1. A conceptual approach of customer lifetime value and customer equity

Transcription

1 THE MEASUREMENT OF CUSTOMER LIFETIME VALUE AND CUSTOMER EQUITY Auhor: Balan Carmen Balan Insttuton: Academy of Economc Studes of Bucharest, Faculty of Marketng, Department of Marketng,. Address: Pata Romana no. 6, Sector 1, Bucharest, Romana, Phone: ; / ext. 469, 237, E-mal: cbalan@ase.ro Customer lfetme value and customer equty are central pllars of the analytcal customer relatonshp management. These concepts reflect the capacty of the organzaton to generate profts consderng the customer portfolo, the current and potental customers. The paper focuses on the measurement of lfetme value (LTV) and customer equty (CE). It ams to present several ways to quantfy LTV and CE. The paper underlnes the man steps and varables that must be consdered by marketng managers n order to assess the LTV and CE. The declaratons made by organzatons about the mportance of satsfyng the needs and expectatons of customers are no longer the excepton n the market, they are the common denomnator of the marketng polcy of most organzatons. However, a queston stll remans relatve to the share of the organzatons that acheve a thorough analyss of the customer LTV and CE, n order to devse the most effectve and effcent strateges. The present paper makes a strde further by provdng a set of methods that brng lght and quantfcaton n an area where qualtatve approaches and brd s eye vew are customary. Key words: analytcal CRM, customer lfetme value, customer equty, measurement Customer-centrc strateges are the trend n today s hghly compettve market landscape. The focus on customers, on ther needs, wants and expectatons s the common characterstc of the organzatons that acheve a sustanable postve performance and mantan ther leadng postons n the market. The concepts of customer lfetme value and customer equty became the steppng stone of marketng polces able to generate value for customers, companes and ther shareholders. 1. A conceptual approach of customer lfetme value and customer equty The essence of marketng management conssts n the desgn of strateges that wll buld proftable relatonshps wth target customers. [1] Marketng management s concentrated on the development of long-term relatonshps wth customers and to a less extent on the achevement of a hgh level of proftablty of each transacton. The core of the marketng phlosophy s the creaton of customer loyalty and retenton. Customer relatonshp management promotes the dea that totally satsfed and delghted customers reman loyal to the brand and the company, spread favorable words among the potental customers and ensure a sustanable postve evoluton of the company through ther contnuous stream of purchases durng the relatonshp wth the organzaton and ts brands. Losng a customer means much more than losng the net proft of one transacton. In fact, losng a customer s equvalent to losng the profts generated by all the purchases that specfc customer would have made from the company durng the entre relatonshp wth the organzaton. Consequently, hgh performance marketng managers focus on customer lfetme value and on customer equty. The customer lfetme value s defned n varous ways. Essentally, t s the value of the entre stream of purchases that the customer would make over a lfetme of patronage. From a suppler standpont, a customer s lfetme value can be defned as the present-day value of all net margns earned n a relatonshp wth a customer [2]. The LTV s a mult-perod assessment of the customer value to the frm. Whle the nterest n LTV ncreases, there are also some pessmstc opnons. Sometmes, LTV s consdered an elaborate fcton of presumed precson. [3] In customer relatonshp management, the generaton of customer equty s the foremost goal of the company. Customer equty s the sum of the dscounted customer lfetme values of all the company s customers. Ths concept refers to both the current and the future customers. The vablty of the company and ts future performance depend drectly on customer equty. The smplest example that reveals the concept of customer lfetme value and customer equty refers to a convenence store that serves a small communty of 700 households. The average value of the purchases made weekly by a household of that neghborhood s 60 Euros. An assumpton could be that on the average, durng a year, a household buys products wth a value of at least 3,000 Euros (60 Euros per week multpled by 50 weeks annually). Losng one of the households as a customer wll stop a revenue stream of 3,000 Euros annually multpled by an average of 4 years durng whch the household members wll very lkely lve n the neghborhood. More precsely, the convenence store wll lose the total undscounted revenue of 12,000 Euros, respectvely a 9,000 Euros dscounted value generated by that household. At the same tme, the store management should desgn and mplement strateges able to satsfy and delght the members of the 700 households, n order to acheve a sustanable level of fnancal performance. Consequently, the customer equty 771

2 wll be the center of the store polcy. Consderng the 700 households (current and potental customers) that create the small communty served by the convenence store and the dscounted revenue stream of 9,000 Euros generated by one household durng a four-year nterval, the organzaton has to proftably manage a customer equty of 6.3 mllon Euros n the specfed perod. 2. The measurement of customer lfetme value The LTV measurement s centered on the present-day value of al net margns earned n the relatonshp wth the customer. Consequently, the hstorcal net margns must be compounded up to today s value and the future net margns must be dscounted back to today s value. The calculaton of LTV requres a precse vew of the revenues and costs assocated wth the creaton and development of the relatonshp wth a specfc customer. The major factors consdered for the calculaton of LTV are presented n fgure 1. Fgure 1 Major factors consdered for LTV calculaton Recurrng revenues Recurrng costs Contrbuton margn Relatonshp duraton Dscount rate Lfetme proft Acquston cost Customer lfetme value There are several ways to compute LTV. Even f the concept seems to be very smple and clear-cut, there are varous quanttatve approaches. The man reasons of the dversty of approaches are the followng: types of varables consdered. A dverse array of varables may be ncluded n the model. The nputs of the model may be defned more broadly or more narrowly. For example, recurrng costs may reflect to a dfferent extent varous types of marketng and servce costs. relatonshp duraton. The duraton of the relatonshp may also generate varatons. On one sde, the relatonshp may have a fnte duraton when t s based on a two-year contract (as n the case of moble telecommuncaton companes) or a non-fnte duraton (as n the case of a hypermarket). data avalablty at customer level. Data avalablty may also be an ssue. A relatvely small number of companes have data at customer level, not only at the entre portfolo level. Few are able to compute the net proft correspondng to each customer. The calculaton of LTV mples that all costs generated for the customer acquston and retenton, for the completon of each transacton and for relatonshp management are traced back to each ndvdual or organzatonal customer. Such an allocaton of costs provdes a complete nsght that s ndspensable for the calculaton of customer LTV. statstcal abltes. The software solutons appled to the databases nfluence the capabltes of the marketers to compute the LTV and desgn approprate one-to-one strateges. tme frame. When marketers want to analyze the hstorcal evoluton of the customer lfetme value, they use data about the past behavor of the customer. The data are avalable n the databases of the company. However, nowadays, specalsts focus more on estmatng the future LTV. The allocaton of ncome and expenses to one customer may be accomplshed accordng to the procedure presented n table 1. Table 1 Allocaton of ncome and expenses to a specfc customer Customer turnover - Dscounts granted + Shppng costs passed on to customer + Suppler s credt 772

3 Gross turnover - Turnover from returns Net order sales - Cost of goods/servces sold - Admnstratve order processng costs - Physcal order processng costs - Admnstratve and physcal costs of processng returns - Bad debt expenses - Cost of acquston and relatonshp management Customer s contrbuton to overhead and the proft of the organzaton Source: [4] In accordance wth the defnton, the lfetme value of an ndvdual customer may be calculated as the sum of the dscounted contrbuton margns generated by that customer over the analyzed perod. The formula s the followng: LTV = T CM t t= δ t (1) where: corresponds to the specfc ndvdual customer; LTV s the lfetme value (expressed n monetary unts) of the customer ; t (from 1 to T) s the tme unt (month, year etc.); CM t s the contrbuton margn generated by the customer n the tme unt t; δ s the nterest rate (cost of captal that s used to calculate the net present value) correspondng to the specfc tme unt t. Formula (1) may be presented under the form of a detaled verson by breakng down the contrbuton margn. T LTV = ( S DC ) MC t t t t= δ t (2) where: S t represents the sales to the customer ; DC t s the drect cost assocated wth the customer ; MC t s the marketng cost assocated wth the customer. 3. The measurement of customer equty Customer equty s measured as the sum of the lfetme values of all the company s customers. Ths ndcator reflects how much a company s worth at a specfc pont n tme as a result of ts customer management efforts. An example of formula for the measurement of customer equty s presented bellow: N T CE = CM t = 1 t= 1 1 t 1 + δ (3) where: CE s customer equty; (from 1 to N) corresponds to the ndvdual customers; t (from 1 to T) s the tme unt (month, year etc.); CM t s the contrbuton margn generated by the customer n the tme unt t; δ s the nterest rate (cost of captal that s used to calculate the net present value) correspondng to the specfc tme unt t. The formulae that have been presented are based on the assumpton that customers reman fully actve durng the perod under consderaton. In a real busness envronment, ths assumpton s not vald. Consequently, marketers should take nto account customer retenton probabltes and adjust the formulae for the determnaton of LTV as follows: 773

4 LTV = CM Rr 1+ δ R r AC (4) where: R r s the retenton rate and AC s the cost of acqurng the customer. The perspectve nto the future s by far more mportant than nto the past when computng the LTV [5]. In the process of strategy desgn, the past does not provde marketers a relevant vew of customer LTV. The man factors that generate the preference for a perspectve nto the future are the followng: () revenues from customers tend to grow over tme as they buy more n terms of quantty and an ever wder range of products from the company s portfolo; () costs assocated wth customer retenton are smaller than customer acquston costs; () totally satsfed and delghted customers generate addtonal revenue to the suppler due to ther referrals; (v) loyal customers pay prces that are often hgher than those offered to new customers (companes provde dscounts to lure potental customers nto buyng). An example of CE calculaton s presented n table 2. The data reflect the stuaton of a company that acqured 2,000 new customers due to a drect malng campagn wth a response rate of 4%. The average annual sales value generated by a customer s 250 Euros and t s assumed to be constant over the lfetme of the customer. The gross margn s 30%. The retenton rate ncreases progressvely from the frst to the ffth year of the customers lfetme. The proft per perod s dscounted to the present value wth an annual rate of 14%. The calculated customer equty s 68,106 Euros generated durng a lfetme of fve years. The CE value reflects the total net present value of the profts generated by the customers retaned by the company. The mprovement n the annual retenton rate may have a postve effect on the customer equty value. Table 2 Example of CE calculaton Year Sales per customer (Euros) Manufacturer s gross margn (Euros) 1 Marketng and servcng costs (Euros) Retenton rate (%) 2 Survval rate (%) 3 Number of actve customers 4 Annual proft per customer (Euros) 5 Annual dscounted proft per customer (Euros) 6 Total dscounted proft per perod (Euros) , , , , ,200 Total CE 68,106 Note: (1) Gross margn calculated accordng to a 30% rate over the sales per customer. (2) The retenton rate s specfc to each annual perod. (3) The annual survval rate s the share of the ntal number customers that have remaned loyal n the year under consderaton. (4) Estmated number calculated by multplyng the ntal number of new customers (2,000 customers) by the survval rate. (5) From the company s perspectve, the annual proft per customer s calculated by deductng the marketng and servcng costs from the manufacturer s gross margn. (6) Calculated on the bass of 14% dscount rate. (7) Total value obtaned by multplyng the annual dscounted proft per perod by the number of actve customers n that perod. The lfetme value and the customer equty are ndspensable metrcs for the effectve and effcent management of the relatonshps wth customers. They gude the strategc decsons of the company. In order to mprove the LTV and CE values, companes must contnuously dmnsh the acquston costs, strengthen the retenton rates and augment the proft earned per customer. Every mprovement n the LTV and CE nfluences the fnancal results of the organzaton and has a sgnfcant mpact on ts poston n the marketplace. BIBLIOGRAPHY 1. Kotler P. Prncples of Marketng, eleventh edton, Pearson Educaton, Prentce-Hall, Upper Saddle Rver, New Jersey, 2006, p Buttle F. Customer Relatonshp Management. Concepts and Tools, Elsever, Butterworth- Henemann, 2006, p Jackson, D.R. In Quest of the Gral: Breakng the Barrers to Customer Valuaton, n Drect Marketng 54, no. 11, 1992, pp

5 4. Roberts M.L., Berger P.D. Drect Marketng Management, Rechheld F., Sasser W.E. Jr. Zero Defectons: Qualty Comes to the Servces, n Harvard Busness Revew, September/October 1990, pp

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