Try treating customer profitability as a demand chain metric, not a financial measure.
In simple terms, lifetime value is the discounted present value of expected revenue streams for each customer. It is derived from customer spending patterns, period-to-period customer retention rates and the organization's internal rate of return on capital. Customer lifetime value derivation calls for a disciplined approach to revenue allocation at the customer level and recognition that timing impacts the value of both money and customers. It also begins to reveal the estimation, allocation and analytical requirements of enabling technology. It's a valuable stand-alone performance metric, provides a revenue basis for calculating customer profitability, and can also serve as a temporary surrogate for the latter measure. Defining and maintaining this metric is a great incremental step that provides footing for addressing the cost side of the equation.
Assigning costs in order to bring the lifetime value equation into the realm of customer profitability is a stiff test. Collecting and managing heterogeneous cost components, data integration, and dynamic maintenance of the pieces and parts, will test an organization's cultural and technical will. Most organizations have a handle on product profitability. At the customer level, product-based unit cost and margin factors can be applied as a starting point. Allocations of cost of sales and general sales and administration (GS&A) expenses are more difficult challenges. Standard costing or activity based costing exercises are options. Process management, data capture, allocation methodologies, and, occasionally, probabilistic and judgmental modeling tools can each play a role in reaching resolution.
The process is one of incrementally building a robust profitability metric over time. In most financial circles, profit is a precise concept, with little allowance for the probabilistic estimation that is sometimes applied liberally. Thus, customer profitability is best treated as a metric in support of demand chain (marketing, sales and service) analysis and planning. Its status as a financial performance metric will come with time, after value is established and a higher level of rigor and precision is achieved.
Customer profitability definition and measurement necessarily involves cross-functional interests that compound the obstacles encountered. Compromise is unavoidable. Ventana Research suggests that companies take four critical attitudes into this organizational negotiation:
1. Agree and understand that precision and rigor is the ultimate goal, but not necessarily an immediate requirement.
2. Focus on what is doable now, but maintain a vision of (and launch a parallel effort to achieve) the ideal solution.
3. Start from a foundation of sound, defensible business logic and apply it consistently.
4. Like in any good negotiation, expect that all parties will come away a little dissatisfied.
It is imperative that companies resist the temptation to tackle this as a one-off effort, making use of spreadsheets, for instance. As more information becomes integrated into the derivation process, the metric will change. Robust support and the dynamic use of the resulting metrics in context with all other customer information is the objective. That can only happen in the context of a consistent performance management foundation.
Jack Hafeli is VP & Research Director - Customer Intelligence & Demand Chain Performance at Ventana Research.