increasing the lifetime value of a customer

Increasing the Lifetime Value of a Customer

Alan D. CampbellPh.D., CPA, CMA, CFP®

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Learning Objectives

1. Explain how to calculate the annual profitability of a customer

2. Explain why customers are assets

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Learning Objectives

3. Explain how to calculate the lifetime value of a customer

4. Explain 11 strategies for increasing the lifetime value of a customer

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Learning Objective 1

Explain how to calculate the annual profitability of a customer

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Customer Profitability Analysis

• Use an activity-based costing (ABC) system with the customer as the cost object

• Accumulate the costs of serving customers in activity center cost pools

• Determine the measure used to assign costs from the activity center cost pools to the customers

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Assigning Costs to Customers

• Calculate the activity center cost driver rate

• Multiply the activity center cost driver rate by the activities used by each customer to determine the costs from each activity center assigned to the customer

• Repeat for all activity center cost pools

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Calculate the Customer’s Profitability

• Subtract cost of goods sold from sales revenue to determine gross profit

• Subtract all direct selling and administrative costs, such as commissions

• Subtract all costs assigned to the customer from the activity center cost pools to determine the customer’s profitability

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Compare Profits and Sales Revenue

• Compare the customer’s profitability to the customer’s sales revenue

• Sometimes the customers who generate large amounts of sales revenue may be unprofitable because of the demands they place on the company (Kanthal (A) Case)

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Example• Able Manufacturing Company (a fictitious

company) sells three products. The three products, their selling prices, and their cost to purchase are as follows:

Price Cost

• Gadget $1,000 $480 (48%)• Gizmo $1,200 $648 (54%)• Super gizmo $1,500 $840 (56%)

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Other Information

• The company keeps the gadget and the gizmo in stock

• The company does not carry super gizmos in stock

• Sales commissions are 20% of sales

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Activity Cost Pools

• Able Manufacturing Company has determined that it should divide its cost of serving its customers into four cost pools:– Order processing—gadgets and gizmos– Order processing—super gizmos– Delivery– Customer service (before and after the sale)

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Order Processing for Gadgets and Gizmos

• Order processing costs for gadgets and gizmos for the year were $500,000

• The company processed 5,000 orders• The cost to process one order for a gadget or

gizmo is $100 ($500,000 / 5,000 orders)

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Order Processing for Super Gizmos

• Order processing costs for the super gizmo were $100,000 for the year

• The company processed 100 orders for super gizmos

• The cost to process one order for a super gizmo is $1,000 ($100,000 / 100 orders)

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Delivery

• The company incurred $300,000 in delivery costs for the year

• The company made 1,500 deliveries during the year

• The cost per delivery was $200 ($300,000 / 1,500 deliveries)

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Customer Service

• The company incurred $480,000 in customer service costs during the year

• The company spent 8,000 hours in providing customer service

• The cost per customer service hour was $60 ($480,000 / 8,000 hours)

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Activities for Customer A

• In a typical year, Customer A purchases– 700 gadgets – 750 gizmos– 50 super gizmos

• Number of orders of gadgets and gizmos: 12

• Number of orders for super gizmos: 2

• Number of deliveries: 14 (12 + 2)

• Number of customer service hours: 4

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Sales Revenue and Gross Profit for Customer A

• Sales revenue $1,675,000

• Less: cost of goods sold (864,000)

• Gross profit $ 811,000

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Profit for Customer A

• Gross profit $811,000• Less: sales commissions (335,000) • Less: order processing

– Gadgets and gizmos (1,200)– Super gizmos (2,000)

• Less: delivery (2,800) • Less: customer service (240)• Profit $469,760

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Activities for Customer B

• In a typical year, Customer B purchases– 600 gadgets– 700 gizmos– 200 super gizmos– Number of orders for gadgets and gizmos: 60– Number of orders for super gizmos: 30– Number of deliveries: 90 (60 + 30)– Number of customer service hours: 145

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Sales Revenue and Gross Profit for Customer B

• Sales revenue $1,740,000

• Less: cost of goods sold (909,600)

• Gross profit $830,400

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Profit for Customer B

• Gross profit $830,400• Less: sales commissions (348,000)• Less: order processing

– Gadgets and gizmos (6,000)– Super gizmos (30,000)

• Less: delivery (18,000)• Less: customer service (8,700)• Profit $419,700

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Comparison of Customer A and Customer B

A B

• Sales revenue $1,675,000 $1,740,000• Gross profit 811,000 830,400• Commissions 335,000 348,000• SG&A expenses 6,240 62,700• Profit 469,760 419,700

• Although Customer B generated more sales revenue and more gross profit, Customer A is more profitable because the cost to serve Customer A was less

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Explain why customers are assets

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Customers Are Assets

• Customers do not appear on a balance sheet prepared according to GAAP

• But customers are the most important asset of a business

• A customer should provide a business with positive cash flows for years

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Acquiring Customers

• Focus on making a sale to acquire a customer rather than acquiring a customer to make a sale

• Be willing to earn little, if any, profit on the initial sale

• View customer acquisition costs as an investment amortized over the expected life of the customer relationship

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Use Risk Reversal to Acquire More Customers

• Provide a reasonably long warranty period

• Offer to pay shipping costs both ways for dissatisfied customers

• Benefits from risk reversal usually exceed the costs

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Businesses Lose Customers

• Yet, businesses typically lose about 10 to 30 percent of their customers every year (The Loyalty Effect, p. 4)

• When a business loses a profitable customer, it loses a valuable asset

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What a Business Loses When It Loses a Customer

• Cash flows from the customer’s business

• Referrals to other customers

• Insight from the customer about how the business can improve its products and services

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Customer Retention Correlated with Productivity and Profits

• Higher customer retention rates are correlated with – higher productivity – higher profits

(The Loyalty Effect, pp. 12-13)

• A customer retention program should be an integral part of a company’s business strategy

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Explain how to calculate the lifetime value of a customer

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Lifetime Value of a Customer

• Present value of all future cash flows expected to be received because of the customer relationship

• Must include – Acquisition cost– Retention cost– Retention rate– Margin (sales revenue

minus expenses) each year (can change)

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Should include future cash flows received from other customers the company would not have acquired without the referrals from the customer

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• Sum of all net future cash flows for each year of estimated life of the customer relationship multiplied by the estimated retention rate

• Discounted to present value

• Less: acquisition cost

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• If the retention rate is constant, then LVC =Margin x (retention rate / 1 + discount rate – retention rate)

• Lifetime value is approximately equal to 1 to 4.5 times annual margin (Managing Customers as Investments)

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Explain 11 strategies for increasing the lifetime value of a customer

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11 Strategies for Increasing the Lifetime Value of a Customer

1. Increase the frequency of purchase

2. Increase the sales amount per purchase

3. Increase the retention rate

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4. Add more products or services to the product or service line and promote them to current customers

5. Implement an active referral and leads program

6. Implement an online affiliate program

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7. Avoid making customers unhappy, especially over relatively small things

8. Show appreciation to profitable customers

9. Provide additional items to the customer that provide value to the customer but that cost the company little or nothing

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10.Convert unprofitable customers into profitable customers

11.Use activity-based management (ABM) to reduce non-value-added costs of serving the customer

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1. Increase the Frequency of Purchase

• Create and maintain a customer database

• Sell products and services a customer will need to buy often

• Use customer rewards programs

• Give bounceback coupons

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Increase Frequency of Purchase by Regular Communications

• Communicate regularly with customers– Email– Newsletters– Catalogs– Coupons

• Do not communicate too often so as not to be annoying

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2. Increase the Sales Amount Per Purchase

• Use suggestive selling “Do you want fries with that?”

• Better “Do you want onion rings or fries with that?” – Alternate of choice

close– Mention the more

profitable of the two last

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2. Increase the Sales Amount Per Purchase

• Accept credit cards and PayPal

• Sell on credit

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3. Increase the Retention Rate

A 5% increase in customer retention rates will yield between a 25% to 100% increase in profits across a wide range of industries.

(The Loyalty Effect, pp. 13, 33)

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Increase Retention by Excellent Customer Service

• Do not hire or retain employees who think they work for the “sales prevention” department

• Train customer service representatives to be positive and helpful

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Increase Retention by Regular Communications

• Communicate regularly with customers– Email– Newsletters– Catalogs

• But not too often• Ask customers what

they want

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4. Add More Products or Services

• The easiest customers to whom a company can sell its products are its existing customers

• As a company adds more products and services to its product line, its customers can increase how much they purchase from the company and thereby increase their lifetime value

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Customers: Existing vs. New

According to Chet Holmes, the cost of acquiring a new customer is six times greater than selling an additional product or service to an existing customer. (The Ultimate Sales Machine, p. 209)

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5. Implement an Active Referral and Leads Program

• Referral – when a customer refers a potential customer to the business

• Lead – when a customers refers the business to a potential customer

• Referrals are usually better than leads

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Referrals: Intentions vs. Results

• When asked, a number of customers may say that they are willing to refer the business to other customers

• But many of them do not actually follow through and make a referral

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Actively Encourage More Referrals

• Ask customers to refer the business to other potential customers

• Give customers something tangible to give to the potential customer such as– Magnets– Pens– Business cards

• Include the company’s Web site

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Increase the Referrals and Leads Rate

• Track referrals and leads

• Calculate the referrals and leads rate

• Reward customers who provide referrals and leads

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Increase the Conversion Rate of Referrals and Leads

• The company must make a strong effort to convert the potential customer to a customer

• Be patient and do not alienate the customer who made the referral or lead

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Referred Customers

• Calculate the profitability of referred customers for the first year

• Calculate the lifetime value of referred customers

• Assess the referrals program and make changes to increase the lifetime value of referred customers

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6. Implement an Online Affiliate Program

• Sell products and/or services online

• Purchase software that will run an affiliate program and pay commissions to affiliates

• Affiliates place advertisements or otherwise refer people to the company’s Web site with a code

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Customers Become Affiliates• Customers can become

affiliates• A customer can earn a

commission when the customer refers someone who makes a purchase from the company

• The company’s sales increase and the customer/affiliate’s lifetime value increases

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7. Avoid Making Customers Unhappy, Especially Over Small

Items• The customer may not

always be right but be very careful not to anger customers unnecessarily

• Unhappy customers may not come back for a long time, if ever

• Is it worth losing potentially large future sales over a small problem?

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Unhappy Customers Inform Others

• Unhappy customers can tell their friends and associates bad things about the business

• Unhappy customers can inform a large number of potential customers about the perceived bad treatment using online social media and bulletin boards

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8. Provide Additional Low Cost or No Cost Items to the Customer

• Customers appreciate additional valuable products that a company gives them

• Receiving free gifts helps the customer relationship

• For example, a company may be able to obtain private label rights (PLR) to e-books, articles, and reports and allow customers to download them free of charge

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9. Convert Unprofitable Customers into Profitable Customers

• Increase the minimum order size

• Make the ordering process more efficient

• Convert in-person and telephone orders to online orders

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Regular Orders Can Increase Customer Profitability

• Encourage customers to order regularly

• Consider continuity programs where an order is generated automatically every month and charged to a credit card

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An Unprofitable Customer Can Be a Loss Leader

• An unprofitable customer can be a loss leader if the unprofitable customer refers profitable customers to the business

• Fire unprofitable customers only as a last resort

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10. Use ABM to Reduce the Cost of Serving the Customer

• Use activity-based management (ABM) to determine the activities used to serve the customer and the cost of each activity

• Classify the activities as value-added activities or non-value-added activities

• Seek to change the processes to reduce or eliminate the non-value-added activities and thereby reduce the non-value-added costs

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Summary

• Use activity-based costing to calculate the annual profitability of customers

• View customers as assets and customer acquisition costs as an investment

• Implement programs to retain customers

• Use the 11 strategies to increase the lifetime value of a customer

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Conclusion

• Customers are assets• When the value of assets

increase and liabilities remain constant, then the value of stockholders’ equity necessarily increases

• Therefore, increasing the lifetime value of every customer leads to greater shareholder value

Appendix

Additional Resources

for Further Study

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Books

1. Raving Fans: A Revolutionary Approach to Customer Service by Kenneth Blanchard and Sheldon M. Bowles. New York: William Morrow and Company, 1993.

2. Return on Customer: Creating Maximum Value from Your Scarcest Resource by Don Peppers and Martha Rogers, New York: Currency Doubleday, 2005.

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Books

3. Managing Customers as Investments: The Strategic Value of Customers in the Long Run by Sunil Gupta and Donald R. Lehmann, Upper Saddle River, NJ: Wharton School Publishing, 2005.

4. Managing Customers for Profit: Strategies to Increase Profits and Build Loyalty by V. Kumar, Upper Saddle River, NJ: Wharton School Publishing, 2008.

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Books

5. The Loyalty Effect: The Hidden Force Behind Growth, Profits, and Lasting Value by Frederick F. Reichheld, Boston: Harvard Business School Press, 1996.

6. The Ultimate Sales Machine: Turbocharge Your Business with Relentless Focus on 12 Key Strategies by Chet Holmes, New York: Portfolio, 2007.

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Books

7. How to Win Customers and Keep Them for Life by Michael LeBoueuf, New York: Berkley Books, 1987.

8. Customers for Life: How to Turn That Onetime Buyer into a Lifetime Customer by Carl Sewell and Paul B. Brown, New York: Pocket Books, 1998.

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Articles

1. “Generational Revenue Analysis,” by Alan D. Campbell, The CPA Journal, February 2001.

2. “Managing Customer Profitability,” by Marc J. Epstein, Michael Friedl, and Kristi Yuthas, Journal of Accountancy, December 2008.

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Articles

3. “Getting the Most Out of All Your Customers,” by Jacquelyn S. Thomas, Werner Reinartz, and V. Kumar, Harvard Business Review, July 1, 2004.

4. “Managing Customers for Profits (Not Just Sales),” by Benson P. Shapiro, V. Kasturi Rangan, Rowland T. Moriarity, Jr., and Elliott B. Ross, Harvard Business Review, September 1, 1987.

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Articles

5. “The Right Way to Manage Unprofitable Customers,” by Vikas Mittal, Matthew Sarkees, and Feisal Murshed, Harvard Business Review, April 1, 2008.

6. “Realize Your Customers’ Full Profit Potential,” by Alan W.H. Grant and Leonard A. Schlesinger, Harvard Business Review, September 1, 1995.

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Cases

1. Kanthal (A) by Robert S. Kaplan, Harvard Business Publishing, 1989.

2. Kanthal (B) by Robert S. Kaplan, Harvard Business Publishing, 1989.

3. Dakota Office Products by Robert S. Kaplan, Harvard Business Publishing, 2001.

4. Great Dakota Bank: Online Banking, by Frances X. Frei, Youngme Moon, and Hanna Rodriguez Farrar, Harvard Business Publishing, 2002.

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Web Site Tool

The following Web site from the Harvard Business School has a calculator for estimating customer lifetime value:

http://hbsp.harvard.edu/multimedia/flashtools/cltv/index.html

