Building the One Big Button (Using LTV to Find Business Opportunities) – Part 3

My last two posts started a discussion of using generic Lifetime Value figures to identify business opportunities. Yesterday described the calculations for acquisition orders. Today will finish up with renewal and cross sell orders. The general approach is similar.

- for renewal orders, the key variable is renewal margin (which I am defining as renewal marketing and product cost divided by renewal revenue). This is calculated for each product, for the company as a whole, and perhaps at relevant intermediate levels such as divisions. (If the company can offer different treatments to customers from different sources, the analysis could be done down to the product/source level too.) The assumption here is that products with above-average margins might be under-spending on experience quality, while products with below-average margins might be spending too much. (Even as I write this, I’m less than thrilled with this approach. Margin has much to do with the nature of particular product, so comparing it across products is questionable. But this method does have the advantage of focusing attention on the high margin opportunities. And even if the approximate margin of a product is due largely to its nature, small increases or decreases vs. current spending can probably still be correlated with improvements or reductions in experience value. That said, if anybody has better suggestions, I’m eager to hear them.)

The next step is to estimate the impact of changes from the current practice. I’m not aware of any rule, similar to the Square Root Rule for advertising, that generally estimates the impact of product and service spend on retention. The best we can do is assume (rather optimistically) that spending has been optimized. This implies taking the current margin as the base and assuming any increase or decrease has diminishing returns—say, that each dollar change in product and service costs yields a fifty cent change in revenues. This differs, I think correctly, from the advertising spend assumption that incremental increases are always less efficient. Cutting service costs may well drive away so many customers that it actually reduces margin. An alternative would be to take the company-wide average margin as the base and assume that the further any product’s margin deviates from the average, the greater the impact of a change back toward the average. But this goes back to the issue raised previously: different products have different natural margins so the company-wide average probably isn’t very relevant.

Whatever method is used, the process is the same: estimate the impact of a standard margin increase or decrease on renewal revenue; translate this into a change in years per customer, and then calculate the related change in LTV. This calculation would include all back-end values (renewal plus cross sell), since changing the length of the customer lifetime would also change how long the customer is available for cross sales. Since renewal costs are largely variable, it doesn’t make sense to calculate a “return on investment” on the margin change, as we did with acquisition costs. Instead, the opportunities would be ranked by change in back-end LTV per customer. To ensure cross sell values are considered, the LTV calculation for this ranking includes them along with renewal values.

- for cross sell orders, we’re back to looking at marketing expenditures. As with acquisition orders, we’d calculate a ROI ratio as net value (cross sell revenue – marketing cost plus product cost) divided by cross sell marketing cost. Then we rank products on this ratio against the company-wide average and use the Square Root Rule to estimate the impact of a 20% increase or decrease. Finally, calculate the estimated change in ROI and rank the opportunities accordingly.

Simple, eh?