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Lifetime Value, I'd Like to Introduce You to the CFO  (part 2)

First published 11/2001, the customer report: retention (UK)

Go to Part 1: Periodic vs. Customer Accounting,  Real World Example

Pre-CRM Analysis

Where does all of this leave us?  On the one hand, managing by customer value is in direct conflict with the well-established periodic reporting accounting system used to manage the majority of firms in operation today, and all the definitions of business success are tied to this system.  On the other hand, managing a business by customer value allows for an unmistakable advantage - the ability to predict future profitability and the effects of changes to the operation before they create any significant economic impact - positive or negative in nature. 

I believe management must clearly understand and implement a customer accounting system before implementing CRM, for it is this accounting system that CRM implementation decisions and ROI calculations should be based on.  The use of periodic statement thinking to measure and manage CRM is simply not appropriate, and the CFO has to feel comfortable in understanding how to reconcile these two accounting systems.  If you are the champion of the CRM effort, it is your job to deliver this reconciliation capability.  After all, your system is late to the financial party.

Note this: in the example above, we did not actually measure "Lifetime Value" in the traditional, absolute sense.  We looked at the relative value of customers, and determined the direction value was moving in.  This idea of tracking relative customer value is one way to convert the concept of Lifetime Value into a more tangible number aligned with the periodic accounting statement system.  There will be more on this idea of tracking relative value and using it to manage a business below.

The customer accounting system does not have to be a piece of software running on a piece of hardware.  It can take the form of customer value reporting, designed to track the value of new and current customers over time.  As long as the CFO understands and approves of how the metrics are constructed, this customer value reporting should be enough for financial people to be comfortable they can reconcile customer accounting with periodic accounting.  Generally, two types of customer accounting reports are valuable - an overall view of customer value status and a campaign or project specific view.  

The overall value view, which could be constructed every 30 days or every quarter to match the periodic accounting cycle, divides customers into value segments and tracks the growth or shrinkage of these segments.  The important idea conveyed here is the direction of customer value - increasing or decreasing?

The campaign or project specific view is just that - a simple analysis of each activity funded to drive customer value.  Each activity has certain costs, generates revenues, and has a profitability associated with it.  The revenues should be measured over a length of time agreed to by the CFO, and a target ROI should be decided upon.  If an activity cannot generate an acceptable ROI, it should be discontinued.  This approach does not mean you stop testing new ideas; it does mean you don't repeat low ROI mistakes.

The idea behind both these reports is simple.  As long as customer value at the macro level and ROI at the campaign or operational project level are tracking incrementally in a positive direction, a CFO can be confident this value will eventually flow through to the periodic accounting system.  The CFO may not be able to "see it" in the periodic accounting statements, but you have proven in advance the value you created is "in there".  These reports become the base or benchmark by which the CFO can be convinced CRM or a customer retention program is indeed contributing value.

Sample Reports

I won't be completely resolving this question of periodic versus customer accounting systems for you in this relatively short article.  I can offer you two examples of "overall value view" reports you can use as prototypes for the pre-CRM effort to begin the examination of these issues.  The following should be fairly simple to accomplish, even if you don't have a data warehouse and a bunch of Ph.D.'s on staff, and should be relevant to most any business with customer transaction records.

The primary difference between a periodic accounting system and a customer accounting system is in the treatment of time.  Any customer analysis you do pre-CRM should lean towards breaking down the variable of time into component parts aligned more closely to the periodic statement accounting system and creating a comfort level for the CFO regarding the concept of tracking customer value.  If you can accomplish this and get "buy in" at a basic level, you can move on to more sophisticated reporting later on when you have the proper analytical tools.

The easiest customer behavior components for most firms to access and report on are total sales and customer start date - the first purchase or billing transaction with the customer.  Here are two simple reports using these metrics that will allow you to start building your case.

Report 1: Sales by Customer Volume
Take any periodic statement time frame - a month, a quarter, a year.  Gather all the customer revenue transactions for this period, and recast them into the total sales by customer for the period.  Decide on some total sales ranges appropriate to your business, and produce a chart on the percentage of customers with sales in each range, including non-buying customers, for the chosen periodic accounting time frame.  For example:

Run this report each period, and compare with prior periods.  In general, you want to see the percentage of customers contributing high sales per period to grow over time, and the percentage of lower revenue customers to shrink.  This means you are increasing the value of customers overall.  If the numbers are moving the other way, this is the type of customer value problem you would expect CRM or a retention program to correct, and if you are successful, you should see the shift in customer value through this report.

Report 2:  Sales by Customer Longevity 
Take any periodic statement time frame - a month, a quarter, a year.  Gather all the customer revenue transactions for this period, and recast them relative to the start date of the customer.  In other words, when looking at the revenue generated for the period, how much of it was generated by customers who were also newly started customers in the same time period?  How much was generated by customers who became new customers in the prior period?  How about two, three, and four periods ago?  More than 4 periods ago?  Depending on the length of the period you use, you may end up with a chart looking something like this:

By the way, customers who leave the firm and then come back should be considered "new"; use the most recent start date you have for the customer.  There is a reason to account for the revenues this way: it is likely you spent money to get these customers to come back, and eventually, you will want to match up those expenditures with the revenues generated by the customer before they defect again to prove out ROI. 

You can run this analysis at the end of each period and track the movement of customer value in your customer base.  Generally, you want to see increasing contribution to revenue from customers in older periods, meaning you are retaining customers for longer periods and growing their value.

While on this topic of customers "leaving", can you even tell if a customer has left?  Do you have any definitions on this topic, for example, how long the span of inactivity on the part of a customer is before you consider them "gone"?  The period of activity from the day the customer starts until the day they leave is called the Customer LifeCycle.  More on this concept of the Customer LifeCycle, which is critical to understanding and using customer value metrics, can be found here.

It's All Relative

The fundamental idea driving relative customer value tracking is this: future or potential customer value is ever changing, and there really is not much point in trying to come up with an "absolute LTV".  What you most want to know is this: is the potential value of the customer growing or shrinking, and at what rate?  Knowing this, the firm can allocate marketing and financial resources to their highest and best use - to accelerate rising potential value and to slow down shrinking potential value in the customer base.

You might use a 2-year LTV to benchmark your acquisition costs, but during this 2-year period and beyond, you want to look at changes in potential value.  This can be done using one or more simple customer behavior modeling techniques.  More on the this topic of absolute versus relative Customer Value, can be found here.  To review concrete examples of the relative value measurement technique in action, see the following tutorials:

Trip Wire Marketing: Latency          Recency Predicts Future Value

One final note.  There are plenty of consultants who will be glad to throw stones at these simple models of customer value tracking, and tell you why you can't possibly manage a business using reports like this.  All I can say to this is you have to start somewhere.  The problem with many if not most CRM efforts so far is the firm launched into them without any idea of where they currently stand in regards to customer value.  Without establishing benchmarks for tracking customer value, how is one ever to prove the ROI of CRM to the periodic accounting world?  

This idea of using relative and potential customer value measurement to bond customer value to the income statement is the driving force behind my Simple CRM workshops and consulting practice.  More information on the Simple CRM method for increasing profits in small to mid-sized businesses can be found here.

Endless navel-gazing on the subject of "true Lifetime Value" is simply a resource drain, and is not going to matter one bit if you can't reconcile it with the real world of periodic reporting statements.  Trust me, I've been there and back, and lived to tell you the story!

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Jim Novo is an interactive Relationship Marketing, Customer Retention, Defection, and Loyalty expert with over 15 years of experience generating exceptional returns on customer marketing investments.  He also authored Drilling Down: Turning Customer Data into Profits with a Spreadsheet.  More about Jim's background and consulting services can be found here.

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