October 20, 2015

Lifetime Value

Question:  You lose $8 profit acquiring a new customer. The customer generates $7 profit in year one, $5 profit in year two, and $3 profit in year three. Which time horizon should you maximize long-term value upon?

  1. You lost $8 profit, so stop marketing to this source of new customers.
  2. You lost $8 profit, and you do not make up the difference in year one, so stop marketing to this source of customers.
  3. The customer generates $15 profit in three years, more than offsetting the $8 lost in year one. This customer source is profitable, and should be profitably mined.
  4. You were not give enough information to make an informed decision.
What is your answer?

The right answer is to run a long-term simulation, and let the simulation determine if you generate enough long-term profit to maximize shareholder value. In other words, the answer is (4).

On average, simulations show that there is a direct correlation between annual repurchase rates and the length of time you are willing to wait for payback.

In other words, if a new customer has a 20% annual repurchase rate, then there is very little future value generated, and as a result, you're going to have to break-even up-front on customer acquisition costs.

If a new customer has a 50% annual repurchase rate, then there is significant future value generated, and as a result, you may be able to wait three years or four years to make up acquisition costs.

But you have to run the simulations to know the right answer.

2 comments:

  1. Forgive what is perhaps a naive comment/question, but aren't repurchase rates just a way of describing future profit potential? In #3 above you describe a customer whose repurchase rate and order values, whatever they are, are such that they generate profit in future periods - unless cost of capital is such that this is negative NPV, what other information has bearing?

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  2. Most of my clients earn a bonus if profit, as a percentage of net sales, is say 8%. You have to run the simulation to understand if that objective is ever achievable. Most online companies would strive for market share at the expense of profit. Many of my clients need short term profit. The simulation guides how deep you invest in order to either maximize market share with marginal profit or obtain quality profit with less top line sales growth.

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