Lifetime Value, I’d Like to Introduce You to the cfo



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

Note: An HTML version of this document is available here:
http://www.jimnovo.com/LTV-CFO.htm
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.
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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.
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.

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 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.
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. For the new customers attracted by the current format, this number was 25%.

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 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 half the value of the old customer, based on our relative value tracking studies.
We were summarily tossed out of the room at this point.

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 the customer accounting approach.
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 right on 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.
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.

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 and management 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 later in this document.
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 – is it 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 businesses.

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 CRM 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:



Total Customer Sales in Periodic Time Frame by
Sales Volume


Percent of Customers
in Volume Range



Greater than $1000


  2%


$750 - $1000

6%

$500 - $749

12%

$250 - $499

15%

$1 - $249

25%

$0

40%

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 smart 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:



Customer Sales Began
in this Period


Current Period Sales
by Customer Start Period



Current Period

40%


One Period Ago

30%

Two Periods Ago

15%

Three Periods Ago

7%

Four Periods Ago

5%

More Than Four
Periods Ago

3%

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 of time 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 customer value metrics, can be found here:
http://www.jimnovo.com/lifecycle.htm

Relative or Absolute Value?

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.

For more on the this topic of absolute versus relative Customer Value tracking and modeling, see:


http://www.jimnovo.com/LTV.htm
To review concrete examples of the relative value measurement technique, see:
Latency Modeling Tutorial

http://www.jimnovo.com/Behavioral-Marketing.htm
Recency Modeling Tutorial

http://www.jimnovo.com/Recency-Model.htm

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:

http://www.jimnovo.com/Simple-CRM.htm
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 program investments. More on Jim’s background and consulting services can be found here:
http://www.jimnovo.com/aboutjn.htm

CopyRight © 2002 by Jim Novo All Rights Reserved in All Media



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