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Prospecting's Lifetime Value Equation
By Jim Wheaton
Principal, Wheaton Group
Original version of an article that appeared in the
July 1998 issue of "Catalog Age"
All other things being equal, the size of
a catalog - or any direct marketing - business is directly proportional
to the number of prospects who can affordably be contacted.
Therefore, a business can achieve its full potential only by maximizing
this prospect quantity. And, the way to do this is to systematically
calculate customer lifetime value.
For every direct marketer, the prospect universe can be divided into two
groups, proven and unproven. The proven universe is all sources from
which customers are being acquired at or above a pre-defined breakeven.
(As we will see shortly, "breakeven" does not necessarily mean "0
profit.") The unproven universe, by definition, is everything else.
A direct and critical link exists between this pre-defined breakeven and the
size of a direct marketing business (again, all other things being equal):
The lower the breakeven, the larger the proven prospect universe. This
makes intuitive sense. As the standards for customer acquisition are
liberalized, marginally-unusable lists (and list segments) become usable.
The larger the proven prospect universe, the bigger the business.
Therefore, by definition, the lower the breakeven, the bigger the business.
Sophisticated direct marketers have utilized this concept to justify the
conscious loss of money when acquiring customers. They recognize that the
cost of a customer can comfortably be exceeded by the profit flow from future
orders. By losing money - that is, by investing - in customer
acquisition, prospect universes are maximized and the business can reach its
Some catalogers insist on acquiring customers at a loss of $0. Others
have determined that they can absorb some sort of a loss on customer
acquisition, although this amount has not been systematically calculated.
This is because they have taken a haphazard, even intuitive, approach to
calculating lifetime value.
If you are one of these catalogers, the bad news is that you are artificially
limiting the size of your proven prospect universe; and, by definition, your
revenues and profits. The good news is that - again, by definition -
large numbers of good prospects remain untapped. The potential of this
untapped prospect universe to spur business growth cannot be underestimated.
Many catalogers agree with all of this in theory. In practice, however,
they are unwilling to fully explore the boundaries of how much can be invested
on customer acquisition.
Calculating Lifetime Value
Lifetime value is a
vehicle for summing the profits from all of a customer's orders
and comparing this sum with the cost of acquiring the customer.
With this approach, future profit is weighed against current cost.
The following simplified example illustrates this process:
Consider an individual who first appeared on a catalog customer file in January
1998. Subsequently, this customer ordered four additional times before
moving in February 2002 without leaving a forwarding address. (Be patient
that we are assuming knowledge of future events. It will become clear why
this unique perspective is appropriate.)
The total profit before tax is $14. This $14 amount, in conjunction with
an adjustment for the time-value of money, forms the basis for determining the
lifetime value of the customer.
The time-value adjustment is necessary because the money to acquire the
customer was spent in 1998. The profits from the orders, however, came in
1999 through 2002. Because current dollars are worth more than future
dollars, these profits must be translated into 1998 dollars.
Every company should have a corporate hurdle rate to accomplish this, which is
a combination of the inflation rate and the annual real cost of capital.
Let's assume a hurdle rate of 15%, comprised of 2% for inflation and 13% for
the annual real cost of capital. In other words, if a company can earn -
say - 5% a year after inflation by investing in low-risk AAA bonds, it would
insist on earning 13% after inflation by investing in a risky new customer.
Using this 15% discount rate, the total profit before tax of $14 for our
customer translates into a lifetime value of $10:
This $10 lifetime value - again, defined as the value of the customer's orders
in 1998 dollars - can now be compared with the 1998 cost to acquire the
customer. This acquisition cost is defined as the total prospect
promotion cost minus the total prospect order profit, all divided by the number
of prospects converted to customers.
How Much to Spend to Acquire a Customer
task is to determine the maximum amount that can be spent to acquire
this customer. We will continue to explore this question within
the theoretical framework of having perfect knowledge of future
events. This framework will give us a basis for understanding
how to calculate lifetime value in the real world.
In our simple theoretical world, determining the maximum to spend to acquire
this customer is easy. Because we have perfect knowledge of the future,
we know that his or her worth is $10. In other words, this is a world
without uncertainty. Therefore, we can afford to spend anything under $10
for acquisition. Even at a cost of $9.99, we are better off. And,
anything under that is gravy.
In the real world, however, lifetime value is based on past data, which is
always imperfect. Even if past data were perfect, what we are interested
in is future lifetime value. And, there is no guarantee that the future
will mirror the past. Declining business conditions, for example, could
lower the lifetime value of a new customer to $7.
Although there is no one correct solution, most successful catalogers spend
less than 50% of historical lifetime value on customer acquisition. And,
even a conservative 25% investment guarantees steady growth.
Importance of Calculating Multiple Lifetime Values
a real-world catalog business, it is important to think not of one,
but several, lifetime values. Although every business is different,
the following are some general guidelines:
Often, lifetime values differ dramatically by the media type of
acquisition. Examples of media types are direct mail, space ads,
television, card packs, and write-ins.
List types can be a major factor, such as catalog, continuity, subscription and
Also of potential importance are the type and dollar amount of the first
purchase, seasonality, and whether the address is business or residential.
The point is that it is critical to identify important customer segments with
significantly different lifetime values. Calculating an average lifetime
value is better than nothing, but is certainly is not optimal.
A Case Study
Besides expanding a cataloger's proven
prospect list universe, lifetime value analysis can also be used
to alter dramatically customer contact strategies. The following
case study illustrates how.
A niche cataloger had annual sales of about 15 million dollars. The
dynamics of this business were similar to a continuity:
Outside rental list response rates were among the lowest in the industry.
Typical prospecting campaigns pulled less than one-third-of-one-percent.
As a result, acquisition costs for new customers were unusually high.
Existing customers, however, were extremely loyal. Many were long-term
buyers who, every year, would faithfully place at least one order.
Although solidly profitable, the cataloger's top-line had been stagnant for
several years. The mission was to grow the business without sacrificing
A large sample of the customer database
was used for the analysis. Investigation revealed an overall
lifetime value of $18. Men with residential (i.e., non-business)
addresses came in at $16, slightly higher than women at $13.
The startling finding, however, was that the small portion of the
file with business addresses had a lifetime value of $150.
These individuals were, on average, ordering well over $1,000 of
Additional analysis uncovered that these business orders took place around the
holiday season, and generally consisted of multiple ship-to addresses.
The logical conclusion was that these were sales people who were purchasing
holiday gifts for their customers. This hypothesis subsequently was
confirmed via survey and focus group work.
A marketing task force was
instituted to leverage the results of the lifetime value analysis.
Members included representatives from the marketing, creative and
analytical portions of the database marketing spectrum.
As a result of this task force, the cataloger began viewing business customers
as a separate profit center. This profit center, in turn, was then
segmented into three groups: major, mid-range, and small accounts.
For each, a separate marketing strategy was developed to drive revenues and
For Major Accounts, two sales people were hired. This was done to take
full advantage of an extremely high lifetime value, which was quite a bit above
the overall business-address average of $150. Also, it proved cost
effective to develop very elaborate prospecting packages.
Outbound telemarketing was also pursued, and was supported by on-demand screens
that summarized each customer's previous year's holiday season order.
Finally, a special catalog of merchandise suitable for corporate gifts was
For Mid-Range Accounts, the lifetime value was not high enough to support
face-to-face sales calls. Nevertheless, outbound telemarketing proved to
be cost effective. Also, a corporate gift catalog was developed for these
For Small Accounts, the lifetime value did not justify extensive outbound
telemarketing. However, it made sense to target these individuals with
the corporate gift catalog.
The task force also put into effect two other significant changes for these
business customers. First, relatively large amounts were spent to resolve
service problems. It was recognized that assuaging the feelings of $150
customers was critical to maximizing the company's long-term profitability.
Second, investment in list hygiene was increased dramatically, because business
lists are notorious for their inaccuracy. The sales force was trained to
ask about and record all changes in the titles and addresses of their
customers. Also, mailroom personnel at client sites were offered gifts to
update the cataloger's customer lists. In short, significant amounts were
invested in the accurate tracking of these very valuable corporate buyers.
Return on Investment
What had been a stagnant 15
million dollar business was transformed within three years into
a growing company doing 30 million dollars a year in revenue.
Profits, which had been impressive to start with, actually increased
as a percentage of top-line. By all quantitative measures,
the business had been revolutionized.
Jim Wheaton is a Principal at Wheaton Group, and can be reached at 919-969-8859
or firstname.lastname@example.org. The firm specializes in direct marketing
consulting and data mining, data quality assessment and assurance, and the
delivery of cost-effective data warehouses and marts. Jim is also a
Co-Founder of Data University www.datauniversity.org.