The Real Value of Customer Loyalty

It's a marketing truism: Higher buying rates and lower service costs make long-term customers more valuable. That, of course, influences what companies spend on customer acquisition and retention. But according to an August 2001 working paper titled “Customers as Assets,” by Sunil Gupta and Donald R. Lehmann of Columbia Business School, Columbia University, customer-lifetime-value metrics can and should inform many business decisions in the marketing realm and beyond. In fact, looking at management decisions through the lens of customer value can generate surprising new perspectives — and often overturn conventional wisdom.

According to the paper's authors, any calculation of customer-lifetime value (LV) must take three factors into account: margin (the annual revenue that customers generate minus the operating expenses a company incurs in serving them), retention rate (the percentage of customers expected to keep doing business with the company) and discount rate (the current cost of capital). The resulting dollar figure can yield a variety of insights.

Firing Customers. Many companies use revenue growth and market share as key measures of success. But the LV perspective shows that this growth may come at a significant cost. Specifically, the cost to generate revenue and growth varies dramatically across customers. To illustrate, after a number of natural disasters struck Florida, several insurance companies realized that in their zeal to grow, they had acquired too many customers in disaster-prone areas.

Clearly, if such companies hope to protect their long-term financial health, they must make unprofitable customers profitable — or “fire” them. Getting rid of customers runs counter to many managers' intuition and training. However, the LV model suggests that revenue growth and market share, per se, may actually be the wrong metrics by which to gauge success.

Serving Customers. According to this study, an enterprise should not raise its customer-service level across the board. Instead, it should provide better service for customers with higher LV — another policy that may contrast with conventional wisdom in many managers' minds. For instance, discount brokerage Charles Schwab answers its best customers' phone calls within 15 seconds. Its other customers may wait for as long as 10 minutes to have their calls answered. Such service discrimination may generate a backlash from some customers, but if companies make their policy clear, customers might accept the adage “You get what you pay for.” The key point is that the policy lets companies protect their long-term profitability.

Segmenting Customers. The LV perspective provides a new way to segment customers. Today's technologies let organizations gather unprecedented volumes of information about customers, not only on their demographics and preferences but also on their profitability. For example, mutual-fund giant Fidelity classifies its customers into segments on the basis of profitability and then uses that information to tailor its offerings to the various segments.

Assessing Marketing-Program Effectiveness. Managers are coming under increasing pressure to show a return on marketing expenditures. But even the most sophisticated ROI models focus on short-term returns. The LV model inherently looks at the long term and is therefore ideally suited for assessing a marketing campaign's effectiveness. Consider Internet banner advertising versus direct mail. How should a manager choose between those strategies? Many critics point out banner ads' dismal conversion rates compared with those of direct mail. But online retention rates are superior — 90% for the Internet and only 60% for direct mail. Higher retention rates imply higher LV — making banner ads more profitable than direct mail in the long run.

Evaluating Strategic Alliances. Flower retailer Gerald Stevens Inc., determined to build a strong presence on the Internet, made deals with several online companies and established its own Web site. It declined one deal with AOL because AOL wanted $75 for each of its customers. How wise was that strategy overall? By using the LV model, Gerald Stevens estimated its typical Internet LV at $60 —short of the $75 acquisition cost through AOL. It then calculated the LV of its average retail customer at several hundred dollars — with an acquisition cost of about $50. Taken together, those numbers suggested a brick strategy would be better than a click deal.

Deciding Mergers and Acquisitions. The LV framework can generate valuable insights about M&As, particularly for investors. Specifically, if an investor company can calculate LV and forecast the growth in a company's number of customers, it can gauge the organization's current and future customer base. To the extent that this base forms a large part of the concern's overall value, it can provide useful insights for the acquirer. For example, the authors calculate online retailer Amazon's market value at significantly above its LV — suggesting that the market expects Amazon to grow margins, increase customer retention and/or cut acquisition costs. In contrast, they calculate online broker E*Trade's market value as below its customer value, indicating a possible expectation of slowing online trading and squeezed margins.

The LV model reveals that customer-lifetime value is more than a metric; it's a way of thinking and doing business. It encourages managers to focus on the long term, and it prompts them to rethink traditional assumptions about how to measure corporate performance and make effective decisions.