MKT 711 Week 2 Customer Equity and Lifetime Value Example

Which Herds Are Worth Keeping? Customer Equity and Lifetime Value Models for a Subscription Dairy Technology Firm

[Student Name]

University of Phoenix

MKT/711: Marketing and Managing the Customer Relationship

Week 2 Assignment

[Instructor Name]

[Date]

HerdSense Technologies, its customer data and its estimates are composites written for a model paper.

Week 1 found that HerdSense Technologies, a composite Madison, Wisconsin, maker of dairy cow health sensors, has strong relationships with farms served through dealers and veterinarians and weak ones with large herds bought direct. Churn was 8 percent a year for dealer-served farms and 19 percent for direct large-herd accounts. The sales team argues that large herds are still the best customers because each brings thousands of cows. The finance team notes that large accounts receive steep discounts, custom integration work and on-site support. This paper develops customer valuation models, estimates the lifetime value of three customer groups and draws implications for how HerdSense should allocate marketing and service resources.

Customer Equity and Return on Marketing

Rust et al. (2004) proposed that a firm's customer equity, the total of the discounted lifetime values of its customers, should be the basis for judging marketing investments. They identified three drivers: value equity, the customer's objective assessment of what the firm offers; brand equity, the subjective view of the brand; and relationship equity, the customer's tendency to stay beyond these assessments. Marketing investments can be compared by their projected effect on customer equity, which turns marketing into an investment decision rather than an expense.

Is Loyalty Always Profitable?

Reinartz and Kumar (2000) studied customers of a general merchandise catalog retailer and found that the link between the length of a customer's relationship and profitability was weaker than commonly claimed. Some long-life customers were only modestly profitable, and a substantial group of short-life customers were highly profitable. They also found little evidence that long-life customers cost less to serve or paid higher prices. Their findings warn against assuming that customers who stay longest are always worth the most.

Selecting Customers by Value

Venkatesan and Kumar (2004) developed a lifetime value framework for a business-to-business computer hardware manufacturer that predicted each customer's future purchase frequency and contribution margin and then optimized the allocation of marketing contacts across channels. Customers selected by predicted lifetime value generated more future profit than those selected by past spending or other common measures. The framework shows that lifetime value can guide not only valuation but also day-to-day decisions about which customers receive attention.

Choosing a Model

HerdSense operates in a contractual setting: farms subscribe monthly and cancel visibly. A contractual retention model is therefore appropriate. Lifetime value equals the sum over future years of the annual contribution margin weighted by the chance the farm still subscribes in that year, discounted at the firm's cost of capital, minus the cost of acquiring the customer. Annual margin includes subscription fees and replacement collars minus software hosting, customer support and, for large accounts, integration and on-site service costs.

The Data

Three years of account records cover 1,520 farms. For each group, the analysis computed average cows per farm, average annual margin per farm after discounts and service costs, annual retention, acquisition cost including sales commissions and dealer incentives and hardware margin at installation. A discount rate of 12 percent reflects the firm's venture-backed cost of capital.

Dealer-Served Farms

The average dealer-served farm has 260 cows and produces annual subscription margin of about $5,600 after support costs and the dealer's share. Retention is 0.92. Acquisition cost, mainly dealer incentives and marketing, is about $3,200, partly offset by $4,100 in hardware margin. Applying the retention formula, in which the yearly margin times the retention rate is set over the gap between one plus the discount rate and retention, future value comes to about $25,760. Adding hardware margin and subtracting acquisition cost gives a lifetime value of about $26,660.

Direct Mid-Size Farms

Direct mid-size farms, 700 to 1,500 cows, average 1,000 cows and annual margin of about $19,800 after discounts and support. Retention is 0.88, and acquisition cost, including a salesperson's time and travel, is about $14,000, with $12,500 in hardware margin. Future value is about $72,600, and lifetime value is about $71,100.

Direct Large Herds

Large herds average 4,200 cows but receive discounts of up to 35 percent and require integration with farm management systems and quarterly on-site visits. Annual margin after these costs averages about $41,000. Retention is 0.81, and acquisition cost, including long sales cycles and trials, averages about $58,000, with hardware margin of about $38,000. Future value is about $107,130, and lifetime value is about $87,130.

A large herd brings sixteen times as many cows as a dealer farm but only about three times the lifetime value.

Value Per Cow

Per cow, the comparison is striking. Lifetime value is about $103 per cow on dealer-served farms, $71 on direct mid-size farms and $21 on direct large herds. Large herds are valuable accounts, but each cow they bring is worth far less than a cow on a smaller farm.

Sensitivity Analysis

Results depend on retention and the discount rate. If large-herd retention rose from 0.81 to 0.90, their lifetime value would rise by about 70 percent, to about $148,000, which shows how much is at stake in the churn problem identified in Week 1. If dealer-farm retention fell to 0.85, their value would fall by nearly a third, to about $18,500. A discount rate of 8 percent instead of 12 percent raises all values but does not change the ranking per cow.

Linking to Customer Equity Drivers

For large herds, value equity is strong, since the system works, but relationship equity is weak, as Week 1 found. Investments that raise retention, such as assigning dairy scientists to large accounts, would raise customer equity more than further discounts, which lower margin. For dealer farms, brand and relationship equity are strong, and the main lever is acquisition through more dealers.

What the Numbers Do Not Capture

Lifetime value omits some benefits of large accounts. A well-known large dairy using HerdSense can serve as a reference that helps sell smaller farms in its region, and large herds generate data that improve the alerts for everyone. These spillovers are real but hard to measure, and they argue for keeping large accounts while serving them more profitably rather than abandoning them.

Allocation Rules

Three rules follow. First, cap new large-herd discounts at 20 percent and price integration work separately. Second, invest in retention for large herds through a named dairy scientist and quarterly reviews of herd results, justified if retention rises by even five points. Third, expand the dealer network into new dairy regions, since dealer farms carry the highest value per cow.

Limitations and Further Research

The estimates assume constant retention and margins, which may change as farms grow or consolidate. Herd consolidation in the dairy industry means some mid-size farms will become large herds. Future research could model customer migration between groups and estimate how relationship investments change retention using controlled trials.

Conclusion

Customer equity research treats customers as assets whose value guides marketing investment, and evidence from noncontractual and business markets warns that size and longevity are not the same as value. At HerdSense, contractual lifetime value models show that dealer-served farms are the most valuable per cow and that large herds, though large in revenue, carry thin value because of discounts, service costs and churn. Allocating resources by lifetime value points to fewer discounts, more retention investment for large accounts and a wider dealer network.

References

Reinartz, W. J., & Kumar, V. (2000). On the profitability of long-life customers in a noncontractual setting: An empirical investigation and implications for marketing. Journal of Marketing, 64(4), 17-35. https://doi.org/10.1509/jmkg.64.4.17.18077

Rust, R. T., Lemon, K. N., & Zeithaml, V. A. (2004). Return on marketing: Using customer equity to focus marketing strategy. Journal of Marketing, 68(1), 109-127. https://doi.org/10.1509/jmkg.68.1.109.24030

Venkatesan, R., & Kumar, V. (2004). A customer lifetime value framework for customer selection and resource allocation strategy. Journal of Marketing, 68(4), 106-125. https://doi.org/10.1509/jmkg.68.4.106.42728