Strategy

Lifetime Customer Value

New business is great, but generally it's a lot cheaper to hold on to existing customers.
John BerrySeptember 15, 2001

In the primordial days of E-commerce — circa 1998 — E-tailers spent a great deal of capital on marketing and advertising. The idea was pretty simple. Convinced that they had to establish market dominance early on, E-commerce operators looked to generate as many sales as possible — no matter the cost of those sales. In their eyes, quantity was quality.

It isn’t. In the rush to become the next Amazon.com, some pureplay dotcoms actually laid out more money courting customers than the customers spent — not exactly a shrewd business plan. When their funding vanished, so did the dotcoms.

There’s a lesson here. New business is great, but generally it’s a lot cheaper to hold on to existing customers. This saw doesn’t apply solely to E-tailers, either. Managers at business-to-business operators also seem to be glomming on to the importance of existing customers. In fact, over the past six months or so, dozens of B2B companies have unveiled customer loyalty programs.

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Good luck. As E-tailers can attest, instilling a sense of brand loyalty in a customer — corporate or otherwise — is mercurial stuff. In a Forrester Research survey of 50 corporate marketers, not one said that their loyalty program was truly effective. Worse, it’s not easy to tell which customers are the best customers. Certainly, current spending is no indication of future performance.

To help get a fix on which customers offer the greatest profit potential, some B2B specialists are turning to an old standby: lifetime customer valuation (LCV). First espoused in the 1930s, the metric was originally designed to assess the net present value of a customer’s future spending. But in the 1990s marketing gurus like Don Peppers and Martha Rogers added their own take on LCV, throwing more-conceptual items into the mix, such as outsourcing potential and partnership quality.

Weighing those kinds of intangibles can get complicated, but the goal of LCV is straightforward: Separate the truly profitable client from the barely profitable, and allocate resources accordingly. “It actually makes a lot of sense,” says Bob Lento, senior vice president of sales at Convergys, a Cincinnati-based outsourcer of customer service and billing. Lento cites the example of a company that does $20 million in business each year with a customer, but will never substantially increase its business with that customer. “Now, is that client more or less valuable than another client that I am currently doing $10 million in business with, but might develop into a $100 million client?” asks Lento. “Which one would I want to apply more resources to?”

Your answer should be B. Convergys management’s answer was to roll out an LCV program a few years back. It appears to be paying off, too. Earlier this year the $2.1 billion-in-revenues company reported a 16 percent increase in operating income for its Customer Management Group; a large percentage of that jump-up came from winning new business from old customers. Steve Rolls, CFO of Convergys, seems sold on LCV. “A formalized depiction of this long-term view of customers gives us a much better picture of what we’re going after,” he insists. “This lifetime value modeling index is an empirical validation of our own instinctive belief that there is potential to grow existing client relationships significantly.”

Never Can Say Goodbye

Creating such an index requires some heavy lifting, however. Lifetime value calculation “is a very powerful and strategic metric and is extremely difficult to do right,” notes William Smith, research director for Hackett Benchmarking & Research, a unit of Answerthink Consulting. In their rush to embrace the idea of customer value, says Smith, some managers overlook critical factors, such as the forecast change in contribution margin, attrition, and customer acquisition costs.

Convergys ran into this very problem. While devising the index, managers realized they lacked exhaustive data for a key category, customer contribution margin. Nevertheless, top brass decided to forge ahead. As Lisa Hayford, a partner at Peppers and Rogers who worked on the project, observes, “It’s really better to start a model and build in the new information on the next iteration than not do anything at all.”

After three months Convergys managers settled on the measures and weights they’d use to help gauge overall customer value. (The figures shown in the chart, at the end of this article, are a refinement of those measures and weights.) Then the finance staff took the company’s customer data and ran it through the LCV rating system.

The results were startling. Rolls says one low-volume customer — a customer that ranked 62nd in sales, mind you — came in 3rd on the LCV index. Another client, 5th in current spending, dropped to 13th on the LCV scorecard.

Not surprisingly, the rankings opened some eyes at Convergys. But Rolls insists that the inclusion of nonrevenue items affords a more accurate picture of the reliability of customer spending. Technology entanglement, for instance, which makes up 20 percent of the index, measures IT integration between Convergys and its clients. Rolls points out that some of the company’s customers provide consumer profiles electronically, while others offer hooks into back-end data platforms. The more technologically entangled with Convergys a customer is, the more it will cost that customer to switch to a Convergys competitor. All else being equal, it’s easier for the client to stay put.

Likewise, the sales staff attempts to size up the sturdiness of their client relationships. Lento says that the company tracks not only traditional LCV items such as repeat business but also whether a customer’s purchasing decisions are based solely on cost. Obviously, clients that buy on price alone may not be the greatest long-term bets. Convergys managers also examine the value of a salesperson’s customer contact; the higher up, the better. In addition, they regularly assess whether a customer views Convergys as a strategic partner or merely a commodity service provider; strategic partner beats commodity provider.

Of course, such figuring is not exactly a hard science. And for his part, Hackett’s Smith believes that LCV calculations should be in dollars. Right now, Convergys management assigns customers a ranking, from one to eight, for each of the intangible categories in the index. Still, it’s hard to argue with results. Convergys recently won an additional billing contract from AT&T Wireless — a longtime customer that scored high on the LCV index. “There is typically a great deal more business we can do with current customers,” says Rolls. “Just in billing, there’s a lot of potential lifetime customer growth.”

Sales head Lento says the value of LCV goes beyond numbers, beyond entanglements and partnerships and share of clients. By his lights, LCV has dramatically changed the way workers view customers. “We constantly talk with staff about servicing new or existing clients,” he notes. “When you hear employees ask, ‘Well, what’s their lifetime value rank?’ it’s kind of music to your ears.” As it turns out, quality is quality.

John Berry is a contributor to eCFO.

Max Factors

The LCV rating system used by Convergys factors in nonrevenue items for a more accurate picture of the reliability of customer spending.
Sources: Convergys; Peppers and Rogers

Index Measures Weight
Average revenue score Current and projected spending 15%
Revenue change score Year-to-year actual spending 15
Profitability score Customer contribution margin 20
Current relationship Signed contract length 10
Total years as client
Technology entanglement Systems integration 20
Reporting
Convergys Web-assisted service
Email
Share of client Outsource potential 10
Partnership Level of contact 10
Referenceable
Future value