Spend on Customers the Way You'd Invest in Any Asset

What it is

Wharton School Publishing brought the book out in 2005. Gupta and Lehmann taught marketing at Columbia Business School, and the book grows out of their research with Jennifer Ames Stuart, published in 2004 as “Valuing Customers”. Using public data on five companies, that article found a 1% improvement in retention, margin or acquisition cost raised firm value by 5%, 1% and 0.1%.

The building block is customer lifetime value, “the present value of all future profits generated from a customer.” For most firms, they show, a customer is worth 1 to 4.5 times a year’s margin, depending on factors like the retention rate. Add up your current and future customers and you have a proxy for a large part of what the firm is worth.

What you’ll take from it

First, acquisition is an investment with a price ceiling. Spending $500 to get a customer only makes sense if that customer will be worth more than $500. CDNow failed the test. The authors estimate it paid $30 to $55 per customer for a lifetime value of $16.70 to $33.40.

Second, value runs both ways. Customers who give you a lot and get little back are vulnerable, so invest in them. Free riders get a lot and give little, so cut their service or raise their price.

Third, retention is the strongest lever, up to a point. At 80% retention and a 12% discount rate, a 1% improvement in retention lifts customer value by 3.5%, and the gain from each extra point keeps rising. So does the cost of getting it, which is why they reject zero defections as a goal.

“total customer loyalty may be a good slogan for an ad and a good motivational goal for employees, but it is a lousy business objective.” Chapter 3, p. 74

Where it shows up in your numbers

The book’s examples value the average customer, like Ameritrade’s at $1,126 against a $203 acquisition cost. In a power-law business the average customer doesn’t exist. A minority of accounts make up a majority of the revenue, so one blended lifetime value overprices the D’s and underprices the A’s. One blended retention rate understates the whole base, too. The authors point the same way. Investment in customers “should vary by their profit potential,” and an acquisition strategy that ignores differences in lifetime value is, in their words, “naïve and inferior.”

So run their math by tier. Work out margin, retention and lifetime value for A through D, and cap what you’ll pay to acquire each tier at its lifetime value. Judge campaigns on the value of the customers they bring in, not the count. Then apply their retention test tier by tier. At 80% retention, they write, a program that costs more than 3.5% of profits for a 1% improvement in retention is too expensive.