Thursday, May 31, 2012

3 ways to use customer lifetime value to maximize revenue

Many companies have long recognized the importance of customer lifetime value (LTV). There's no shortage of customer lifetime value calculators and formulas out there to help companies compute LTV and use it to predict and evaluate the potential results of new marketing programs. But few companies understand how to take LTV to the next level and use the analytics to generate triple-digit growth for their business.

Customer lifetime value essentially tells you the projected revenue a customer will generate for your company over his or her lifetime. From this, you can determine several powerful marketing metrics: how much you should spend to acquire the customer, how much you should spend to retain the customer, which customer segments to target, and the ROI of your marketing campaigns.

I took the concept of LTV to heart early on, especially with advertising costs soaring through the roof during the dot-com era. My mentors emphasized how crucial it was to properly calculate your customer lifetime value to inform your cost per acquisition (CPA) choices, and develop your online customer acquisition strategy and customer retention strategy.

Herein lies something most companies don't understand. They often don't think about optimizing revenue as a way to increase a customer's lifetime value and thereby boost profit. Rather, they focus on minimizing costs, especially marketing spend, to increase margins. So here are three core steps you should bake into your customer lifetime value calculation process to help you maximize your revenue:

1. Determine how long your customers generally stay with you. If you're just starting out, take it easy here in your estimate so you don't lose your shirt. If you've been in business for some time, review your metrics monthly and by acquisition source.

2. Set your risk tolerance. Setting a customer's lifetime value comes with risk. Set it too long, and you can easily bankrupt your company by investing too much money in your ad spend that is never recouped over the long term (Dot-bomb era anyone?). At the same time, if you underestimate the lifetime value of a customer, you throttle your own growth by failing to spend as much as possible to increase your customer pool at the outset. The longer the lifetime value, the greater the risk of never seeing a return on the initial investment. Safeguarding that return is a function of customer service, call center discipline, and how well you create increasing value for your customers. Your risk tolerance must be determined over time as you gain competence and confidence in your ROI.

3. Understand contribution margins. Why would any company spend more to land lower margin customers? The answer lies in your contribution margin, and requires a sophisticated ability to understand your real costs, how to cover them, and then how to benefit from narrowing profit margins that still contribute to growth. Internally, we talk a lot about optimization, and much of this revolves around contribution margins by channel and technique. We are more than willing to trade margin once costs are covered, and then incremental sales drop directly to the bottom line. But understanding the process requires careful modeling, strong analytics, and the ability to track each dollar spent by channel.

At Stroll, that ability is quaintly referred to as my "hamburger talk." To simplify the lesson, I take a hamburger and show that the real costs include not just the beef, but the cheese, lettuce, tomato, and roll. Once those costs are subtracted out, you're left with contribution margin. That's the amount of money left to pay for overhead.

BEEFED UP: A hamburger comes in handy to illustrate how to calculate contribution margin 
Web analytics are a crucial component in all these steps. They can be combined with media cost data to tell you acquisitions costs across your channels, giving you insight into which channels bring in the most valuable customers. James Brown, Stroll's Director of Analytics; and Ron Pirollo, Stroll's Vice President of Finance, will be delving into analytics further in future posts.

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