Measuring and Managing Customer Lifetime Value

Measuring and Managing
Customer Lifetime Value

An Oracle White Paper
Updated August 2006

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Measuring and Managing Customer Lifetime Value
EXECUTIVE SUMMARY
When a company considers the value of its most important corporate assets, it
typically looks to the balance sheet—cash, property, manufacturing plants,
equipment, and other capital assets. While many of these hard assets can help a
company achieve advantage in the marketplace, none is as valuable as the “softer”
asset—the customer.
Ultimately there are only two things that can provide unique, long-term, sustainable
advantage in the marketplace—a company’s culture and the relationships it fosters
with its customers. Yet ironically, the value of the customer relationship is one of
the least measured and most poorly managed assets in business.
The key to acquiring and cultivating long-term, highly profitable customer
relationships is in understanding customer lifetime value. Many businesses work
frantically to either bring in new customers who will contribute from minimal to no
profit, or neglect to understand how to gain maximum value from existing
customers. Meanwhile companies armed with a deep understanding of customer
lifetime value can
• Quantify and predict profitability for customer segments, business units,
products, and services
• Measure and influence the factors that affect customer value over time
• Understand the relative cost and tradeoffs of acquiring, retaining, and
growing specific customer segments
• Develop actionable programs to maximize profitability
This white paper offers a definition of customer lifetime value and provides insight
for companies to measure and manage their customer relationships to return
maximum benefit.
VALUE OF THE CUSTOMER ASSET
Lifetime value analysis begins by understanding customer value drivers, such as the
value of individual transactions, the frequency of purchases, and the cost of service.
An understanding of these variables can only be gained by leveraging a rich
database of customer needs and behavior. To gain this advantage, companies in
recent years have been investing heavily in customer relationship management
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(CRM) software. To fully realize the benefits of these investments, however,
companies must not only understand the data, but also exploit it to actively build
and grow customer relationships. Only by doing so can they realize optimum value
from the customer asset.
The hardest, most expensive sale a company makes to a customer is the first one.
In that first critical transaction, the customer’s trust is either won or lost. To
understand a customer’s lifetime value, many companies analyze the initial cost to
acquire a customer versus the profit generated by that first sale. Focusing on this
one individual transaction, however, illustrates only near-term profitability; it does
not capture the underlying potential lifetime value a customer might represent
through long-term relationships and referrals. By understanding the lifetime value
of customers, a company can make customer acquisition and management
investment decisions based on the long-term positive expected value.
The lifetime value of a customer can be defined as the future financial value the
customer supplies to the company minus the cost of acquiring and retaining that
customer. Acquisition and retention costs can include the costs of incentive and
reward programs and the pricing discounts associated with long-term purchase
commitments.
The relatively broad concept of customer value can be divided into two key
components. The first component, transaction value, is extrapolated from the
customer’s historical transaction activity (historical value) and the historical
transaction activity of similarly segmented customer groups. The second key
component, network value, is the potential value that exists in the customer’s
network of relationships. This network can be leveraged through referrals and other
methods to gain new customers and enter new markets.
Figure 1: The relatively broad concept of customer value can be divided into tw o key
components: transaction value and netw ork value.
TRANSACTION VALUE
Historical customer behavior is likely the most important customer information a
company can leverage to sell additional products and services. Understanding how
the customer interacts with channels and consumes products and services today is a
key indicator of future transaction activity. Transaction value comprises three key
variables: frequency, transaction size, and customer churn rate.
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Frequency
Frequency measures how often the customer interacted with the company for
products or service offerings. The more frequently a customer has made purchases
from the company in the past, the more likely that customer is to purchase again in
the future. Also, a frequent customer is typically more profitable for the company
because, after the initial purchase, acquisition costs are no longer incurred.
Recency, a subset of frequency, measures how recently the customer purchased a
product or service offering. The more recently a customer purchased a product, the
more likely that customer is to purchase again. Most companies understand this
equation, which is why they send customers catalogs immediately after they make a
purchase.
Frequency and recency analysis can be used when designing channel systems, new
products, and customer incentive plans. For example, customers who frequently
purchase a particular product or suite of products might not need direct sales
interaction. These customers might be more inclined to purchase through a
dedicated internet or call center presence, thus lowering the cost per transaction
further. In addition, customers who frequently purchase the same products can
offer key insight into the design of future product offerings to meet their needs or
those of other consumers. For durable products, recency and frequency analysis
can be combined with average product lifetime assessments to aid in planning and
forecasting manufacturing and sales.
Recency analysis can help a company refine the information it gathers from
frequency analysis. For example, consider a company that attempts to expand its
market penetration by offering new customers an incentive for initial purchases. If
that company relies exclusively on a frequency analysis to measure the rate of repeat
purchases, it might discover that the rate is flat but acceptable—indicating that the
business is running smoothly. By applying recency analysis, however, the company
might discover that most repeat purchases come from customers acquired six
months earlier and the incentive program is generating little or no repeat business.
This additional information would be valuable to marketers in reassessing the
incentive target market and the campaign itself. The combination of frequency and
recency analysis helps a company to focus more effectively on those customers
who are actually contributing to the long-term profitability of the business.
Transaction Size
Average transaction size is a second key indicator of future expected transaction
value. Future expected transaction value is what a customer is willing to invest in
products or services in exchange for the value the customer assumes the product or
service will deliver. Average transaction size also indicates the volume of business
that the customer is willing to transact at any time, which indicates current and
potential need. Retail brokerages routinely consider transaction size when they
segment their customers according to the size of their stock transactions and their
assets under management. Typically customers with more assets under management
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receive a higher level of service. This level is seen as justified because owners of
significant assets also generate higher transaction fees.
Customer Churn Rate
Customer churn rate—the rate at which customers shift to competing providers—
is perhaps the greatest cost a company must confront in managing customer value.
This issue is of particular importance for commodity-based businesses. For
example, retail telecommunications businesses spend a considerable amount to
acquire customers of voice and data services. However, these customers often
switch plans or programs based on insignificant volume discounts. After they
switch to a competing provider, the original provider must invest to reacquire them,
and for many telecommunications companies this means offering cash incentives to
re-subscribe. While small in comparison to potential future customer value, these
incentives can present a significant investment and—if customers continuously
“churn” back and forth—a major impact on profit.
Understanding how recently and how frequently customers have made purchases
can help a company identify customer churn. If, for example, a customer has not
purchased in a long time, it is reasonable to assume that the customer has churned
out of the relationship and might be an appropriate target for a win-back campaign.
By understanding churn as it relates to frequency and recency, companies can avoid
trying to win back customers they have not lost.
Evolving Habits
As customers mature, their buying habits and needs evolve. Their requirements can
grow in volume of product purchased, product attribute requirements, and service-
level requirements. As customers evolve, their value can grow significantly if it is
measured and managed appropriately. Evolving customer needs present
tremendous opportunities for cross-selling and up-selling new products, managing
product development and upgrades, and managing product lifecycles. This is why
most multiproduct and multiservice organizations consider cross-selling and
up-selling to be the key to sustained competitive advantage. If such a strategy is
managed properly, it can reduce customer churn, because it minimizes the
attraction of switching to another company to purchase additional products.
Changes in frequency and transaction size can have a significant impact on
profitability. As shown in Figure 2, despite an annual 5 percent customer attrition
rate, a company could still increase profit per customer by 21 percent by increasing
order frequency and average order size by 10 percent.
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Figure 2: Changes in frequency and transaction size can significantly affect profitability.
NETWORK VALUE
Beyond the profit and its potential generated by an individual customer, there is
also tremendous value in understanding the customer network. For example, a
customer might offer high referral value to a previously untapped population of
customers. Network value refers to the sum total of value that a company might
anticipate from sales to its initial customers, plus sales to all those influenced—
directly or indirectly—by that initial base. When considering network value, the
company views the market not as a static aggregate of individual entities, but as a
dynamically extended and interconnected value potential.
To tap into the existing network value of a customer, suppliers must identify
potential opportunities in the network, understand how best to exploit those
opportunities, and build relationships to extend further into the network. For
example, consider a vendor that supplies its products to one division of General
Electric (GE). Given GE’s diversified operations, the supplier has a tremendous
opportunity to extend its reach across other GE divisions or lines of business by
leveraging existing relationships and existing contractual agreements. When a
company approaches a large customer in this manner, it greatly increases the
likelihood of cross-selling and up-selling.
Or consider the healthcare industry, where medical professionals such as
pharmacists and physicians have great influence over formularies and prescription
practices. A strategic relationship with one of these market influencers might have a
significant impact on sales throughout the network. For example, if a
pharmaceutical company gains mind share with a key doctor, researcher, or other
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influencer for a particular treatment, the influencer can positively affect doctors’
prescription rates, which in turn affects the pharmaceutical company’s sales. In this
example, the network value would be composed of the potential revenue generated
by these additional prescriptions.
A third example of network value is evident in the common practice of universities
offering group credit card arrangements to their alumni. A financial services
organization that wants to target a large alumni population would, in purchasing a
mailing list, gain much more than the accumulated names on the list. The
relationship between the university and its alumni could facilitate the sales process
by exploiting the already existing value relationship.
ACQUISITION AND RETENTION COSTS
Customer acquisition cost can be calculated by dividing total acquisition expenses
by total new customers. These acquisition expenses can vary by customer segment
and by product if a company chooses to develop unique and tailored acquisition
strategies for specific customer segments. Acquisition costs typically include
marketing process and people costs, material and collateral costs, sales and channel
resource-related costs, and discount and rebate costs. Customer retention costs are
typically composed of the same elements managed over the lifetime of the
customer.
Failure to understand and manage acquisition costs can have a dramatic negative
impact on managing customer value. The online pet store Pets.com, for example,
attempted to acquire new customers by spending millions of dollars on Super Bowl
advertisements. In doing so, however, it ignored one of the largest pet owner
demographic groups: elderly women, who seldom watch the Super Bowl and
seldom order online. So while the Super Bowl campaign was successful at
generating brand awareness, it was not a cost-effective means of acquiring the most
likely Pets.com customers. Moreover, the cost to acquire each customer, combined
with the costs of the free shipping that the company offered, exceeded the average
transaction income per customer. Pets.com’s failure to measure acquisition costs
effectively clearly contributed to the rapid decline of this online venture.
ALIGNING OPERATIONS
To build a customer-centric organization that is focused on maximizing customer
lifetime value, companies must align their organization and operations toward this
common goal. Many companies identify the need to manage the profitability and
lifetime value of customers, but they either build distribution models that only
erode profitability or they develop products without customer needs in mind. The
key to maximizing customer lifetime value and profitability is in the execution of a
properly designed go-to-market strategy comprising three elements: integrated
channel systems, marketing and incentive programs, and product design strategies.
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Integrating Channels
Executives must be able to balance customer preferences with the cost to provide
adequate service. Further, they must be able to coordinate multiple channels in the
customer interaction process. For example, companies must consider how the Web
might integrate with the call center to provide improved, lower-cost customer
service or how the call center might drive productivity in the field sales force. The
role of each channel must be clearly defined, measured, and managed accordingly.
In addition, each channel must be able to gather customer data from each
interaction so that subsequent interactions will be incrementally valuable to the
customer and the provider.
Compelling evidence of the impact of an integrated, multichannel strategy can be
seen in retail. For example, JCPenney has proved that multichannel integration is an
effective strategy to increase profits. In 1999, JCPenney found that internet-only
shoppers spent an average of US$121 per year, retail-only customers spent US$194
per year, and catalog-only shoppers spent US$242 per year. Customers who
shopped all three channels, however, spent more than US$1,000 per year, which
was four times more than a single-channel shopper. Armed with this knowledge,
JCPenney set out to integrate its channels and enable all three channel operations to
share customer information. The result: store and catalog profits increased
83 percent in the third quarter of 2003 compared with the year before. The
incremental revenue from customers who shop all three sales channels has been a
key to JCPenney’s success.1
Incentive Programs
To drive revenue, companies invest heavily in marketing efforts such as branding
campaigns and co-marketing agreements with partners. Companies also invest in
customer incentive programs such as discounts and acquisition programs.
Long-distance telecommunications providers sending incentive checks to retail
customers to “buy” business is an example of such an acquisition program. These
programs represent significant investments and significant drains on profitability
per customer. When armed with in-depth knowledge on revenue per customer,
companies can judiciously use these investments to increase profit per customer.
For example, a company that invests the same amount to acquire and retain all
customers will still have varying levels of profit per customer. To increase profit per
customer, and therefore customer lifetime value, companies must build tiered
customer investment programs to match the current and potential return generated
by each customer.
Product Design Strategies
Finally, companies must develop product design strategies to meet the needs of
customers as well as the distribution channel system. For example, Dell Computer

1 “How JCPenney Got Its Groove Back,” eBusiness IQ, September 18, 2003.
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revolutionized the PC industry by allowing customers to configure computer
purchases individually through the company’s primary distribution channels: the
Web and the call center. Dell’s product design, manufacturing, and distribution
strategies are aligned to maximize customer interaction and profitability. In
addition, the customer-centric nature of the business model creates significant
brand loyalty, which increases repeat purchases and each customer’s lifetime value.
Another example can be seen in a recent initiative by Levi Strauss & Co. to offer
customized jeans. In this initiative, Levi Strauss & Co. lets each customer design
jeans to meet his or her unique body requirements; the customized product sells for
approximately US$70 a pair. This has allowed Levi Strauss & Co. to increase
customer loyalty while gathering useful information on size and attribute
preferences.
THE ROLE OF TECHNOLOGY
A key factor in measuring and managing customer lifetime value is having the
technology to capture customer interactions across all company touchpoints,
establish more insightful customer segmentation schemes, and ultimately facilitate a
more effective dialogue and experience for each customer relationship.
CRM technology facilitates data gathering and analysis for customer profiling and
planning. This is done in two ways. First, the resources that interact with
customers—whether they are call center representatives, field agents, or Web
pages—are enabled to gather important customer transaction, preference, and
profile data through data capture fields and processes. Second, once the data is
captured, analytical engines segment and analyze it to identify trends in customer
behavior and preferences. These trends and preferences can be exploited to yield
cross-sell and up-sell opportunities and to gain a better understanding of how to
serve customers more profitably.
Technology also provides the ability to align and integrate channel resources to
meet customer needs. In an expertly deployed CRM solution, each channel has a
defined role in the customer interaction process, and all channels are seamlessly
integrated to reduce redundant or conflicting activity while maximizing profit and
superior customer service. In addition, CRM technology can measure and manage
channel resources based on fact-based, real-time reporting.
MANAGEMENT AND PROCESS
Companies often conduct customer lifetime value analyses during one-time,
standard customer segmentation exercises. While such exercises might be beneficial
at any given time, they do not help companies effectively manage customer lifetime
value. To extract true value from customer lifetime value analysis, companies must
build a process and culture that continually monitor and manage this critical success
factor. For example, Federal Express has seen improvements in marketing
effectiveness by focusing on analyzing customer lifetime value. By analyzing
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customer purchase behavior over a two-year period, Federal Express has identified
four specific groups of customers:
• Stable customers—very high value
• Growing shippers—high value
• Six-month lapsed customers—medium value
• Seasonal shippers—low value
Based on this segmentation, Federal Express learned that stable customers
generated nearly three times the lifetime value of the average customer, leading to
the development of marketing initiatives focused on retaining customers in this
segment. Federal Express also identified seasonal shippers as a segment of the
customer base that only ships products on a seasonal basis. As a result, Federal
Express has adopted a more seasonal marketing strategy for this segment, to
increase the efficiency of its marketing spending and further align its marketing
messages with a customer’s propensity to purchase shipping services.2
To achieve results through customer lifetime value analysis, senior management
must first establish a mandate to monitor customer value and build a customer-
centric culture in which management, decision-making, and business strategy are
rigorously supported by fact-based analysis. This mandate must include clear
definitions of business strategy, customer strategy, and product strategy. Second,
processes must be put in place to facilitate customer management. For example,
customer-related metrics must be implemented, understood, and standardized
across the enterprise to manage customer retention activity and, more importantly,
customer acquisition investments. Coca-Cola’s Fountain Division for example,
analyzes the potential lifetime value of fountain customer agreements when
determining potential marketing development fund allocations. By better
understanding the potential volume value of individual fountain customers,
Coca-Cola manages its marketing investments more intelligently.
CONCLUSION
Measuring and managing customer lifetime value is the key to sustaining a
competitive advantage in the marketplace. Companies must invest in robust and
integrated technology, in people with the skills required to manage customer
relationships effectively, and in process solutions to enable in-depth customer data
gathering. Once armed with this data, companies can exploit operational
competencies to manage and grow customer value as defined by historical value,
anticipated future value, and network value. These values can be assembled to form
a customer lifetime value equation that not only helps quantify value, but also aids a
company to understand the components that drive it.

2 Sellers, Jim, and Arthur Middleton Hughes, “RFP Migration Analysis—A New
Approach to a Proven Technique,” Database Marketing Institute, March 2003.
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