Customer value refers to the profits the firm earned by having a particular customer (for instance, last
year), while customer lifetime value (CLV) is an estimate of the future profitability of the customer over their lifetime as a customer; that is, until they are no longer a customer.
As discussed earlier, profitability is simple to correctly calculate for a single firm but is a much more problematic concept to apply to units or activities within a firm. This is especially true when applied to customers, for the following reasons:
■ It can be difficult to even estimate how much a particular customer is currently buying from
the firm. Customers often have multiple relationships with the firm, and their buying may be recorded in separate databases without the company realising that they are the same customer. This is particularly true for large firms, and in business-to-business (B2B) settings for large customers where different divisions may each open different trading accounts.
■ Customers vary in their behaviour over time due to random influences (having visitors, taking
holidays, unseen expenses and so on), so it can be hard to correctly classify a customer. also, many marketers don’t understand how inappropriate this metric can be as a judge of marketing investments. rOi is a simple equation that results in a percentage. take the contribution to profits that is returned from the marketing ‘investment’ and divide it by the cost of the investment: rOi (%) = profit contribution/marketing costs. so, if we conducted a direct marketing campaign that cost $80,000 then our investment is $80,000. if that direct marketing campaign sold one million extra products on which we earn twenty cents in profit margin for each unit sold, we have a return of $200,000.
200,000 ____________ 80,000 = 2.5 (or 250%)
this looks like a fantastic return, and the rOi technique looks very useful. But there are serious problems. the first is that rOi takes attention away from the actual return, in dollars. it’s the size of the actual return that matters to shareholders. Marketing expenditure is only a part of a company’s total expenditure, and often only a small part. What matters is how effective it is, not how efficient it is. an rOi of $1.50 (150 per cent) on a million dollar campaign is $500,000, while an amazing $5 (500 per cent) rOi on a $10,000 campaign is still only $40,000. concentrating on rOi tends to encourage smaller campaigns, as these are more likely to generate higher rOi, even if dollar returns are small. it can also encourage cutting marketing expenditure; indeed, it’s possible to deliver infinite return on advertising expenditure by slashing advertising to zero.
rOi tends to encourage campaigns that target existing customers, and heavier customers. these show higher rOi largely because many of the sales aren’t really extra sales but sales that would have happened anyway, or sales that have merely be brought forward in time. the danger is that ignoring light buyers of the brand prevents growth, and encourages erosion of market share.
it’s good to be careful with costs and for marketing activities to be evaluated in quantitative terms—but rOi is not a sensible marketing metric.
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■ Over the longer term, customers change, as their lifestyles change with age and changes in
circumstance. So, a very profitable customer may become less profitable—for example, perhaps they start using another provider for some of their requirements—or a low-value customer may in the future be very valuable. Therefore, a classification based on what they purchased last year may undervalue or overvalue the real value of the customer.
■ Customer profitability is not the same as potential profitability if the firm finds ways of
serving them differently or if they change their buying behaviour. Often a firm knows only what the customer is buying from them and does not know what they are buying from other providers—so what appears to be a small customer may actually potentially be a very large one.
■ Allocating costs to individual customers, or even customer groups, can be a very subjective
exercise, and these cost allocations have a big effect on the calculation of customer value. Customer lifetime value calculations are even more problematic. They have all the above problems but also require predicting how much a customer or customer group will buy in the future, and what the costs of servicing them will be. Furthermore, CLV requires an estimation of how long the customer will remain a customer. This can be difficult to estimate, especially when many customers who have defected actually return some time later. CLV calculations usually depend on a number of uncertain assumptions and patchy data.
The point of trying to calculate customer value or customer lifetime value is said to be to decide which customers are most worth acquiring and which customers are worth spending most money and effort on retaining. However, in practice the most profitable customer tends to be the very next customer that the firm acquires, whoever they are, because typically fixed costs do not increase. As long as the purchases the customer makes exceed the direct costs of supplying them, they make healthy contributions to the firm’s profit. Similarly, customers who don’t appear to be very profitable still make a contribution, and if they were lost (some consultants talk of firing unprofitable customers) then company profits would actually decline.
In practice, customer value estimates often have little more accuracy or practical value than simple classifications (Donkers, Verhoef & De Jong, 2007) such as heavy versus light customers. In B2B markets it can be particularly useful simply to note, for example, the size of the firm you are selling to. A firm with thousands of employees and billions of dollars in sales revenue usually offers more potential return and less risk than a customer with only a few employees and small revenues. Similarly, in consumer markets wealthier households and households with more people often offer greater potential.
A more fruitful exercise than calculating customer profitability is to identify particular behaviours that are costly or beneficial to your firm, and encourage or discourage these, and/or change pricing to change the financial attractiveness of these behaviours. For example, in recent years banks have increased fees for transactions that occur within
branches. This was because they identified these behaviours as particularly costly for banks—much more costly than if customers undertook their transactions online. The increased fees made branch transactions more profitable for banks and encouraged more people to use online banking, which also saved banks money.
critical reflection
should banks try to recover the full costs of branch transactions, or are there marketing benefits of having customers come into branches?
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