Friday, August 31, 2012

What's Wrong with Lifetime Value of a Customer Models?

Bill Gurley, a partner at Benchmark Capital, has written an outstanding column for Forbes which is titled, "The Dangerous Seduction of the Lifetime Value (LTV) Formula."    Lifetime value, of course, is the net present value of the profits that will be generated by a particular customer over time.   As Gurley points out, many companies, particularly of the consumer internet variety, use the LTV model to argue for "get big fast" strategies in which a firm spends aggressively to acquire customers today in expectation of healthy future profits.   Unfortunately, many companies use the tool to justify wildly excessive marketing spending in the near term.  Moreover, as Gurley points out, the people who "own" the tool within a company often are the very same individuals who are petitioning for bigger marketing budgets.  The advocates are the analysts, and their calculations are clearly biased.   Gurley also explains some of the common mistakes people make in their calculations.  Here's an excerpt:

As an example, marketers often divide spend by total customers to calculate SAC rather than just those customers that were “purchased.” If you have organic customers, they shouldn’t be included in the spend calculus. They would have arrived regardless of spend. Also, many people discount “revenues” rather than marginal cash contribution. It is critical to bundle all future variable costs of supporting the customer in order to fairly estimate the future contribution.

I cannot stress this last point enough.  I see students make this mistake a great deal.  For instance, they conduct a break-even analysis, and they divide a fixed cost investment by the revenue per unit that will be generated in the future.  No! That's not right.  You have to divide by contribution margin, not revenue.  For every dollar in revenue that will come in the door down the road, there will be some variable costs.   You have to deduct those variable costs when thinking about value. 

Gurley makes one other key point that cannot be stressed enough.  He explains that, "Organic users typically have a higher NPV, a higher conversion rate, a lower churn, and more satisfied than customers acquired through marketing spend."   Many companies fail to acknowledge that key point. I've hit on a few key points here in this post, but I strongly encourage you to read the entire article.  It's filled with great points about this widely used, and widely misused, analytical tool. 

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