Lifetime Value of a Customer
This article originally appeared in the Texarkana Gazette on November 7, 2010
Dr. Robert S. Owen, Professor of Marketing, Texas A&M-Texarkana, College of Business
Wal*Mart has recently been in the news for having deliberately raised its prices in an effort to increase sales. In our current economy, wouldn't you think that lowering prices is a better strategy?
As it turns out, Wal*Mart had lowered its prices last Spring on the expectation that lower prices would stimulate sagging sales in a limp economy. The idea was to help traditional Wal*Mart customers who were trying to stretch a dollar. Contrary to what you might have intuitively expected, however, sales and profits went down. Near the end of Summer, Wal*Mart raised prices back to at least traditional Wal*Mart price levels. While sales remained sluggish in this economy, profits were on the positive side in its last quarterly report.
My understanding of the price-increase strategy is that Wal*Mart hopes to shed the price-shopping customers that it gained in last Spring's price-cut strategy and hopes to gain back and retain the more loyal customers that it lost. To implement the price-cutting strategy, Wal*Mart had to lower its costs. This can be done by discontinuing lower turnover items. With only high turnover products on the shelves, you might think that it would be possible to maintain profits with lower prices on a higher volume of sales of fewer product items. But this bean counting perspective doesn't account for future repeat business from loyal customers. When loyal customers cannot find a complete assortment of goods on the shelves, they ultimately buy nothing and gravitate toward competitors who do have all that they need in one store. The customers who are attracted to buying an incomplete basket of goods are ones who are only buying on price. These customers are less profitable in the short run, they can be difficult to retain in the long run, and they can be customers who cost more to serve than loyal customers who are willing to pay higher prices.
In many cases, the costs and future value of these strategies can be calculated. In logistics, you will sometimes come across the term of art, "cost of a lost customer." From a logistics perspective, we realize that it isn't practical to give every potential customer what he, she, or it always wants. A reseller cannot stock all items that every potential customer might want and cannot always have a complete inventory of all regularly stocked items. Attempting to do so would drive costs so high that prices would be too high to satisfy any customer. But a reseller will also occasionally lose a customer because of an item that is never stocked, or because of an item that is currently out of stock. Sometimes the customer is lost for just one basket of goods, sometimes the customer is lost forever on all future sales. If you know the typical price of a basket of goods and the frequency at which that customer makes purchases, then you can calculate the cost of losing that customer once or over a lifetime. If the cost of maintaining stocks of products that customer wants is higher than future profits gained from that customer, then it makes financial sense to let that customer go.
In marketing, you will sometimes come across the term of art, "lifetime value of a customer," and it is similar to the logistics concept of cost of a lost customer. The idea is that if you know the shopping behaviors of a customer, then you can calculate the future value of that customer with regard to a revenue and profit stream. If you could know that a particular customer is likely to generate $50,000 in profits for your firm over the next five years, would you be willing to invest, say, ten percent of that amount today to gain that customer initially, and then another ten percent over the life of that customer to retain that profit stream? On the other hand, would you want to invest $5,000 initially and another $5,000 over the life of a customer that you can forecast to generate only $5,000 in lifetime profit?
The moral of the Wal*Mart story is that even when times are tough for your customers, you must be cautious about cutting prices, cutting services, and altering the product lineup for which you are known. You don't want to chance losing your loyal core customer base to competitors, and you don't want to chance attracting customers that your competitors have already determined to be an unprofitable segment. Some customers are more profitable than others, and some customers are simply too costly to serve.
Robert Owen, Ph.D., is Associate Professor of Marketing in the College of Business at Texas A&M University-Texarkana.