CLV for broad segments of their business.

Knowing the CLV of the various market segments helps managers to concentrate their resources on the high profit segments and to investigate and improve those segments that are performing less well.

Frank Friend

friend@ffauk.com

Part 3 of the report will be posted on August 24

 

CUSTOMER LIFETIME VALUE (CLV) Part 1.

Do you know what CLV is?

Do you know the CLV for your company?

Do you know how to calculate the CLV?

Do you know how to use the CLV to improve your decision making?

If you answered NO to any of the above then take a few minutes to read this report, you will not regret it.

Let’s start with a definition

“The Customer Lifetime Value is the direct margin generated on the sale of products or services to the average customer over the length of time the average customer continues to purchase from the company plus any other benefits derived from the average customer: minus the average cost of acquiring a customer and the cost of programs to maintain and retain the average customer”.

So, if the average customer buys $1,000 a year and stays for 5 years and if the average Direct Margin is 40% and the average cost of acquiring a new customer is $200 and the average cost of on-going customer care programs is $100 a year then the CLV is $3,300.

$1,000 x 5 years = $5,000 x 40% = $2,000 - $200 and – ($100 x 5 years) = $3,300

Simple!

Actually it isn’t, but for now let’s assume that we can calculate the CLV (we’ll get into the methodology and maths later) and that it is $3,300 and that no other benefits accrue. Just for the record the “other benefits” refer in the main to the referrals made by customers.

OK, but why go to the trouble of calculating the CLV, what use is it?

The first, and ultimately the most important, reason to calculate the CLV is that it makes everyone in the company acutely aware of the true value of a customer. For example, the loss from messing up an order for a customer isn’t just the value of the order it could well result in losing the customer – and all of his or her future Lifetime Value. It is important therefore to make sure that all employees know of and understand the importance of the CLV.

The most obvious value of knowing the CLV is that it shows how much can be invested to acquire a new customer. Say you spent $1,000 on a direct mail program that generated sales of $500 from 5 new customers. An apparent failure since you received less in sales and margin than the program cost. However, the CLV of a new customer is $3,300 so the program was a huge success because it would generate $16,500 of Direct Margin over the next 5 years for a cost of just $1,000. Knowing the CLV makes it easier to create marketing strategies and develop more accurate budgets and it provides a reliable way to measure the success/failure of customer acquisition initiatives such as direct mail, click purchase and advertising.

The CLV is largely determined by customer retention rates and the amount of business conducted with the average customer and the Direct Margin generated on it. Also, as will be discussed later, the number of new customers referred by existing ones. A regular re-calculation of the CLV is a convenient way to measure the company’s progress. 

Part 2 of this report on Customer Lifetime Value will be posted on Thursday August 21.

CUSTOMER SURVEYS - A DOUBLE WINNER

If you don’t listen you don’t learn.

Listening to your customers, whether face-to-face, by phone or by surveys is the essential first step in developing programs to build business and profits with and through them.

If you don’t listen to your customers you are likely to fall into the trap of providing products or services that you want to sell rather than those your customers want to buy. If you don’t know that a customer is dissatisfied then you are hardly able to correct the situation – 80% of customers who are dissatisfied, usually as a result of a service breakdown, don’t complain they just walk away - never to return.

There are all kinds of survey designs aimed at collecting customer information, some useful some not, one approach receiving much attention is The Net Promoter Score developed by Frederick Reicheld of Bain & Co. The beauty of this approach is that your customers are asked just one question – the “Ultimate Question”

“Would you happily recommend this company to your friends and associates?”

The assumption, of course, is that there can’t be any serious negatives about a company if you are prepared to recommend it to a friend.

The percentage of respondents who say they are unlikely to recommend the company is deducted from the percentage who say they are highly likely to recommend the company to arrive at the Net Promoter Score.

The NPS has been shown to be the most reliable indicator of a company’s future growth prospects.

So why the DOUBLE WINNER?

Research has shown that customers who have been surveyed are less than half as likely to defect and are more profitable than those who have not been surveyed.

This makes sense when you consider that most customers who defect say that they felt ignored by the company.

 

SATISFIED VS. LOYAL CUSTOMERS

A satisfied customer is much the same as loyal customer, right? - WRONG.

Many, even most, managers think that satisfied and loyal are synonymous terms and pat themselves on the back when their Customer Satisfaction Surveys show that 80 or 90% of their customers are satisfied with the company.

Most of these customers are satisfied only until they are offered a better price or some other inducement by a competitor. Several studies have shown that 60 to 85% of companies that switched suppliers were satisfied or very satisfied with their previous supplier.

What’s the difference?

Satisfaction relates to the results of a process - as for example when you put a coin in a soft drinks dispenser you expect to get a can delivered, if that happens you are satisfied, if it doesn’t you move on to another dispenser (after kicking the first one!)

Loyalty occurs when an emotional bond is established with a customer either by building human-to-human relationships over a long period, or by the customer having a “moment of truth” experience. This is when the company does something so exceptional (in the customer’s mind) that a bond is established that isn’t easily broken. The loyal customers compared to simply satisfied ones are more forgiving of mistakes, have greater retention and referral rates and give the company a bigger share of their purchasers.

The Lifetime Value of a loyal customer (the net gain to the company over the lifetime of the relationship) can be several times higher than that of the simply satisfied one.

More companies are emphasizing the importance of satisfying their customers but few understand that this is but the first step and they fail to move on to implementing programs to convert the satisfied customers into loyal ones.