a primer on ltv - uva darden school of business · lifetime value of a customer (a.k.a. customer...

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Copyright © 2000. Paul Farris, Phil Pfeifer, and the Darden School Foundation

A Primer on the Lifetime Value of a Customer


How do we measure firm performance?

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We most often look at financial performance across time….the income statement.

-21573362-2326-1965Income after Taxes

-14372241-1551-1309Income Taxes

-35945603-3877-3274Income Before Taxes

10779268621420212230Total Expenses

3491664249334226SG&A

72882022092698004Cost of Sales

729432641105719074Total Revenue

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If the firm is composed of several divisions, we also look at profitability of each division.

1606.7308.5199.91098.3Net Operating Assets

18.313.725.918.5Operating Margin %

331.451.851.4228.2Profit before taxes

1809.4379.1198.41231.9Turnover

TOTALInvestments and Other

LimeCement

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Strategic Business

Units

1606.7308.5199.91098.3Net Operating Assets

18.313.725.918.5Operating Margin %

331.451.851.4228.2Profit before taxes

1809.4379.1198.41231.9Turnover

TOTALLime

Cash Cows Dogs

Question MarksStars

LowHigh

Indu

stry

G

row

th R

ate


Profitability by Product May Require Different Line Items

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Profitability/ Square Foot By Category

Specialty Foods Staples Wine Produce Meat/Seafood Deli/Prepared Other TotalSquare Feet 3975 1490 500 930 596 1490 800 9781Gross Margin $565.4 $212.6 $135.6 $226.8 $198.5 $981.7 $38.7 $2,359.3

GM/Sq Ft $0.142 $0.143 $0.271 $0.244 $0.333 $0.659 $0.048 $0.241

Allocated Cost 404.4 233.5 144.4 160 215 821.6 60.5 2039.1Contribution $161.0 ($20.9) ($8.8) $66.8 ($16.5) $160.1 ($21.8) $320.2

Contribution/Sq Ft $0.041 ($0.014) ($0.018) $0.072 ($0.028) $0.107 ($0.027) $0.033


Measuring Firm Performance

• By quarter or year• By Strategic Business Unit• By Product• By Category

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There is one other important way to look at firm performance:

By Customer -21573362-2326-1965Income after Taxes

-14372241-1551-1309Income Taxes

-35945603-3877-3274Income Before Taxes

10779268621420212230Total Expenses

3491664249334226SG&A

72882022092698004Cost of Sales

729432641105719074Total Revenue

RaviSuePhilBob


The Big Idea

The purpose of a firm is to create and satisfy a customer.

The customer is King.

Love your customers more and your products less

If “customer focus” or “customer orientation” is part of your business philosophy, then consider measuring the performance of each customer

relationship.

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Not a New Idea

• B2B marketers measure profitability of each large account (customer). Account management generated the need for custom-specific P&L statements.

• Shop keepers know who their best customers are.

• Insurance providers price based on an individual’s (or segment’s) actuarial risk.


But an Idea whose time has come…because

• E-business enables direct relationships with customers.– Any firm with a website is forced into relationships with

individual customers. – Disintermediation cuts out layers—marketers converse with

individual consumers, not just with channel partners.

• Information Technology makes it easier and cheaper to monitor a large number of customer relationships.– Customer clicks are easy to track.– Moore’s law keeps reducing costs.

• Customers expect more– and are less likely to accept “one size fits all.”

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Love your products less

• How profitable is this product? • How should I price this product?• Are we doing enough new-product

development?• How can we extend the product life cycle?• What is our share of market?


And your customers more

• How profitable is this customer? • How should I price this customer?• Are we doing enough new-customer

development?• How can we extend the customer life cycle?• What is our share of customer

requirements?

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Why bother evaluating individual customer

relationships?


Because customers are not alike

Most ValuedCustomers

Second TierCustomers

Below Zeros

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And should be treated differently

Customers to Reward

Customers to Fire?

Customers to Grow


In order to improve firm performance

Customers to Reward

Customers to Grow

Customers to Fire?

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Evaluating Customer Relationships


Step 1. Know how many customers you have.

• Coke and P&G may never know.• Dell knows! Does Compaq? • Some firms that should know do not.

– A very large bank knew how many accounts it had, but not how many customers.

• You may have to incent them to identify themselves– frequent shopper cards– online registration– cookies as a last resort

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Step 2. Develop the capability to construct P&L statements for individual

customer relationships.

• Billing systems need to interoperate with marketing databases.

• You may need to build a Customer Database• ABC analysis of the costs of maintaining customer

relationships.


It is important to fully understand the financial implications of all interactions between your organization and your customers.

+

order/purchase referral upgraderenewalregister/applyfees

++

+

++

Added Value: interactions leading to orders, upgrades, conversions, referrals, etc...

+

Customer Interaction Metrics

-----

-------

- Negative Value: interactions leading to returns, dismissals, credit write offs, bad payment...return

complaintrequestchange of addresssite visit

promotionnewsletterbillrenewal noticesurveydiscount/incentivewrite-offs

TheFirm

Source: “The Evolution of Direct Marketing: Enterprise Customer Management,” Presentation by Christopher Becke (Darden ’92), May 7, 1999.

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Deposits $1.00 for every $400 deposited/monthFees $6.00 per customer/month

Bank calculated revenues/costs per customer interaction:

Bank Story

Back office maintenance ($3.00) per customer/monthTeller Transactions ($2.50) per transaction ATM Transactions ($0.50) per transactionPhone VRU calls ($0.30) per transactionDirect Deposits ($0.80) per transaction



Depositrevenues

$850

+

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$850

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Customer value

Customer A

Customer B


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Depositrevenues

$850

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ATMvisits

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Customer value

Customer A

Customer B



Depositrevenues

$750

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($175)

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Customer value

Customer A

Customer B


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Depositrevenues

$750

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ATMvisits

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Customer value

Customer A

Customer B



B’s Look Bad

A’s Look Good 7% of savings customersgenerate 55% of profits $750 per customer

10% of checking customersgenerate losses = 50% of total profits($175) per customer


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The 80/20 Rule

• The top 20% of customers account for 80% of company profits.– Is this surprising? – The fact that 20% account for 80% is not as

important as knowing who the 20% are.– Conventional accounting (quarterly company

P&L) only tells us the profit from 100% of the customers.


LifeTime Value (LTV)

• That was then, this is now– So far, we have only talked about measuring the past

performance of our customer relationships.– While this is helpful, we’d also like to forecast the

value of those relationships into the future.– Ultimately, we’d like to figure out what we can do to

maximize the value of our relationships.– In particular, we’d like to value proposed new

relationships so that we can make intelligent investments in customer acquisition.

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LifeTime Value of a Customer(a.k.a. Customer Equity)

• the discounted sum of all future customer revenue streams minus product and servicing costs and remarketing costs.


LifeTime Value of a Customer(a.k.a. Customer Equity)

• LTV is the expected NPV of the cash flows from a customer relationship.

• Just like we use NPV to evaluate investments and companies, we use LTV to evaluate customer relationships.

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Estimating LTV

• First, find out what LTV is on average.– Calculate LTVs for representative current

customers at the date you acquired them. The resulting number is an estimate of the LTVs of customers you are about to acquire. This number is VERY helpful in making prospecting decisions.

– Historical versus “Forward-Looking” estimates of LTV?


Modeling LTVA Simple LTV Model

discount rate per periodd

retention rate (fraction of current customers retained each period)

r

Retention Spending per period per active customer.

$R

Contribution per period from active customers.$M

ASSUMPTIONS

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A Simple LTV model

r $M – r $Rt=1

etc.

r3 $M – r3 $Rt=3

r2 $M – r2 $Rt=2

$M - $Rt=0

EXPECTED CASH FLOWS

With a little algebra, someone came up with a formula for the NPV of these expected cash flows.

Click anywhere to see it.

LTV = [$M – $R]× [(1+d)/(1+d-r)]


ExampleAn Internet Service Provider charges $19.95 per month. Variable costs are about $1.50 per account per month. With marketing spending of $6 per year, their attrition is only 0.5% per month. At a monthly discount rate of 1%, what is the LTV of a customer?

$M = $19.95 - $1.50

= $18.45

$R = $6/12 = $0.5

r = 0.995

d = 0.01

LTV = [$18.45 – $0.5]× [1+.01)/(1+.01-0.995)]

LTV = $1,209

LTV = [$M – $R]× [(1+d)/(1+d-r)]

LTV = [$17.95]× [66.3]

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Future Value Multipliers as a function of discount and retention rates

For example, a discount of .10 and a retention rate of .95, customer producing $10 in per period contribution after retention spending would have an estimated LTV of $73.30.

r = d= discount rateretention 0.1 0.11 0.12 0.13 0.14 0.15 0.2

1.00 11.00 10.09 9.33 8.69 8.14 7.67 6.000.95 7.33 6.94 6.59 6.28 6.00 5.75 4.800.90 5.50 5.29 5.09 4.91 4.75 4.60 4.000.85 4.40 4.27 4.15 4.04 3.93 3.83 3.430.80 3.67 3.58 3.50 3.42 3.35 3.29 3.000.75 3.14 3.08 3.03 2.97 2.92 2.88 2.670.66 2.50 2.47 2.43 2.40 2.38 2.35 2.220.50 1.83 1.82 1.81 1.79 1.78 1.77 1.710.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00


Lifetime Customer Value Comparison

$40

$30

$20

$10

0-$250 0 $250 $500 $750 $1,000

Customer Lifetime Value

PerOrderContribution

*Drugstore

*Bookstore

*Pure-play Apparel

*DirectMail Apparel

*Cash Rx

*3rd Party Rx

*Off-price Apparel

*Grocery

*Vertically Integrated Specialty

*Dept Store Apparel

Assumes 15% discount rate, 4-year customer life for all but Rxwhich is 7-year customer life.

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LTV in PracticeBut evaluating success solely on the basis of ROI may be taking a nearsighted view of business. That’s why iGo also measures the long-term value (LTV) of its customers, based on their purchases over a period of months or years. It uses an algorithm -- which is based on a present-value annuity model -- that measures customer retention by how often customers visit the website and how much they buy.

Investments in customer service, content and advertising are modeled by balancing the anticipated increase in retention against the costs. Recently, for example, iGo looked at LTV data for repeat buyers and first-time website purchasers, and then changed the look and feel of its site, believing that the change would generate more long-term sales.

Source: Nick Wreden, Computing Your Website Payoff, by Nick Wreden, Beyond Computing, April 2000, Volume 9, Number 3


Estimating LTV

• Next, find out how LTV varies by– Source. Are customers who typed in your web address

more or less valuable than those referred by Yahoo?– Offer. Are customers acquired through special

promotions just as valuable?– Pricing plans. Does the pricing plan the customer

chose affect his/her LTV?– Demographics. Are women more valuable than men?– Usage Patterns. Are weekend shoppers more or less

valuable than those shopping during the week?

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The Sports Illustrated Sneaker Phone Promotion

HUGE SUCCESS…it brought in lots of new customers and cost per acquired customer (trial) was low.

DISMAL FAILURE…..those customers had very low LTVs, because of low conversion of trial subscriptions.


Acquiring credit card customers using the WWW

HUGE SUCCESS…relative response rates and cost per acquired customer were great compared to other media.

DISMAL FAILURE…..However, the acquired customers had above average default rates.

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The Technology of Tracking• Dell print ads contain “e-values” codes. Visitors to the site

enter the code…and Dell knows exactly what ad brought them to the site.

• Catalog codes and tailored 800 numbers serve the same purpose.

• Train your customer service reps to ask, “how did you hear about us?”

• Online..do you want to track the site they just came from? the search word they used to get there?

• Most importantly…make sure you add the information to your database….it’s almost impossible to retrieve later.


The Importance of Tracking

Source: Leo Cullum, The New Yorker, 7/94

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Estimating LTV• Ultimately, run experiments to learn how to

maximize LTVs. – Every contact with your customers is an opportunity to

test your customer retention strategies.– For example, if you haven’t heard from someone in six

months should you?– send a “we miss you” email– phone them– mail them a coupon.– do nothing.– do nothing, but if they do return say “we missed you”

– You should…test each of these strategies, track the resulting LTVs and see which one leads to the highest LTV.


The Challenges of Testing

• The firm has to admit it doesn’t have all the answers.

• The firm has to try things it believes aren’t the best.

• Tests add work for everyone. (Instead of mastering one way to handle a situation, service reps have to randomly apply k ways.)

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ExampleAn Internet Service Provider charges $19.95 per month. Variable costs are about $1.50 per account per month. With marketing spending of $6 per year, their attrition is only 0.5% per month. At a monthly discount rate of 1%, what is the LTV of a customer?

$M = $19.95 - $1.50

= $18.45

$R = $6/12 = $0.5

r = 0.995

d = 0.01

LTV = [$18.45 – $0.5]× [1+.01)/(1+.01-0.995)]

LTV = $1,209

LTV = [$M – $R]× [(1+d)/(1+d-r)]

LTV = [$17.95]× [66.3]


Example (continued)

If the firm cuts retention spending from $6 to $3 per year, they expect attrition will go up to 1% per month.

Should they do it?

Don’t move to the next slide until you have an answer.

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Example (continued)

To decide, we need to recalculate LTV under these new assumptions. If the new LTV is higher, we should do it. Otherwise, we should not.


Example (continued)An Internet Service Provider charges $19.95 per month. Variable costs are about $1.50 per account per month. With marketing spending of $3 per year, their attrition will be1% per month. At a monthly discount rate of 1%, what is the LTV of a customer?

$M = $19.95 - $1.50

= $18.45

$R = $3/12 = $0.25

r = 0.99

d = 0.01

LTV = [$18.45 – $0.25]× [1+.01)/(1+.01-0.99)]

LTV = $919

LTV = [$M – $R]× [(1+d)/(1+d-r)]

LTV = [$18.2 ]× [50.5 ]

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Example (continued)

The new LTV is LOWER.

The savings in retention spending is NOT worth the increased attrition.

The firm should stick with the $6 retention spending.


Example—acquisition spendingThis same ISP spends $5 per prospect to initiate the first signup. They are successful 5% of the time.

They have considered a more aggressive acquisition plan costing $10 per prospect. What success rate must this new plan have in order to be preferred to the old one?

(Assume the ISP must use one plan or the other, and cannot use both.)

You are encouraged to try this one on your own. A solution appears on the next slide.

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Example—acquisition spendingWith the old plan, $5 buys them a 0.05 chance of acquiring a new customer. If the new customer has a LTV of $1,209, the expected NPV of the $5 investment is 0.05*$1,209 - $5 or $55.45. In other words, the LTV of a prospect is $55.45. Again, under these assumptions the ISP should be making as many of these investments in acquisition as possible.

For the new plan to do just as well, its acquisition rate must be such that the LTV of a prospect is at least $55.45. A little algebra or goal seek shows that the acquisition rate must be at least 0.054.


Modeling LTV

These examples should give you a taste for the kinds of analysis that are possible using this simplest LTV model.

If the firm was able to develop schedules of how r varied with $R and how the acquisition rate varied with acquisition spending, it would be able to find the optimal balance between retention and acquisition spending.

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Modeling LTVMore Complicated Models

Only in very simple situations is it possible to write a formula for LTV. When the situation gets more complicated, build an electronic spreadsheet model to calculate LTV.

See the next slide for an example.


Modeling LTVMore Complicated Model

Consider an online content provider selling annual subscriptions to its service. Regular subscriptions are priced at $99 with a one-year initial trial available for $56.

By company policy, subscribers are not automatically renewed each year. The average amount the company spends in efforts to renew someone’s subscription depends on whether or not they achieve success. The renewal cost for successful renewals averages about $2. For unsuccessful renewals, the cost is $11.

The incremental cost to provide the content to each subscriber is negligible.

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Historically, the company converts about 40% of its initial $56 trial subscribers into $99 regular subscribers. Renewal rates for regular subscribers are running 70% the first year, 90% the second year, and are expected to level off at 95% each year thereafter. The firm uses a 15% hurdle rate.

What is the LTV of a new trial subscriber?

What is the LTV of a first-time regular subscriber?

What is the LTV of a two-time regular subscriber?

What is the LTV of a three-time regular subscriber?



SUMMARY OF SITUATION

Initial subscription price $56

Conversion rate 40%

Regular subscription price $99

Renewal rates 70%, 90%, 95% thereafter.

Variable Cost = $0

Renewal Spending = $2 if successful, $11 if not.

Hurdle rate = 15%

Horizon—use 15 years.

Fire up your spreadsheet and try this one yourself.

Move to the next slide when you are ready to look at a solution.

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Renewal cost if success 2$ Renewal cost if fail 11$ Conversion rate 0.4Renewal rates 0.7

0.90.95

Hurdle rate 0.15

Year 0 1 2 3 4Number of subscribers 1000 400 280 252 239.4Revenue 56,000$ 39,600$ 27,720$ 24,948$ 23,701$ Renewal Costs 7,400$ 1,880$ 812$ 617$ 587$ Cash Flow 48,600$ 37,720$ 26,908$ 24,331$ 23,114$ NPV 186,059$ 158,078$ 138,411$ 128,229$ 119,483$ LTV 186.06$ 395.19$ 494.33$ 508.84$

Click here if youwant to move on.

Click here if youwant a detailed

explanation of thisspreadsheet.



0.90.95

Hurdle rate 0.15



We arbitrarily start with 1,000 trial subscribers

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0.90.95

Hurdle rate 0.15



40% convert to regular

subscriptions



0.90.95

Hurdle rate 0.15



70% resubscribeat end of year 2.

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0.90.95

Hurdle rate 0.15



$2 per success, $11 per failure



0.90.95

Hurdle rate 0.15



NPV at year 0 of year 0-15 cash flows

is $186,059.

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0.90.95

Hurdle rate 0.15



NPV at year 1 of year 1-15 cash

flows.



0.90.95

Hurdle rate 0.15



NPV at year 0 per year 0 customers.

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0.90.95

Hurdle rate 0.15



So the LTV of an initial subscriber

is $186.



0.90.95

Hurdle rate 0.15



The LTV of a new regular subscriber is

$395.

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0.90.95

Hurdle rate 0.15



The LTV of a two-time regular

subscriber is $494.



0.90.95

Hurdle rate 0.15



Click here if youwant to see the

spreadsheet.Click here if youwant to move on.

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Modeling LTVMore Complicated LTV Model

• Does it make sense to you that– The LTV of a trial subscriber is $186,– The LTV of a first-time regular subscriber Is

$395,– The LTV of a two-time regular subscriber is

$494,– The LTV of a three-time regular subscriber is

$509?• Can you explain why these LTVs go up?


Caveats of LTV analysis

• While it is good that LTV analysis helps the firm focus on serving individual customers, the firm shouldn’t expect their customers to do everything. The customers are not going to– develop the next big thing– warn the firm about impending competitive entry…the

firm will only find out after it’s too late--when the customers have left.

• Share of customer (wallet) (requirements)

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Caveats of LTV analysis

• The LTV of a customer accounts for the cash flows from that customer.

• There are other reasons to acquire a customer beyond his/her cash flows:– Acquiring customers can help discourage competition.– Acquiring customers can help secure financing.– Acquiring customers can make it easier to acquire

future customers and can raise the LTVs of future acquired customers—(network effects..think AOL, Ebay) (Michael Jordan).


Which firm is doing better?FIRM A 1 2 3 4 5Revenue 833.33$ 1,166.67$ 1,700.00$ 2,553.33$ 3,918.67$ COGS 708.33$ 991.67$ 1,445.00$ 2,170.33$ 3,330.87$ Marketing 100.00$ 150.00$ 230.00$ 358.00$ 562.80$ Profit 25.00$ 25.00$ 25.00$ 25.00$ 25.00$

Cogs/Rev 85.0% 85.0% 85.0% 85.0% 85.0%Mkt/Sales 12.0% 12.9% 13.5% 14.0% 14.4%ROS 3.0% 2.1% 1.5% 1.0% 0.6%

FIRM B 1 2 3 4 5Revenue 1,320.43$ 1,385.18$ 1,463.16$ 1,557.07$ 1,670.17$ COGS 1,122.37$ 1,177.40$ 1,243.69$ 1,323.51$ 1,419.65$ Marketing 173.06$ 182.78$ 194.47$ 208.56$ 225.53$ Profit 25.00$ 25.00$ 25.00$ 25.00$ 25.00$

Cogs/Rev 85.0% 85.0% 85.0% 85.0% 85.0%Mkt/Sales 13.1% 13.2% 13.3% 13.4% 13.5%ROS 1.9% 1.8% 1.7% 1.6% 1.5%

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Which firm is doing better?Firm A 1 2 3 4 5New Customers 1.33 2.00 3.07 4.77 7.50Total Customers 3.33 4.67 6.80 10.21 15.67Sales/Customer 250.00$ 250.00$ 250.00$ 250.00$ 250.00$ Mkt/New Cust 75.00$ 75.00$ 75.00$ 75.00$ 75.00$ Churn rate 20% 20% 20% 20%

Firm BNew Customers 1.86 1.97 2.09 2.24 2.43Total Customers 3.86 4.05 4.28 4.55 4.88Sales/Customer 342.00$ 342.00$ 342.00$ 342.00$ 342.00$ Mkt/New Cust 93.00$ 93.00$ 93.00$ 93.00$ 93.00$ Churn rate 46% 46% 46% 46%


Comparing LTVs

LTV = [$M – $R]× [(1+d)/(1+d-r)]

$M = $250(.15)

= $37.50

$R = $0

r = 0.80

d = 0.15

$M = $342(.15)

= $51.30

$R = $0

r = 0.54

d = 0.15

FIRM A FIRM B

LTV = [$37.5 – $0]× [(1+.15)/(1+.15-0.8)] LTV = [$51.3 – $0]× [(1+.15)/(1+.15-0.54)]

LTV = $123 LTV = $97

LTV = [$37.5]× [3.29] LTV = [$51.3]× [1.89]

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Which firm is doing better?

• FIRM A– Customer LTVs of

$123.– Customer acquisition

costs of $75.– 15.67 active customers

at end of year 5.– Terminal Value =

15.67($123) = $1,931.

• FIRM B– Customer LTVs of

$97.– Customer acquisition

costs of $93.– 4.88 active customers

at end of year 5.– Terminal Value =

4.88($97) = $472.


Which firm is doing better?

FIRM A

And we realize this only after looking at CUSTOMERS.

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Additional Reading(required)

• Stewart Alsop. “The Price Tag on You is What Drives Net Stocks.” Fortune (March 1, 1999). Two-page article with quick and dirty speculative calculations for the LTV of AOL and Amazon customers and comparisons to Market Cap per customer.

You should find a link to this article on the course website.


Additional Reading(optional)

• Robert C. Blattberg and John Deighton. “Manage Marketing by the Customer Equity Test.” Harvard Business Review (July-Aug 1996). They define customer equity to be the sum of the LTVs of all current customers and present a version of the simple LTV model.

• F. Robert Dwyer. “Customer Lifetime Valuation to Support Marketing Decision Making.” Journal of Direct Marketing 3(4) Autumn 1989. Award-winning article illustrating the usefulness of LTV calculations.

• Don Peppers and Martha Rogers. Enterprise One to One (New York: Currency Doubleday, 1997), chapter 2. This chapter captures the main ideas in the presentation.

a primer on ltv - uva darden school of business · lifetime value of a customer (a.k.a. customer...

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