PROSPECTING’s Lifetime Value Equation

Jul 01, 1998 9:30 PM  By

All other things being equal, the size of your catalog business is directly proportional to the number of prospects you can contact affordably. But many catalogers don’t know how much they should spend to acquire new customers because they don’t have a true measure of what a customer is worth to them. If you don’t properly calculate lifetime value, you may be surprised to find that you’re spending too much, or in many cases not enough, on prospecting.

The direct marketing prospect universe can be divided into two groups of responders: proven and unproven. The proven universe is all sources from which customers are acquired at or above a predefined breakeven. The unproven universe, by definition, is everything else.

There’s a direct link between this predefined breakeven and the size of a catalog-again, assuming all other things are equal:

I The lower the breakeven, the larger the proven prospect universe. As the standards for customer acquisition are liberalized, marginally unusable lists and list segments become usable.

I The larger the proven prospect universe is, the bigger the business is.

I The lower the breakeven, therefore, the bigger the business.

Most catalogers would agree with these principles in theory. In practice, however, many are not willing to fully explore the boundaries of how much they can invest in customer acquisition. For instance, some catalogers insist on acquiring customers without losing money. Others have determined that they can absorb some sort of a loss on customer acquisition, but they’re not sure how much-usually because they haven’t systematically calculated the lifetime value of customers.

By not understanding the lifetime value of a customer, you may be artificially limiting the size of your proven prospect universe, not to mention your revenue and profits. Figuring out what your customers are worth and what you can afford to spend to attract new buyers will open up a new world of untapped prospects and spur business growth.

Calculating lifetime value Calculating lifetime value involves adding the profits from all of a customer’s orders and comparing this sum with the cost of acquiring the customer. With this approach, future profit is weighed against current cost.

Consider a customer who first appeared on a catalog buyer file in January 1998. Subsequently, this customer ordered four additional times before moving in February 2002 without leaving a forwarding address. The total profit before tax is $14 (see chart, right), which in conjunction with an adjustment for the time-value of money (basically converting all profits into 1998 dollars) forms the basis for determining the customer’s lifetime value.

You need to make the time-value adjustment because the money to acquire the customer was spent in 1998. The profits from the orders, however, came in 1999 through 2002. Because current dollars are worth more than future dollars, these profits must be translated into 1998 dollars.

To know how much future dollars are worth, every company should have a corporate hurdle rate, which is a combination of the inflation rate and the annual real cost of capital. Let’s assume a hurdle rate of 15%-2% for inflation and 13% for the annual real cost of capital. In other words, if a company can earn, say, 5% a year after inflation by investing in low-risk AAA bonds, it would insist on earning 13% after inflation by investing in a risky new customer.

Using this 15% discount rate (dividing each year’s order profit by 1.15, as in the chart at right), the total profit before tax of $14 for our customer translates into a lifetime value of $10. This $10 lifetime value, defined as the value of the customer’s orders in 1998 dollars, can now be compared with the 1998 cost to acquire the customer. This is defined as the total prospect promotion cost, minus the total prospect order profit, all divided by the number of prospects converted to customers.

Spending on customer acquisition Once you have the lifetime value, the next step is determining the maximum amount you can spend to acquire this customer. In our theoretical world, this is easy, because we have perfect knowledge of the future, and we know that this customer is worth $10. We can therefore afford to spend anything under $10 to acquire a new customer.

But in the real world, lifetime value is based on past data, which is always imperfect. And even if past data were perfect, there would be no guarantee that the future would mirror the past. Declining business conditions, for example, could lower the lifetime value of a new customer to $7.

Although there is no one correct solution, most successful catalogers spend less than 50% of historical lifetime value on customer acquisition. Even a more conservative investment of 25% of lifetime value guarantees steady growth.

Calculating multiple lifetime values Calculating an average lifetime value is better than not doing it at all, but it’s not the best way to determine your prospecting budget. In most cases, it’s best to calculate several types of lifetime values. For instance, lifetime values often differ dramatically by the acquisition medium. Customers who came through direct mail offers may have a different lifetime value than names rented from space ads, television, card packs, or write-ins (orders received from individuals without a source code.)

When prospecting using rented lists, the type of list can also be a major factor in lifetime value. Names from a catalog list, for example, may be more valuable over time than names from subscription or compiled lists.

The specifics vary by cataloger, but the type and dollar amount of the first purchase, seasonality of purchase, and whether the customer’s address is business or residential can be important to lifetime value as well. One cataloger, for instance, has found that customers who place their first order during the holiday season have half the lifetime value of customers who place their first order at other times of the year. That’s why it’s critical to identify those important customer segments with significantly different lifetime values.

Besides expanding your proven prospect list universe, lifetime value analysis can also prompt you to dramatically alter contact strategies to target different groups of customers.

A catalog case study Consider how lifetime value helped revive a $15 million niche cataloger in the following case study.

This cataloger, which has business dynamics similar to those of a continuity marketer in that its response rates are typically lower and average orders typically higher than the average catalog’s, found that its outside list rental response rates were among the lowest in the catalog industry: Typical prospecting campaigns pulled less than one-third of 1%. As a result, acquisition costs for new customers were unusually high. But many existing customers were extremely loyal long-term buyers who would faithfully place at least one order every year.

Although solidly profitable, the cataloger’s revenue had been stagnant for several years. The mission was to grow the business without sacrificing profits. Using a large sample of the customer database for the analysis, an investigation revealed an overall lifetime value of $18. Male customers at residential addresses came in at $16, slightly higher than female names at residential addresses, which were worth $13. The startling finding, however, was a small portion of customers at business addresses with a lifetime value of $150. On average, these individuals were ordering well over $1,000 of merchandise.

Additional analysis uncovered that these business orders were placed around the holiday season and generally consisted of multiple ship-to addresses. The logical conclusion was that these were salespeople buying holiday gifts for their customers-a hypothesis subsequently confirmed via surveys and focus groups.

The cataloger formed a task force, which included representatives from the marketing, creative, and analytical portions of the database marketing spectrum, to help the cataloger view its business customers as a separate profit center, segmented into three groups: major, midrange, and small accounts. For each group of business customers, the cataloger developed a separate marketing strategy to drive revenue and profits.

For major accounts, the cataloger hired two field salespeople to take full advantage of these customers’ extremely high lifetime value, which in some cases was two times the overall business-address average of $150. Also, the mailer found it cost-effective to develop elaborate prospecting packages, some of which included free samples.

The mailer also started outbound telemarketing programs for this group of buyers, supported by on-demand computer screens that summarized each customer’s previous holiday season order. Finally, the company developed a special catalog of merchandise suitable for corporate gifts.

For midrange accounts, the catalog task force determined that the lifetime value was not high enough to support face-to-face sales calls. Nevertheless, outbound telemarketing proved to be cost-effective. This group of customers also received the corporate gift catalog.

And for the small accounts, the company decided that the lifetime value did not justify extensive outbound telemarketing. But it did make sense to target these individuals with the corporate gift catalog.The task force also conv inced the company to spend relatively large amounts to resolve customer service problems, recognizing that assuaging the feelings of $150 customers was critical to long-term profitability. For example, customers with problems received follow-up letters and phone calls-even visits from the salespeople, as well as significant discounts on their next purchase.

The cataloger also dramatically increased its investment in list hygiene, since business lists are notoriously difficult to keep up-to-date. The sales force was trained to ask about and record all changes in customers’ titles and addresses. In addition, mailroom personnel at client sites were offered gifts to update the cataloger’s customer lists. In short, significant amounts were invested in the accurate tracking of these very valuable corporate buyers.

The return on investment? Within three years, what had been a stagnant $15 million catalog company was transformed into a growing company doing $30 million a year in revenue. Profits, which had been impressive to start with, actually increased as a percentage of sales. By all quantitative measures, the business had been revolutionized.

Spend money to make money You may think you don’t have the time or resources to conduct lifetime value analyses, but the reality is that you probably can’t afford not to-if you want to grow and thrive in a competitive catalog market.

When spending money to make money in terms of customer acquisition, you need to set your breakeven number based on the lifetime value of a specific buyer or segment of buyers. Sophisticated direct marketers can justify the conscious loss of money when acquiring customers by recognizing that acquisition cost can be far outweighed by the profit flow from future orders.