By Dr. Baumin Lee and Mei Lin Fung

Why it matters to your business

     Information Week just published the list of the Top 500 Innovators in Business Technology in the US. One of my favorites on that list is Harrah’s Casino which came in at number 10. That’s because they are one of the best examples of doing CRM right! They REALLY understand their customers. And then they take that understanding and put together marketing programs, loyalty programs that keep customers coming back and spending more.
How do they do it? By tracking the activities of their customers, no matter where the customers is in their group of Las Vegas properties or 36 casinos in other US states. Previously each casino tracked their own customers in their own database. Customers today are recognized as a Harrah’s customer no matter where they go, and their gambling is tracked in real time.

     Harrah’s takes this data to segment customers and uses it to reward loyal customers with special benefits. As customers feel treated so specially, they feel like coming back. And they do.

     So how does Harrah’s do it? How did they justify the IT expenses to create a “multi-property” CRM system that tracked spending in dozens of casinos, for individual customers?  They used a concept called Customer Lifetime Value. By projecting how much customers could bring to the casino in “additional” cash flow, based on Harrah’s taking certain actions, Harrah’s management could take calculated risks in investing in IT and creating programs which distinguished their properties in a way that attracted more customers.

     Your business can enjoy the benefits enjoyed by Harrah’s if you start to understand the concept of putting financial measures on customer relationship development. Once you begin applying it in your business, you can be smarter and more profitable as you choose which customers to develop relationships with. So let’s get started.

Customer Relationship Lifecycle

     Economists used to ask this question: What is the ideal rate of savings?  Economics Nobel Prize winner, Franco Modigliani offered a key insight: It depends on the stage of the person’s lifetime. A child’s savings rate is negative, as is the case when the person retires. During the income earning years the savings rate turns positive, increasing to a peak, and then declining.

Table 1: How Profits change over Customer Lifecycle

     Customer Lifetime Value is a way to calculate the financial factors in the Customer Relationship and summarize in a single number.

     Physical product costs are now a smaller and smaller part of the cost of what the customer purchases. The cost of providing services is becoming an increasingly larger part of the overall cost. The cost of services varies over the lifecycle of a customer. The cost of services for a customer will vary with each stage of the relationship. We need to understand these costs better.

Activity- Based Costing

     In order to calculate customer lifetime value, we need to develop standard costs for services.  Average Cost or Standard Cost has routinely been calculated for the components of products.  Where service activities now make up a larger portion of the cost of what is delivered to a customer, we need to start working out the Standard Costs for Activities that are frequently repeated.

     The accounting profession developed Activity Based Costing/Management or ABC/M to address this need.  ABC/M takes historical data from the standard accounting general ledger, and uses it to calculate the average cost of servicing activities. Using these average service costs, business managers can project in a systematic way, the costs at different volumes of activity. ABC/M is one of the critical components, the cost side of calculating CLV.

     By looking closely at the costs and the activities we decide to put in place, we can improve the profitability of the customer relationship at different stages of the customer lifecycle.  In order to do this, we need to take a look at what revenue might be generated by the activities we apply.

Expected Revenue

     When looking at Activity Based Revenue projections, the revenue is not 100% guaranteed. When we work with a customer, the customer may or may not “stay with us” for the next step of the relationship.

     For example: the salespeople for a business work to interest prospective customers in their product or service. They might introduce the product to the customer, next they might suggest how to use it in the customer’s business, the next step could be to “loan” it to the customer for a trial period to see if they like it, and so on. And so on. We don’t know whether or not the customer will actually make a purchase. CLV requires the introduction of the concept of “probable revenue”. This is the Revenue X Probability of getting the Revenue. For those who have studied statistics, they would call it Expected Revenue. Calculating Expected Revenue requires making a guess at the probability of receiving that revenue.

     When first we make such a guess, it is normal to feel very uncertain, not knowing whether it is right or wrong. Don’t let your concern stop you. By making a start, you are putting forward a “hypothesis”. Just like in the Scientific Method, we have to start testing that hypothesis.

     The guess needs to be tested against what actually happens. Over and over again. And reviewed in order to improve the accuracy of the guess. By systematic learning through making hypothesis and testing them, we understand more and more about the outcomes that result from our activities. So we can accelerate improvement by doing more of those activities that make it more likely to achieve the outcomes we are looking for. Like acquiring a customer. Like keeping a customer.