Using Customer Relationship Managment To Analyse Lifetime Value of Customer

JULIE HENNESSY AND EVAN MEAGHER
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Using Customer Relationship Management

to Analyze the Lifetime Value of a Customer
CRMs Rise, Fall, and Redemption
The first wave of customer relationship management (CRM) began during the IT boom of the
late 1990s. Before the rise of the public Internet, the associated growth of client/server
architecture, and the shift to online sales, companies typically stored customer data in
disconnected databases segregated by geography, channel, product, customer size, and so on.
However, the move to online transactions made it attractive to integrate customer data into central
locations, and improvements in data storage technology made such integration possible.
tC
Companies began spending vast sums on CRM software solutions that would, in theory,
integrate all of their customer data and provide a comprehensive picture of customer behavior
across channels, product lines, and business units. This capability would enable companies to
build a competitive advantage by fostering stronger customer relationships, reducing customer
attrition, and growing margins by better serving customers needs.
In practice, this did not happen.
No
The vast majority of early CRM implementation efforts were deemed failures. All too often,
they were ill-conceived from the beginning, undertaken simply because a competitor had made
headlines with an expensive purchase of its own, or because a new C-level executive wanted a
high-profile accomplishment. Some projects were victims of highly paid CRM salespeople who,
tempted by the prospect of seven-figure commissions, overpromised when they described how a
CRM system could increase sales and customer loyalty by integrating data seamlessly across the
customer relationship cycle (see Exhibit 1), be easily implemented, and quickly pay for itself.
Do
Why did CRM software fail to deliver on its initial promise? Although it aggregated customer
data into one location, the data itself was often low-quality and inaccurate, which validated the
adage Garbage In, Garbage Out. Moreover, data collection practices in large companies
frequently differed across units, which meant that, notwithstanding the promises of the CRM
salesperson, the software could not be implemented off the shelf but required significant
customization. As a result, companies were left with the worst of both worlds: the high initial
2012 by the Kellogg School of Management at Northwestern University. This case was developed with support from the December
2009 graduates of the Executive MBA Program (EMP-76). This technical note was prepared by Evan Meagher 09 under the
supervision of Professor Julie Hennessy. Technical notes are developed solely as the basis for class discussion. Technical notes are not
intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. To order copies or
request permission to reproduce materials, call 800-545-7685 (or 617-783-7600 outside the United States or Canada) or e-mail
custserv@hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or
transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of
Kellogg Case Publishing.
This document is authorized for educator review use only by Rajat Sharma Indian Institute of Management - Kashipur until November 2014. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860

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TECHNICAL NOTE: CRM AND LIFETIME VALUE OF CUSTOMER
price of a commercial package paired with the long-term costs and headaches of maintaining and
upgrading a custom-built solution.1
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Perhaps the greatest reason for CRM softwares initial failures, however, was a fundamental
misunderstanding of what CRM actually was and should be. Early proponentsnot
coincidentally, the same salespeople who stood to benefit most from its salepitched CRM as a
plug-and-play software solution that would immediately deliver a return on investment (ROI)
based on its technological capabilities. A more accurate description of CRM would have been a
process, one that can be facilitated by technology but that was by no means defined by it. In order
to implement CRM successfully, a company needed to start by verifying that its underlying
business processes made sense to automate. In the absence of such examination, the automation
of unnecessary business processes simply amounted to what many IT professionals
contemptuously call paving cow paths.2
A related problem also arose: because CRM was perceived as a technology rather than a
process, many companies failed to get internal support to change or create the business processes
necessary to exploit the full potential of the software. For example, salespeople and customer
service representatives who needed to change the way they interacted with clients as part of a
CRM implementation often werent convinced the software or process change was needed. These
changes often required significantly more time to enter data such as purchase likelihood and
expected timeline, which was valuable for business functions such as sales forecasting, but to a
salesperson it was time spent not calling on new accounts, servicing existing ones, or increasing
commissions.3 Predictably, when users were not convinced of the potential benefits of the
software, implementation stalled and organizations were unable to realize the promised returns on
their investments.
tC
The early failures created widespread disappointment in CRM products, with one observer
calling the category officially dead in 2002.4 CRM software products were increasingly seen as
shelfware: software that was purchased and left on the shelf, never to be adopted or used.
No
However, two technological developments during the mid-2000s returned CRM software to
prominence: one changed the behavior of salespeople that used CRM, and the other changed the
way the software was deployed and sold. First, mobile devices with Internet connectivity and the
processing power to run CRM software remotely became common, which encouraged usage of
the software by salespeople in the field.5 Second, new vendors such as Salesforce.com introduced
less costly hosted CRM software products. Founded by former Oracle executive Marc Benioff in
1999, Salesforce.com pioneered the software as a service (SaaS) delivery model, which offered
customers the opportunity to avoid the one-time and ongoing costs of installing and running their
own software and purchase only what they needed on a monthly basis.
The remote storage of customer data in the Internet cloud raised security concerns among
clients with sensitive information, but the SaaS model in effect allowed companies to try the
Do
Arthur OConnor, The Rise and Fall of CRM, Part 2, ClickZ, April 25, 2002, http://www.clickz.com/clickz/column/1699950/therise-fall-crm-part.
2
Daniel Tynan, The 10 Biggest CRM Mistakes, Sales & Marketing Management, December 1, 2005.
3
J. David Lashar, The Cautionary Tales of CRM, CRM, July 2010.
4
Arthur OConnor, The Rise and Fall of CRM, Part 1, ClickZ, April 25, 2002, http://www.clickz.com/clickz/column/1702798/therise-fall-crm-part.
5
Lauren McKay, CRM Is No Longer a Four-Letter Word, CRM, July 2010.
2
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software before investing in enterprise-wide installations. Paying a small monthly fee for a few
licenses enabled companies to evaluate the software, figure out how to integrate it with their
business processes, and identify key functions the software lacked. As a result, SaaS solutions
rose from just 15 percent of CRM systems in 2003 to 53 percent in 2010.6 The success of
Salesforce.com and other SaaS vendors prompted CRM magazine to declare CRM no longer a
four-letter word in July 2010.7
CRM in Action
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One of the benefits of CRM software is its ability to dynamically manage a companys
customer base through its sophisticated data analytics capabilities. For example, in order for a
firm to identify profitable customer segments and subsegments, it needs to gather and forecast
multiple customer metrics, including cost of contact, likelihood of purchase, purchase margin,
and attrition (or conversely, retention) rate. Using this data, CRM software can help a firm make
important calculations about its target customers.
Customer Acquisition Costs
Consider Omaha Steaks,8 a company that sells gourmet steaks, seafood, and other perishable
food products that are shipped to customers around the country in sealed containers filled with
dry ice to preserve freshness. Originally founded as the Table Supply Meat Company in 1917 and
operating for decades through mail order, Omaha Steaks now sells through multiple channels,
including nearly one hundred retail stores, telemarketing, and its online e-commerce site.
No
tC
Imagine that Omaha Steaks is contemplating the purchase of a list of gourmet food
enthusiasts (or foodies) from a list broker for $1.50 per name. The companys intent is to send
each person on the list a full-color catalog, which costs the company $0.40 to produce and $0.25
to mail, every month for a year; those who do not purchase within one year will be removed from
the mailing list. Data from the companys CRM system reports that such lists generally result in a
response rate of approximately 7.5 percentthat is, 7.5 percent of customers who receive an
unsolicited catalog in this manner will make a purchaseand customers who do not identify as
foodies will exhibit a response rate of 5 percent.
Do
One can therefore calculate Omaha Steaks cost of acquiring a foodie customer as follows:9
Juan Martinez, Reading the Text: McGraw-Hill Learns to Sell Smarter, CRM, July 2010.
McKay, CRM Is No Longer a Four-Letter Word.
8
Although the background information on Omaha Steaks is accurate, none of the financial information should be interpreted as
representative of Omaha Steaks actual business; the authors created it to illustrate concepts rather than to depict an accurate picture of
the economics of a mail-order food products business.
9
Some of the background information that follows is drawn from Elie Ofek, Customer Profitability and Lifetime Value, Industry
and Background Note #9-503-019 (Harvard Business Publishing, August 7, 2002).
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$1.50
12 $0.40
0.075
$0.25
$124.00
Acquiring a non-foodie customer using free names would cost:
12 $0.40 $0.25
0.05
$156.00
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Even though the cost of the brokers list makes contacting the foodie customers almost 20
percent more expensive ($9.30 vs. $7.80), the increased response rate more than justifies this
added cost, and Omaha should go forward with purchasing the list.
The company must recognize that lists featuring attractive foodie customers are necessarily
finite; there are a limited number of gourmet food aficionados just as there are a limited number
of model car enthusiasts, former NFL athletes, or any other target customer segment. As a result,
companies eventually must purchase lists of customers with potentially lower response rates and
account for them when deciding whether to purchase the lists.10
Customer Break-Even
tC
Once Omaha Steaks knows how much it costs to acquire customers, it can calculate how long
it takes to recoup the acquisition costs through customer purchases.
No
Suppose that Omaha sends out catalogs each month to all customers that have made
purchases. Foodie customers purchase more frequently than non-foodies, making three purchases
per year with an average order size of $50; non-foodies make one purchase annually with an
average order size of $125. Foodies also tend to remain customers longer, with an annual
retention rate (the percentage of customers who will continue to make purchases the next year) of
70 percent versus a retention rate of 60 percent for non-foodies.
Lastly, because they view gourmet products such as Omaha Steaks as staples, foodie
customers tend to purchase slightly less expensive products than their non-foodie counterparts,
who view Omaha Steaks as special-occasion products on which to splurge. This behavior results
in a margin to Omaha Steaks of 60 percent for non-foodies versus a foodie margin of 50 percent.
Do
With this information, we can build tables that show how long it will take to break even on
both types of customers (see Table 1 and Table 2).
10
Ibid.
4

Table 1: Omahas Break-Even on Foodie Customers

Foodie Customers
Year 1
Year 2
$50
$50
50%
50%
$75
$75
100%
70%
Annual orders
Order size
Margin
Annual margin (A B C)
Survival rate
Customer acquisition cost
$124
Catalog mailing cost
$7.80
Annual profit (D E) F (G E)
$(49)
$47.04
$(49)
$(1.96)
Cumulative profit
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Year 3
Year 4
Year 5
$50
$50
$50
50%
50%
50%
$75
$75
$75
49%
34.3%
24%
$7.80
$7.80
$7.80
$32.93
$23.05
$16.13
$30.97
$54.02
$70.15
The n-year survival rate is calculated as (retention rate) . For example, the four-year survival rate for foodie customers will be (0.70)4, or
approximately 24 percent, whereas non-foodie customers will have a four-year survival rate of (0.60)4, or approximately 13 percent.
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b
Note that the customer acquisition cost occurs up-front; for each catalog recipient who becomes a customer, the cost of sending the
catalog to all recipients who did not become customers is included. This cost only occurs in Year 1.
c
Savvy readers will point out that cash flows should be discounted for the time value of money, and that one should account for inflation in
growing both costs and revenues. We have not done so here simply because we prefer to focus instead on the baseline calculations
regarding customer profitability; the necessity of discounting cash flows is covered in the next section. Discounting cash flows will lengthen
the time to break even when customer acquisition involves an up-front expense.
tC
Omaha Steaks will break even on foodie customers in Year 3. In Year 1, the company loses
$49 because the customer acquisition cost exceeds the annual margin. In Year 2, 30 percent of
customers have succumbed to attrition and ceased to be customers. The company makes an
additional $47.04 on each remaining customer, which brings the cumulative loss on each
customer to $1.96. In Year 3, the customer relationship finally turns profitable. Although attrition
reduces the annual profit per customer in the out years, the value of the relationship grows over
time as the remaining customers continue to make purchases.
An analysis of non-foodie customers reveals quite a different picture.
Table 2: Omahas Break-Even on Non-Foodie Customers
Non-Foodie Customers
Annual orders
No
Order size
Margin
Annual margin (A B C)
Survival rate
Year 1
Year 2
Year 3
Year 4
1
Year 5
1
$125
$125
$125
$125
$125
60%
60%
60%
60%
60%
$75
$75
$75
$75
$75
100%
60%
36%
21.6%
13%
$7.80
$156
$7.80
$7.80
$7.80
Annual profit (D E) F (G E)
$(81)
$40.32
$24.19
$14.52
$8.71
Cumulative profit
$(81)
$(40.68)
$(16.49)
$(1.97)
$6.74
Do
Omaha Steaks will break even on non-foodie customers in Year 5. The longer break-even is
due partly to the higher customer acquisition cost and partly to the higher attrition (and lower
survival) rate. It is noteworthy that the annual dollar margin on sales to foodies and non-foodies
alike is identical at $75; the higher order frequency of foodies is offset by the higher margin on
non-foodie purchases. Foodie customers therefore become profitable more quickly not because

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they buy more, but rather because they stay customers longer and are less expensive to acquire
because of their higher response rate.
It is important to note that these calculations are highly sensitive to the assumptions used. For
example, if the non-foodie survival rate drops just five percentage pointsfrom 60 percent to 55
percentthe non-foodie customer will not become profitable until Year 9, a full four years later.
The cumulative profitability will also decrease significantly. The longer it takes for a customer to
break even, the less likely it is to occur; new competitors enter, markets change in size, and
customer behavior evolves, all of which means that todays reasonable assumptions are unlikely
to stay reasonable long into the future.
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Lifetime Customer Value
Once Omaha Steaks knows what it costs to acquire a customer and how long it will take that
customer to become profitable, it can determine the lifetime value of a customer. Lifetime
customer value is equal to the net present value (NPV) of all the cash flows associated with a
customer over the life of his or her relationship with the company.
When calculating lifetime customer value each cash flow must be discounted to represent the
time value of money.11 The lifetime customer value tables below assume a 10 percent discount
rate (see Table 3 and Table 4). They also reflect the simplifying assumption that once the NPV
of annual profit dips below $1.00, complete customer attrition has effectively occurred and
customer lifetime has ended.
tC
The NPV of annual profit for foodies falls below $1.00 in Year 11, at which point a 0 percent
survival rate is assumed and the calculation stops. The result is a lifetime customer value of
$67.32 for Omaha Steaks foodie customers.
Do
No
Non-foodies, on the other hand, never become profitable once future cash flows are
discounted, in large part due to high attrition rates that shorten customer lifetime to only eight
years. This result suggests that non-foodies with the assumed characteristics would be an
unprofitable customer segment for Omaha Steaks to target.
11
A cash flow is discounted by dividing it by (1 + discount rate)n, where n equals the number of years in the future until that cash flow
occurs. The sum of discounted cash flows is the NPV.
6
$(49)
NPV of cumulative profit
$(6.24)
$20.98
$30.97
$27.21
$(44.35)
$(40.68)
$81.45
$7.01
$11.29
$7.80
16.8%
$75
Year 6
$89.35
$4.46
$7.91
$7.80
11.8%
$75
Year 7
$94.89
$2.84
$5.53
$7.80
8.2%
$38.29
$(24.35)
$(16.49)
$19.99
$24.19
$7.80
36%
$75
Year 3
$(13.45)
$(1.97)
$10.91
$14.52
$7.80
21.6%
$75
Year 4
$49.31
$56.33
$(7.50)
$6.74
$5.95
$8.71
$7.80
13%
$75
Year 5
$60.79
$75
Year 8
$(2.48)
$15.10
$1.77
$3.14
$7.80
4.7%
$75
Year 7
$65.44
$66.59
$101.47
$1.15
$2.71
$7.80
4%
$75
Year 10
$(1.52)
$16.98
$0.97
$1.88
$7.80
2.8%
$75
Year 8
$67.32
$103.37
$0.73
$1.90
$7.80
2.8%
$75
Year 11
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$(4.25)
$11.96
$3.24
$5.23
$7.80
7.8%
$75
Year 6
$63.63
$98.76
$1.81
$3.87
$7.80
5.8%
$75
Year 9
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The NPV of cumulative profit function is an asymptotic function without the assumption that 100 percent of customers attrite when the NPV falls below $1.00. For foodies it is asymptotic
approaching $68.60 and for non-foodies it approaches $(0.36).
$(81)
$(81)
Cumulative profit
NPV of cumulative profit
$(81)
NPV of annual profit
$36.65
$7.80
$40.32
$(81)
Annual profit
(A B) C (D B)
$156
60%
$75
Year 2
100%
$75
Year 1
Survival rate
Annual margin ($)
Non-Foodie Customers
$70.15
$11.02
$16.13
$7.80
24%
$75
Year 5
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$54.02
$17.32
$23.05
$7.80
34.3%
$75
Year 4
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$42.76
$(1.96)
$32.93
$7.80
49%
$75
Year 3
Table 4: Lifetime Customer Value of Non-Foodie Customers
$(49)
$(49)
Cumulative profit
$47.04
$(49)
Annual profit
(A B) C (D B)
NPV of annual profit
$7.80
$124
70%
$75
Year 2
100%
$75
Year 1
Survival rate
Annual margin ($)
Foodie Customers
Table 3: Lifetime Customer Value of Foodie Customers
No
Do
Strategic Implications
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The insight gained by using CRM data to calculate customer break-even points and lifetime
customer values can have an impact on multiple strategic decisions. For example, it can reveal
that certain customers may be unprofitable to target or even to continue to serve. In the Omaha
Steaks scenario, high customer acquisition cost and high attrition rate made the non-foodie
segment unattractive to target. Likewise, CRM data can be used to identify current customers that
purchase low-margin products infrequently but are costly to service, suggesting that ending or at
least modifying the customer relationship may improve overall company performance. One way
to accomplish this would be to quote such customers higher prices unless they bundle their lowmargin purchases with higher-margin products.
Do
No
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Conversely, CRM data can also reveal the companys best customers. Salespeople may
assume those with the largest overall sales volume are the best customersespecially if their
compensation is based on revenue rather than profitabilitybut CRM data can reveal which
customers account for the companys profitability. Once these customers have been identified,
companies should focus on increasing their loyalty (which would reduce their attrition rate); one
way to do this would be to offer preferential service or other enticements.
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No
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Exhibit 1: How CRM Software Fits into the CRM Cycle
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Source: Darrell K. Rigby and Dianne Ledingham, CRM Done Right, Harvard Business Review, November 2004.


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JULIE HENNESSY AND EVAN MEAGHER

For the exclusive use of R. Sharma

Using Customer Relationship Management

For the exclusive use of R. Sharma

TECHNICAL NOTE: CRM AND LIFETIME VALUE OF CUSTOMER

For the exclusive use of R. Sharma

Customer Acquisition Costs

KELLOGG SCHOOL OF MANAGEMENT

For the exclusive use of R. Sharma

TECHNICAL NOTE: CRM AND LIFETIME VALUE OF CUSTOMER

Acquiring a non-foodie customer using free names would cost:

For the exclusive use of R. Sharma

Table 1: Omahas Break-Even on Foodie Customers

Customer acquisition cost

Catalog mailing cost

Customer acquisition cost

Catalog mailing cost

KELLOGG SCHOOL OF MANAGEMENT

For the exclusive use of R. Sharma

TECHNICAL NOTE: CRM AND LIFETIME VALUE OF CUSTOMER

Lifetime Customer Value

NPV of cumulative profit

KELLOGG SCHOOL OF MANAGEMENT

NPV of cumulative profit

NPV of annual profit

Customer acquisition cost

Catalog mailing cost

Annual margin ($)

Table 4: Lifetime Customer Value of Non-Foodie Customers

NPV of annual profit

Customer acquisition cost

Catalog mailing cost

Annual margin ($)

Table 3: Lifetime Customer Value of Foodie Customers

TECHNICAL NOTE: CRM AND LIFETIME VALUE OF CUSTOMER

For the exclusive use of R. Sharma

TECHNICAL NOTE: CRM AND LIFETIME VALUE OF CUSTOMER

For the exclusive use of R. Sharma

Exhibit 1: How CRM Software Fits into the CRM Cycle

KELLOGG SCHOOL OF MANAGEMENT

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