Thursday Mar 27, 2014

Customer Lifetime Value: Viewing Customers as an Investment


In this age of customer-centricity, do you really know how to put a value on your customers? I had the pleasure of interviewing Gary Cokins, the founder of Analytics-Based Performance Management - an advisory firm in Raleigh North Carolina - for a Thought Leadership podcast on this topic. We discussed Customer Lifetime Value and how to view customers – not only as profitable or unprofitable to a business – but similar to investments for a business like in an equity stock portfolio. The objective from a shareholder’s view is increase the return on investment from the customers. Gary has written a dozen books on Enterprise Performance Management, Activity-Based Costing, Quality Management and more.

Many of you likely already have a firm grasp on the concepts of measuring and reporting profitability, but may be less familiar the concept of Customer Lifetime Value. Gary defined it for us this way: “Customers and consumers pass through life cycle stages. For example, teenage girls become young adults, then mothers, and so on. At each stage, their consumer needs change. Each type of consumer’s future profit potential needs to be understood based on which stage in their life-cycle they are. The marketing and sales functions have begun exploring what is basically a math equation that calculates Customer Lifetime Value in monetary terms. The equation is intended to measure the future potential level of profitability of a customer or consumer to a supplier.” In essence, Customer Lifetime Value is a forward-looking view of shareholder wealth creation possibilities.



So how are these calculations different from customer profitability calculations, such as from last month or last year? Gary explained that most profitability measures are historical and do not consider the products’ and customers’ prospective profit contribution. Customer Lifetime Value math is trickier, because it also considers the probability of losing some customers (or churn). In addition, the calculation of future streams of revenue and their associated costs, which would include the net present value of discounted cash flows, are taken into consideration. This involves time value of money principles and math that considers both the timing of future cash inflows and outflows, as well as the weighted average cost of capital. A lot to think about when considering Customer Lifetime Value!

Customer classifications come into play as well. Some customers are high maintenance types with substantial demands on a supplier and some are low maintenance - often referred to as demon customers and angel customers., The substantial costs-to-serve incurred below the product gross profit margin line (i.e., channel, marketing, sales, and customer service costs) for high maintenance customers obviously erodes profits. But Gary explained that understanding the amount of the cost-to-serve for each customer is very important. A shift is needed from being product-centric to customer-centric. Suppliers need to understand the unique preferences of and differentiated services for each customer, as well as different distribution channel expenses to service their existing customers, and desirable, prospective customers to acquire.

So how does this affect spend by the suppliers? According to Gary, the key is to spend “the next dollar” on consumers who will most likely generate a relatively higher incremental increase in sales relative to the incremental expense to “lift” those sales. And this analysis should focus only on the impact of interventions with consumers independent of how the consumer might increase their volume of purchases from a supplier simply due to their progression through their life cycle.

I highly recommend listening to the entire podcast as we covered a lot more content in the interview. But the long and short of it is that suppliers must consider Customer Lifetime Value when understanding profitability to get a complete picture and determine which best actions to retain and grow profits from consumers. They must view customers as an investment – the financial return on customer – and not just a short term gain.

To listen to the entire podcast, click here.

To learn about Hyperion Profitability and Cost Management, click here.

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