How to Calculate Customer Lifetime Value Using Loyalty Economics

How to Calculate Customer Lifetime Value Using Loyalty Economics

A clear understanding of loyalty economics can help executives determine how to invest in customer advocacy.

Investing to earn the loyalty of your customers often requires trade-offs—you must decide which of the many investments you could potentially make will result in the greatest return. A clear understanding of your company’s loyalty economics will help you make those decisions. It will give you a quantitative basis for investments in long-term customer assets and provide a defense against the short-term, "quarterly earnings" mindset that often tempts leaders to generate "bad profits."

You can calculate loyalty economics precisely if you have the resources and the tools to do so. If not, you can make rough estimates to help guide decision-making. We have identified a relatively simple way to get reasonable and rough estimates of the potential value that can be created by improving your company’s Net Promoter ScoreSM and earning the loyalty of more of your customers.

Note: The calculations below are simplified versions of the work that Bain does with clients. To learn more about how Bain can help your company calculate customer lifetime value and referral value, contact us.

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Lifetime Value

Lifetime Value

Loyalty economics (sometimes called "Net Promoter economics") quantifies the differences in customer lifetime value between promoters, passives, and detractors. Your promoters are your loyal, enthusiastic fans. Passives are satisfied for now, but if a competitor’s ad catches their eye, they may defect. Detractors are unhappy customers. They account for more than 80% of negative word-of-mouth.

The first step to understanding the differences among these groups is quantifying the lifetime value of your average customer. From this average customer, you can then estimate the differences for promoters, passives, and detractors. The simple formula for estimating the lifetime value of a customer is:

The lifetime value of the average customer is calculated by multiplying the number of years a customer remains active and annual variable contribution, and discounting it before adding the value of referrals.

The number of years a customer remains active describes the average duration of a customer's relationship with your company. (For some companies, it may be easier to think in terms of churn or attrition rates. For instance, if you have a 5% annual churn rate, the average customer remains active for 20 years.) Typically, you'll find that promoters have lower churn or attrition rates than detractors and therefore have more active years. Each business and each customer segment will show different variations between promoters, passives, and detractors.

The annual variable contribution per customer can get a bit more involved if you don't have a reasonable handle on which of your costs are fixed vs. variable. Nevertheless, for many purposes, a simple gross margin can suffice. To calculate the annual variable contribution per customer for your whole customer base, on average, you would simply divide your annual variable contribution (or gross margin) by the number of customers on the books.

To get an estimate of how this differs for promoters vs. passives or detractors requires understanding who your promoters, passives, and detractors are. The best source is to use relationship NPS, which is a good measure of the sentiment any individual known customer feels toward your company. Next, you need to understand how the behaviors driving lifetime value differs between your promoters, passives, and detractors:

Elements that affect annual variable contribution per customer

  1. Share of wallet and number of products purchased

    Calculate how the annual purchases of your promoters, passives, and detractors vary. This will help you estimate revenue differences. If you have actual revenue per customer, you’ll be able to estimate more precisely, of course.

  2. Cost to serve

    Calculate how the costs to serve customers vary among promoters, passives, and detractors. At its simplest, you could use the percentage of your average gross margin multiplied by the revenue per customer. Of course, if product mix varies among these groups, you’ll want to use a prorated variable cost estimate, based on how costs and margins vary by product. And if you wanted to get even fancier, you could factor in differences in customer tenure, which are often quite variable for early tenure customers than for customers who have been buying from you for a long time. The cost to serve will be subtracted from the revenue calculated in the first step.

  3. Cost to acquire

    Calculate the cost to acquire each group of customers. The simple version of this uses the average cost to acquire a new customer (perhaps by adding up all the sales and new customer marketing and onboarding costs and then dividing by the number of new customers acquired) and amortizes it over the life of the customer. Because promoters, passives, and detractors have different expected numbers of years as active customers, you would amortize over different periods, resulting in a different annual cost to be subtracted. A more sophisticated approach might also take into account other factors, such as the cost of selling different products or the differences in customer acquisition costs for promoters vs. detractors, based on the mix of market segments represented among each group. These annual cash flows should be discounted appropriately to reflect their present value.

Value of a Referral

Value of a Referral

Many companies fail to take into account one of the most important sources of value differences among promoters, passives, and detractors: the value of the positive and negative referrals they make.

The value of referrals can be difficult to estimate with precision, but you can make reasonably accurate estimates using this formula:

Many companies estimate the "percentage of new customers coming via referral" and the "number of referrals made" based on surveys of new customers (for example, they may ask a sample of customers to name the most important reasons they chose to buy from their company). With those estimates in hand and the lifetime value calculation from above, you should be able to calculate the value of a referral. Then you can use referrals as the positive baseline for estimating the impact of negative comments (generally three to four times the power of a positive).

The final step is to estimate the number of positive versus negative referrals made by promoters vs. passives and detractors to add up all the referrals and their value and add those in with the customer lifetime value for each.

With a solid understanding of the critical differences in lifetime value for promoters, passives, and detractors, you can make investment trade-offs built on a more solid understanding of the potential value that could come from turning more detractors into passives or promoters.

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