This presentation explains how to calculate and increase the lifetime value of a customer.

1. Increasing the
Lifetime Value of a Customer
Alan D. Campbell
Ph.D., CPA, CMA, CFP®

2. Learning Objectives
1. Explain how to
calculate the annual
profitability of a
customer
2. Explain why
customers are
assets
2

3. Learning Objectives
3. Explain how to
calculate the lifetime
value of a customer
4. Explain 11 strategies
for increasing the
lifetime value of a
customer
3

4. Learning Objective 1
Explain how
to calculate
the annual
profitability of
a customer
4

5. Customer Profitability Analysis
• Use an activity-based
costing (ABC) system
with the customer as the
cost object
• Accumulate the costs of
serving customers in
activity center cost pools
• Determine the measure
used to assign costs from
the activity center cost
pools to the customers
5

6. Assigning Costs to Customers
• Calculate the activity center
cost driver rate
• Multiply the activity center
cost driver rate by the
activities used by each
customer to determine the
costs from each activity
center assigned to the
customer
• Repeat for all activity center
cost pools
6

7. Calculate the
Customer’s Profitability
• Subtract cost of goods
sold from sales revenue
to determine gross profit
• Subtract all direct selling
and administrative costs,
such as commissions
• Subtract all costs
assigned to the customer
from the activity center
cost pools to determine
the customer’s
profitability
7

8. Compare Profits
and Sales Revenue
• Compare the customer’s
profitability to the
customer’s sales revenue
• Sometimes the
customers who generate
large amounts of sales
revenue may be
unprofitable because of
the demands they place
on the company (Kanthal
(A) Case)
8

9. Example
• Able Manufacturing Company (a fictitious
company) sells three products. The three
products, their selling prices, and their
cost to purchase are as follows:
Price Cost
• Gadget $1,000 $480 (48%)
• Gizmo $1,200 $648 (54%)
• Super gizmo $1,500 $840 (56%) 9

10. Other Information
• The company keeps the gadget and the
gizmo in stock
• The company does not carry super gizmos
in stock
• Sales commissions are 20% of sales
10

11. Activity Cost Pools
• Able Manufacturing Company has
determined that it should divide its cost of
serving its customers into four cost pools:
– Order processing—gadgets and gizmos
– Order processing—super gizmos
– Delivery
– Customer service (before and after the sale)
11

12. Order Processing
for Gadgets and Gizmos
• Order processing costs for gadgets and
gizmos for the year were $500,000
• The company processed 5,000 orders
• The cost to process one order for a gadget or
gizmo is $100 ($500,000 / 5,000 orders)
12

13. Order Processing
for Super Gizmos
• Order processing costs for the super gizmo
were $100,000 for the year
• The company processed 100 orders for super
gizmos
• The cost to process one order for a super
gizmo is $1,000 ($100,000 / 100 orders)
13

14. Delivery
• The company incurred $300,000 in delivery
costs for the year
• The company made 1,500 deliveries during
the year
• The cost per delivery was $200 ($300,000 /
1,500 deliveries)
14

15. Customer Service
• The company incurred $480,000 in customer
service costs during the year
• The company spent 8,000 hours in providing
customer service
• The cost per customer service hour was $60
($480,000 / 8,000 hours)
15

16. Activities for Customer A
• In a typical year, Customer A purchases
– 700 gadgets
– 750 gizmos
– 50 super gizmos
• Number of orders of gadgets and gizmos: 12
• Number of orders for super gizmos: 2
• Number of deliveries: 14 (12 + 2)
• Number of customer service hours: 4
16

17. Sales Revenue and
Gross Profit for Customer A
• Sales revenue $1,675,000
• Less: cost of goods sold (864,000)
• Gross profit $ 811,000
17

18. Profit for Customer A
• Gross profit $811,000
• Less: sales commissions (335,000)
• Less: order processing
– Gadgets and gizmos (1,200)
– Super gizmos (2,000)
• Less: delivery (2,800)
• Less: customer service (240)
• Profit $469,760
18

19. Activities for Customer B
• In a typical year, Customer B purchases
– 600 gadgets
– 700 gizmos
– 200 super gizmos
– Number of orders for gadgets and gizmos: 60
– Number of orders for super gizmos: 30
– Number of deliveries: 90 (60 + 30)
– Number of customer service hours: 145
19

20. Sales Revenue and
Gross Profit for Customer B
• Sales revenue $1,740,000
• Less: cost of goods sold (909,600)
• Gross profit $830,400
20

21. Profit for Customer B
• Gross profit $830,400
• Less: sales commissions (348,000)
• Less: order processing
– Gadgets and gizmos (6,000)
– Super gizmos (30,000)
• Less: delivery (18,000)
• Less: customer service (8,700)
• Profit $419,700
21

22. Comparison of
Customer A and Customer B
A B
• Sales revenue $1,675,000 $1,740,000
• Gross profit 811,000 830,400
• Commissions 335,000 348,000
• SG&A expenses 6,240 62,700
• Profit 469,760 419,700
• Although Customer B generated more sales
revenue and more gross profit, Customer A is
more profitable because the cost to serve
Customer A was less
22

23. Learning Objective 2
Explain why
customers are
assets
23

24. Customers Are Assets
• Customers do not
appear on a balance
sheet prepared
according to GAAP
• But customers are the
most important asset
of a business
• A customer should
provide a business
with positive cash
flows for years
24

25. Acquiring Customers
• Focus on making a sale
to acquire a customer
rather than acquiring a
customer to make a sale
• Be willing to earn little, if
any, profit on the initial
sale
• View customer
acquisition costs as an
investment amortized
over the expected life of
the customer relationship 25

26. Use Risk Reversal to
Acquire More Customers
• Provide a reasonably
long warranty period
• Offer to pay shipping
costs both ways for
dissatisfied customers
• Benefits from risk
reversal usually exceed
the costs
26

27. Businesses Lose Customers
• Yet, businesses
typically lose about 10
to 30 percent of their
customers every year
(The Loyalty Effect,
p. 4)
• When a business
loses a profitable
customer, it loses a
valuable asset
27

28. What a Business Loses
When It Loses a Customer
• Cash flows from the
customer’s business
• Referrals to other
customers
• Insight from the
customer about how
the business can
improve its products
and services
28

29. Customer Retention Correlated
with Productivity and Profits
• Higher customer
retention rates are
correlated with
– higher productivity
– higher profits
(The Loyalty Effect,
pp. 12-13)
• A customer retention
program should be an
integral part of a
company’s business
strategy
29

30. Learning Objective 3
Explain how
to calculate
the lifetime
value of a
customer
30

31. Lifetime Value of a Customer
• Present value of all future
cash flows expected to
be received because of
the customer relationship
• Must include
– Acquisition cost
– Retention cost
– Retention rate
– Margin (sales revenue
minus expenses) each
year (can change)
31

32. Lifetime Value of a Customer
Should include future
cash flows received from
other customers the
company would not have
acquired without the
referrals from the
customer
32

33. Lifetime Value of a Customer
• Sum of all net future cash
flows for each year of
estimated life of the
customer relationship
multiplied by the
estimated retention rate
• Discounted to present
value
• Less: acquisition cost
33

34. Lifetime Value of a Customer
• If the retention rate is
constant, then LVC =
Margin x (retention rate /
1 + discount rate –
retention rate)
• Lifetime value is
approximately equal to 1
to 4.5 times annual
margin (Managing
Customers as
Investments)
34

35. Learning Objective 4
Explain 11
strategies for
increasing the
lifetime value
of a customer
35

36. 11 Strategies for Increasing the
Lifetime Value of a Customer
1. Increase the
frequency of
purchase
2. Increase the sales
amount per purchase
3. Increase the retention
rate
36

37. 11 Strategies for Increasing the
Lifetime Value of a Customer
4. Add more products
or services to the
product or service
line and promote
them to current
customers
5. Implement an active
referral and leads
program
6. Implement an online
affiliate program
37

38. 11 Strategies for Increasing the
Lifetime Value of a Customer
7. Avoid making
customers unhappy,
especially over relatively
small things
8. Show appreciation to
profitable customers
9. Provide additional items
to the customer that
provide value to the
customer but that cost
the company little or
nothing
38

39. 11 Strategies for Increasing the
Lifetime Value of a Customer
10. Convert unprofitable
customers into
profitable customers
11. Use activity-based
management (ABM)
to reduce non-value-
added costs of
serving the customer
39

40. 1. Increase the
Frequency of Purchase
• Create and maintain a
customer database
• Sell products and
services a customer
will need to buy often
• Use customer
rewards programs
• Give bounceback
coupons
40

41. Increase Frequency of Purchase
by Regular Communications
• Communicate
regularly with
customers
– Email
– Newsletters
– Catalogs
– Coupons
• Do not communicate
too often so as not to
be annoying
41

42. 2. Increase the Sales
Amount Per Purchase
• Use suggestive
selling “Do you want
fries with that?”
• Better “Do you want
onion rings or fries
with that?”
– Alternate of choice
close
– Mention the more
profitable of the two
last
42

43. 2. Increase the Sales
Amount Per Purchase
• Accept credit cards
and PayPal
• Sell on credit
43

44. 3. Increase the Retention Rate
A 5% increase in
customer retention
rates will yield
between a 25% to
100% increase in
profits across a wide
range of industries.
(The Loyalty Effect,
pp. 13, 33)
44

45. Increase Retention by
Excellent Customer Service
• Do not hire or retain
employees who think
they work for the
“sales prevention”
department
• Train customer
service
representatives to be
positive and helpful
45

46. Increase Retention by
Regular Communications
• Communicate
regularly with
customers
– Email
– Newsletters
– Catalogs
• But not too often
• Ask customers what
they want
46

47. 4. Add More Products or Services
• The easiest customers to
whom a company can sell
its products are its
existing customers
• As a company adds more
products and services to
its product line, its
customers can increase
how much they purchase
from the company and
thereby increase their
lifetime value
47

48. Customers: Existing vs. New
According to Chet
Holmes, the cost of
acquiring a new
customer is six times
greater than selling an
additional product or
service to an existing
customer. (The Ultimate
Sales Machine, p. 209)
48

49. 5. Implement an Active
Referral and Leads Program
• Referral – when a
customer refers a
potential customer to
the business
• Lead – when a
customers refers the
business to a
potential customer
• Referrals are usually
better than leads
49

50. Referrals: Intentions vs. Results
• When asked, a
number of customers
may say that they are
willing to refer the
business to other
customers
• But many of them do
not actually follow
through and make a
referral
50

51. Actively Encourage More Referrals
• Ask customers to refer the
business to other potential
customers
• Give customers
something tangible to give
to the potential customer
such as
– Magnets
– Pens
– Business cards
• Include the company’s
Web site
51

52. Increase the Referrals
and Leads Rate
• Track referrals and
leads
• Calculate the referrals
and leads rate
• Reward customers
who provide referrals
and leads
52

53. Increase the Conversion Rate
of Referrals and Leads
• The company must
make a strong effort
to convert the
potential customer to
a customer
• Be patient and do not
alienate the customer
who made the referral
or lead
53

54. Referred Customers
• Calculate the profitability
of referred customers for
the first year
• Calculate the lifetime
value of referred
customers
• Assess the referrals
program and make
changes to increase the
lifetime value of referred
customers
54

55. 6. Implement an
Online Affiliate Program
• Sell products and/or
services online
• Purchase software that
will run an affiliate
program and pay
commissions to affiliates
• Affiliates place
advertisements or
otherwise refer people
to the company’s Web
site with a code
55

56. Customers Become Affiliates
• Customers can become
affiliates
• A customer can earn a
commission when the
customer refers someone
who makes a purchase
from the company
• The company’s sales
increase and the
customer/affiliate’s lifetime
value increases
56

57. 7. Avoid Making Customers
Unhappy, Especially Over Small
Items
• The customer may not
always be right but be
very careful not to anger
customers unnecessarily
• Unhappy customers may
not come back for a long
time, if ever
• Is it worth losing
potentially large future
sales over a small
problem?
57

58. Unhappy Customers Inform Others
• Unhappy customers can
tell their friends and
associates bad things
about the business
• Unhappy customers can
inform a large number of
potential customers
about the perceived bad
treatment using online
social media and bulletin
boards
58

59. 8. Provide Additional Low Cost or
No Cost Items to the Customer
• Customers appreciate
additional valuable
products that a
company gives them
• Receiving free gifts
helps the customer
relationship
• For example, a
company may be able
to obtain private label
rights (PLR) to e-books,
articles, and reports
and allow customers to
download them free of
charge
59

60. 9. Convert Unprofitable Customers
into Profitable Customers
• Increase the minimum
order size
• Make the ordering
process more efficient
• Convert in-person
and telephone orders
to online orders
60

61. Regular Orders Can
Increase Customer Profitability
• Encourage customers
to order regularly
• Consider continuity
programs where an
order is generated
automatically every
month and charged to
a credit card
61

62. An Unprofitable Customer
Can Be a Loss Leader
• An unprofitable
customer can be a
loss leader if the
unprofitable customer
refers profitable
customers to the
business
• Fire unprofitable
customers only as a
last resort
62

63. 10. Use ABM to Reduce the Cost of
Serving the Customer
• Use activity-based
management (ABM) to
determine the activities used
to serve the customer and
the cost of each activity
• Classify the activities as
value-added activities or
non-value-added activities
• Seek to change the
processes to reduce or
eliminate the non-value-
added activities and thereby
reduce the non-value-added
costs 63

64. Summary
• Use activity-based costing to
calculate the annual
profitability of customers
• View customers as assets
and customer acquisition
costs as an investment
• Implement programs to retain
customers
• Use the 11 strategies to
increase the lifetime value of
a customer
64

65. Conclusion
• Customers are assets
• When the value of assets
increase and liabilities
remain constant, then the
value of stockholders’
equity necessarily
increases
• Therefore, increasing the
lifetime value of every
customer leads to greater
shareholder value
65

66. Appendix
Additional Resources
for Further Study

67. Books
1. Raving Fans: A Revolutionary Approach
to Customer Service by Kenneth
Blanchard and Sheldon M. Bowles. New
York: William Morrow and Company,
1993.
2. Return on Customer: Creating Maximum
Value from Your Scarcest Resource by
Don Peppers and Martha Rogers, New
York: Currency Doubleday, 2005.
67

68. Books
3. Managing Customers as Investments: The
Strategic Value of Customers in the Long Run
by Sunil Gupta and Donald R. Lehmann,
Upper Saddle River, NJ: Wharton School
Publishing, 2005.
4. Managing Customers for Profit: Strategies to
Increase Profits and Build Loyalty by V.
Kumar, Upper Saddle River, NJ: Wharton
School Publishing, 2008.
68

69. Books
5. The Loyalty Effect: The Hidden Force
Behind Growth, Profits, and Lasting
Value by Frederick F. Reichheld, Boston:
Harvard Business School Press, 1996.
6. The Ultimate Sales Machine:
Turbocharge Your Business with
Relentless Focus on 12 Key Strategies
by Chet Holmes, New York: Portfolio,
2007.
69

70. Books
7. How to Win Customers and Keep Them
for Life by Michael LeBoueuf, New York:
Berkley Books, 1987.
8. Customers for Life: How to Turn That
Onetime Buyer into a Lifetime Customer
by Carl Sewell and Paul B. Brown, New
York: Pocket Books, 1998.
70

71. Articles
1. “Generational Revenue Analysis,” by
Alan D. Campbell, The CPA Journal,
February 2001.
2. “Managing Customer Profitability,” by
Marc J. Epstein, Michael Friedl, and
Kristi Yuthas, Journal of Accountancy,
December 2008.
71

72. Articles
3. “Getting the Most Out of All Your
Customers,” by Jacquelyn S. Thomas,
Werner Reinartz, and V. Kumar, Harvard
Business Review, July 1, 2004.
4. “Managing Customers for Profits (Not
Just Sales),” by Benson P. Shapiro, V.
Kasturi Rangan, Rowland T. Moriarity,
Jr., and Elliott B. Ross, Harvard
Business Review, September 1, 1987.
72

73. Articles
5. “The Right Way to Manage Unprofitable
Customers,” by Vikas Mittal, Matthew
Sarkees, and Feisal Murshed, Harvard
Business Review, April 1, 2008.
6. “Realize Your Customers’ Full Profit
Potential,” by Alan W.H. Grant and
Leonard A. Schlesinger, Harvard
Business Review, September 1, 1995.
73

74. Cases
1. Kanthal (A) by Robert S. Kaplan, Harvard
Business Publishing, 1989.
2. Kanthal (B) by Robert S. Kaplan, Harvard
Business Publishing, 1989.
3. Dakota Office Products by Robert S. Kaplan,
Harvard Business Publishing, 2001.
4. Great Dakota Bank: Online Banking, by
Frances X. Frei, Youngme Moon, and Hanna
Rodriguez Farrar, Harvard Business
Publishing, 2002.
74

75. Web Site Tool
The following Web site from the Harvard
Business School has a calculator for
estimating customer lifetime value:
http://hbsp.harvard.edu/multimedia/flashtools/c
75