Customer lifetime value: How to target your customer intimacyby
12th May 2010
Customer intimacy is valuable but expensive, so must be focused on the most valuable targets. Customer lifetime value is one way of doing this, says Jack Springman.
For B2B firms, growing existing customer relationships is often seen as an easy way to generate additional revenue and profits. Managers perceive that the 'hard part' – winning that first piece of business – has been done and existing relationships provide a platform on which the sales team can build.
Both these points are true, of course. But while the opportunity may exist, innate egocentricity – compounded in organisations by 'groupthink' – frequently blinkers us from conceiving that competitors may be thinking the same way. And opening up the ‘we can do what they do’ conversation is not without its risks, raising the question in the customer’s mind – if it did not already exist – that the opposite may also be true, something which procurement teams can be quick to exploit.
To avoid such dangers, growing existing relationships must be approached in a strategic rather than tactical manner. This means identifying all the growth opportunities that exist and focusing on those that best match the business’ source of differentiation. Typically there are three dimensions on which businesses differentiate:
- Providing products or services that deliver the greatest value-addition.
- Providing the best overall solution – solving a broader problem than the product does alone.
- Providing products at the lowest cost.
In terms of identifying the opportunity, growing existing relationships is typically achieved in one of the following ways – selling more of existing offerings (either because the customer grows or the business increases its share of the customer’s purchases), moving into adjacent product categories (and replacing the customer’s existing suppliers in those areas) or creating completely new offerings that the business has not purchased before.
All three sources of differentiation offer the potential to grow with the customer’s business or gain market share. In terms of accessing other opportunities, product and cost leaders are best suited to moving into adjacent product categories – either offering superior functionality to existing suppliers’ offerings or a lower price for the same value addition. However, those who seek to offer the best overall solution are well positioned to access both additional avenues of growth – offering new solutions that simplify the customers business, one of which is becoming a single source supplier across categories (partnering where necessary, e.g. until an internal supply capability has been developed).
In addition, such an approach is less risky. Rather than going head-to-head against suppliers in adjacent categories – and triggering retaliatory action – expansion is into new, uncontested areas. And any attack on competitors is indirect, through the creation of a new game at which they are less likely to have the skills to succeed. In both respects, a solution-based strategy is a far less risky way to expand.
Solving a customer’s broader problem requires customer intimacy. Even for businesses that don’t differentiate on this dimension, growing existing relationships requires increased levels of intimacy with the customers they are targeting for growth. Demands for customisation will increase, especially for companies differentiating on product leadership. The more a business supplies to a customer, the more the relationship between the two becomes strategic rather than transactional. Typically service has to become less reactive and more proactive. Serving proactively and customising effectively both demand the high levels of insight associated with customer intimacy.
Becoming more solution-oriented impacts every customer-facing team across marketing, sales and service. But the greatest need for customer intimacy – and therefore the greatest transformation – is in sales. Account managers must become more like general managers – capable of analysing the customer’s business to identify and quantify opportunities, facilitating contact between interfacing teams across both companies (e.g. accounts payable team at the customer with the invoicing and accounts receivable teams in the business, engineering with engineering, marketing with design, etc.) and co-ordinating the activities of both internal functions and external providers.
This transformation from a traditional sales approach requires training, information access and the deployment of value-based selling tools. Most importantly, sales teams need to be comfortable with the expansion in their responsibilities and the additional demands required. Equally, businesses must appreciate that an account manager can support fewer relationships than with a more transactional approach.
In addition, the business’ capability to manage partnerships becomes more important as some elements of the offer may be provided by third parties. Rather than manage a supply chain into the business, businesses have to manage a network of suppliers into the customer. Managing these partner relationships on a day-to-day basis will require time, new skills and often the creation of a new team.
Customer lifetime value
As the above examples highlight, becoming customer intimate increases the costs of serving customers. Relatively few businesses can afford to be highly intimate with all their customers, the exception being B2B companies which have just a handful – businesses in the automotive supply chain, for example. As such, intimacy should only be targeted with customers where the greatest opportunity exists. One means of quantifying this is through calculating customer lifetime value.
Calculations of customer lifetime value recognise that the relationship with the customer is long term. Measuring customer profitability focuses on current contribution and, by definition, is backward-looking. By contrast, customer lifetime value is future-focused and captures the potential value in the relationship. And by encompassing the different sources of value to the company, it provides a more strategic perspective on relationships - providing the necessary insight to define how to nurture customer relationships and which ones to nurture.
Through the application of a consistent approach across customers to the measurement of value, companies can rank their importance, using this ranking for value-based segmentation, the result of which is a rigorous approach to allocating resources to serving different customers or customer groups. (Segmentation on customer value complements rather than replaces segmentation on customer needs. Needs-based segmentation supports the process of value creation for customers. Value-based segmentation supports the process of transforming value creation for customers into value creation for the business.)
Effective decision-making based on customer lifetime value requires two measures to be calculated – actual and potential (see Figure 1).
Calculating actual customer lifetime value requires estimating by customer or customer segment the costs of acquiring new customers and current costs to serve. It also needs the propensity to churn for each customer or customer group to be estimated to define the expected length of relationships. The final component is forecasting the growth or decline that each customer or segment will enjoy and how that will translate into demand for the business’ offerings in both volumes and pricing.
Calculating potential lifetime value requires factoring in how the above variables might change in the light of actions taken by the business – the reduction in cost to serve from enabling self-service; the potential for new launches to increase overall category spending, increase share of wallet or enable cross-selling into adjacent product areas; or the effect improving the customer experience will have on the expected length of the relationship. In each case, the maximum potential impact needs to be quantified and a probability of success applied – a key driver of the latter being how well the opportunity maps to the business’ main source of differentiation.
Figure 1: Customer lifetime value – actual, potential and unrealised
The difference between actual and potential customer lifetime value is the unrealized value in a customer relationship. Mapping unrealised value against actual value identifies where intimacy will yield the greatest returns, both in terms of ensuring the most valuable existing customers are served appropriately and prioritising the customers with the greatest growth potential (see Figure 2).
Figure 2: Customer prioritisation matrix
The value in the process
Calculating customer lifetime value is not a pre-requisite for growing existing customer relationships. However, the process it forces is highly supportive. (A key test of the quality of any approach to strategic decision making is that the process used for obtaining the answer should be as valuable as the answer it produces). Firstly, all potential sources of growth are considered. Secondly, the likelihood of success with each is taken into account, the key driver of which will be how well each potential value source maps to the business’ ability to unlock it.
Even if a business believes measuring and monitoring customer lifetime value on an ongoing basis would be over-engineering a solution, understanding how it would be calculated – the key drivers, the measures that would be used – will provide the foundations for customer value management, thereby increasing the prospects of growing existing customer relationships, turning from aspiration into reality.
Jack Springman is head of corporate advisory group at consulting and systems integration firm Business & Decision.
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Why invest in customer intimacy if current profitability is relatively minor? In both B2B and B2C markets, we've come to use basic RFM measures as indicative factors (and many others) in the decisioning related to intimacy yet I often ask why we overlook potentially large prospective segments in favour of focusing on and servicing just the more/highly profitable ones. Often this is because it's just too difficult to predict future profitability with sufficient accuracy; in fact, current profitability can still be quite challenging.
I agree that premier customers should be treated as premier, but I also think that customers with a high potential to become more profitable through better service are frequently mis-managed and/or disregarded in practice - when they shouldn't be.
In theory, the opportunity cost of not addressing customer intimacy surely justifies investment in it, but let's not be so naive as to think that this is so for all businesses; clearly it isn't. A convincing business case has several unknowns.
Thanks Jack, great article.
-- Alex Berry Decision Lobe www.decisionlobe.com