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Lifetime Value, I'd Like to Introduce You to the CFO

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

And then there was Lifetime Value, the mysterious, near  impossible-to-figure Holy Grail of Customer Marketing.  Is there more to Lifetime Value (LTV) than just a ruse for keeping a consulting contract open-ended?  Customer behavior expert and author Jim Novo thinks so - if you transform LTV into a concept your CFO can reconcile with the existing financial reporting system.

This white paper is available as a download 
(Word doc, text, or zipped Word doc) here.
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Conflicting Values

Why is this idea of Lifetime Value (LTV) so difficult for a firm to absorb, never mind to calculate and implement?  Because it is a "fish out of water" relative to the way most firms are managed.  The idea of LTV contradicts the entire structure of a firm driven by periodic financial statements.  

When profits, security prices, compensation, and budgeting are all tied to the income statement and balance sheet, then how would you expect a firm to embrace the idea of a customer Lifetime?  Where is the incentive?  What value will implementing the use of Lifetime Value measurement bring to the firm?  If you don't have a way to reconcile the notion of LTV with the internal financial yardsticks of the firm, it is not likely you will find a lot of support for managing based on customer value measurements.  Who would care?

But Lifetime Value is a central idea in customer retention and Customer Relationship Management (CRM); after all, if you cannot extend and increase the value of a customer, then why bother with CRM at all?  There may be some measurable operational efficiencies and cost reductions to be had with a properly planned CRM installation, but without a measurable increase in customer value tied directly to CRM itself, CRM will continue to be a bitter pill to swallow for many a CFO.

So even before you get started planning for CRM, you are faced with a conflict between the customer accounting approach of LTV and the periodic statement accounting approach of the CFO.  It is this conflict, buried deep in the heart of the firm, which I believe ultimately results in "CRM failure".  

Unless this conflict is resolved prior to the implementation of CRM, it will grow and begin to manifest itself in the CFO's eyes as lack of Return on Investment (ROI), viewed through the lens of the periodic statement system.  You must prove you know how to track customer value and establish benchmarks if you ever expect to forecast and measure the effects of a CRM implementation.

Question of Time 

The critical difference between customer accounting and periodic accounting is the way time is handled.  Customer accounting based on Lifetime Value is forward looking; the periodic statement system is at best a snapshot of the current situation, and more frequently backward looking.  

The Lifetime Value system is constructed using mathematical predictions of customer value based on historical data; the periodic statement system is based on a "best guess" forecast of what revenues and expenses will be, or by taking past performance and incrementing it by a percentage.  It is not based on customer value "facts".

These different accounting treatments often result in different management styles.  Firms using customer accounting (as many catalogs do) understand and believe in the concept of Lifetime Value; they know as long as they continue to incrementally increase the ROI of mailings and acquire customers of higher and higher Lifetime Value, the periodic statements will take care of themselves.  

Firms managing by periodic statement can only rely on what they transact, and are loath to trust "future value".  They are also frequently surprised when profitability shifts in either direction due to operational or marketing changes in the business.

In order for CRM to be successful, there has to be a reconciliation of these two accounting systems and management styles in order for costs and benefits to be aligned and ROI proven out.  The best time to do this is in the "pre-CRM" phase, before any serious discussion of organizational changes or software occurs.  The firm should undertake a significant study of customer value and be very clear on how customer value accounting relates to periodic statement accounting as the very first step of a CRM effort.  Not doing this study risks CRM failure.

Periodic Error

Does the whole customer accounting versus periodic accounting premise sound quite fantastic to you?  Allow me to relate a true story I believe clearly demonstrates the difference between the customer accounting and periodic accounting measurement and management styles, and offers some insight on the value of a pre-CRM customer accounting effort.

A direct-to-customer retailing company I was doing work for generated new customers with an average Lifetime Value of $120 (profit, not sales), and the LifeTime of the customer was about 2 years.  These numbers could differ substantially by customer acquisition method and category of product sold, but the averages related above had been stable for over 5 years.  Revenues and profits were quite predictable based on the number of new customers acquired using these metrics.  If you know every new customer is worth on average $120 in profits over 2 years, it is quite a simple matter to project the financial health of the firm out into the future.  This is an example of the forward-looking nature of customer accounting in practice.

New management came in to run the company, and as new management frequently likes to do, changed the marketing and merchandising approach.  The new format was to emphasize the marketing and merchandising of products generating higher volumes of new customers.  Unfortunately, this change was made without concern for the value of the new customers attracted by this change; we predicted these new customers would have significantly lower Lifetime Values based on past experience with these methods and products.

As the changes in marketing and merchandising took hold, sales remained flat to slightly higher, and the number of new customers acquired started growing faster than before the changes.  From a traditional periodic financial reporting view, the changes appeared to be successful.  But on the Lifetime Value ledger, after studying the new customers generated by these changes for several months, we saw the dramatic drop in the value of new customers relative to the "old customers" we had predicted.

When examining customers three months after their first purchase, customers acquired under the previous business format spent on average about $200.  The new customers attracted by the current format had cumulative sales of only $100 at three months after first purchase.  Further, under the previous format, 50% of customers would still be active buyers at 3 months.  New customers attracted by the current format clocked in at 25% for this "LifeCycle" metric.

We flagged this situation immediately to management.  At this rate, we predicted sales for the firm would drop significantly 12 months in the future.  Under the old business format, we could depend on customers acquired in one year to still be buyers in the next year.  Under the new scheme, it appeared the average new customer stopped buying considerably sooner and spent less overall.

You can probably guess the response from management to this prediction. 

According to the periodic financial statements, everything was just fine.  Sales were flat to up, and new customers were coming on even faster than before - proof the new strategy was working.  

We warned a high percentage of the current sales activity was coming from old customers who would be "rolling off" next year, and that the new customers replacing them would not purchase as much.  In fact, it looked like we would have to more than double the number of these new customers we brought in if we wanted to replace the sales of the old customers rolling off - the new customer value looked to be about 25% - 50% of the value of the old customer, based on our relative value tracking (change in LifeTime Value) studies of these new customers..

We were summarily tossed out of the room.

About 6 months later, year over year sales started sliding, gradually at first, and then at an increasing rate.  A short 6 months after this, the company was on the verge of going out of business, management was replaced, and the original marketing and merchandising format put back into place.  

How long do you think it took for this company to build sales and profits back to the level of performance before the change in format?  It took as long as it took to destroy the Lifetime Value of the customer base in the first place. 

Sales and profits initially continued to erode under the reversion to the old format.  The rate of new customers coming in dropped significantly, back to levels consistent with the old format.  This was not a comforting sign for the new management, because the periodic financial statements presented increasingly bad news - for a time.  

But the new management believed in the concept of Lifetime Value, and our analysis showed the new customers coming in were indeed twice the value of the new customers created by the rejected format.  We advised management stay the course.  The rate of decline in sales started to slow, then reversed and sales began to grow month after month.

Just as we predicted using customer accounting.  Or more precisely, the relative potential value metrics that are at the heart of Simple CRM.

It took a full year for the low value customers created by the new format to be replaced with higher value customers created by returning to the original format.  Once this customer value replacement cycle was complete, the company surpassed the old sales and profitability level it had achieved before the initial change in format - and kept growing at double digit rates.

The periodic financial accounting statements failed to provide vital management input on two occasions.  They could neither tell of the future decline in business due to a faulty change in format, nor could they predict the future rise in profitability due to a beneficial return to the original format.  Only an accounting system based on measuring and managing the future value of a customer can do this.  Customer value accounting is forward-looking and predictive of sales and profitability in the future.

Go to Part 2

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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