Butterflies and True Friends
When business bounces back, the most valuable thing in the world will more obviously be - a loyal customer. We will want to welcome them back, treat them exceptionally well and do all we can to keep them engaged. Our temptation will be to spoil them all a little, to invest in the all relationships.
As a long term strategy, this is fraught with danger. Companies have many more light buyers than heavy buyers, so we run the risk of making many of our clients unprofitable if we over-invest. Effectively taking profits from our best customers to subsidise extra service to our unprofitable customers.
Investments made to increase the value of marginal (or new) customers are important but are more effective if we know which customers are already really valuable so we can treat them accordingly. We talk about chasing ‘butterflies’1, those customers who flit into your business, perhaps have a large transaction, and then depart. Marketers are tempted to chase them, but you can waste a lot of money chasing butterflies who have no sign or inclination of being loyal to your brand.
The starting point in preparing for the recovery should be to ask, ‘which customers should I focus on satisfying?’, and in most businesses the answer is ‘those that deliver the greatest value to the business’. Typically, marketers look at last year’s sales, segment customers by value and try to work out how to best meet the needs of the supposed ‘High Value’ (HV) customers since they, as a segment, were disproportionally valuable to us.
But is this always where the most valuable customers reside; in last year’s HV segment?
We have a client who agreed to have us look at the value of customers over a longer period, including the investment made to reward them with privileges directed to HV customers.
Turned out the most valuable customers (in profit terms) were in fact customers who had remained loyal, continuing to buy over more than 5 years, never once achieving the volume in a single year that would mark them for special attention.
If the (practical) goal is to align marketing investment with potential customer value, the highfliers were not it! The implicit assumption in many programs is that this year’s HV customers will remain HV if we invest in them.
This is too simplistic. High Value customers know they are important, so they often search for privileges, skipping to the next best ‘perk’ like a butterfly to the next bright flower. But, importantly for this retailer, there was no necessary connection between this year’s high volume spending and loyalty over time. So we moved the focus to measuring the Lifetime Value of customers.
How to determine Lifetime Value
Customers have two types of value to us: current cash flow plus the revenue they will deliver in the future. Many marketing initiatives ignore, or do not attempt to measure, the future value and therefore fail to include it in their priorities. That’s because it is ‘hard to make predictions, especially about the future’2. Of course, adding current and future customer cash flow equals a customer’s ‘Life Time Value’ (LTV).
Our distilled advice is to determine your most valuable long term customers and start by designing the best retention strategy you can for them and their look-alikes. Then you are at least ‘fishing where the fish are’.
Knowing how to determine LTV is hard and can be overly technical. Just trying to determine the expected length of a customer’s lifetime with you is a complex puzzle in most companies, often you don’t even know they have gone.
Luckily we have been shown one way to sharpen Occam’s Razor by Gupta & Lehmann at the Wharton school. Their thinking can be paraphrased as follows:
- Suspend the quest for precision at the individual customer level, and begin with valuing segments
- Trends are more important than absolute values. Consistent, repeated LTV measurements will show if our marketing efforts are increasing the value of our selected segment or not. And by how much.
- Take a ‘moment in time’ approach the same way a Balance Sheet does. At this moment in time, with their current sales and churn rate, how much value will this group of customers deliver before they are all gone? Monitor this number over time to determine the impact you are having on the LTV of the customers in the segment. Use it initially to set retention design priorities.
- Customer churn rates are already operationally important and here they remove the need to know the length of a customer lifetime (e.g. 20% churn means the segment will shrink to 0 in just over 5 years). If you have no precise way of measuring customer churn rates, plot inter-purchase intervals and arbitrarily set a limit beyond which only a small portion return. Or set an arbitrary limit and stick to it over time.
Gupta and Lehmann then apply a simple formula, multiplying customer segment value by a discounted retention rate, to yield the future lifetime of the segment in today’s dollars.
There are, of course, some business approximations involved in this approach, but in our experience they are acceptable.
Providing outstanding customer experiences will always require investment, and so the question of where to invest first is critical.
In other words, underpinning customer centricity is the requirement for a robust framework for making decisions about prioritisation and focus. LTV is the starting point in deciding which customers you should treat differently, first.
We are Ellipsis, the Customer Loyalty Experts. We help businesses thrive through solving complex customer problems. Please get in touch, we’d love to talk.
- Gupta introduced this concept in his seminal HBR ‘The Mismanagement of Customer Loyalty’ way back in 2002.
- Yogi Berra, Trad