What's Wrong with Lifetime Value of a Customer Models?

Bill Gurley, a partner at Benchmark Capital, has written an outstanding column for Forbes which is titled, "The Dangerous Seduction of the Lifetime Value (LTV) Formula."    Lifetime value, of course, is the net present value of the profits that will be generated by a particular customer over time.   As Gurley points out, many companies, particularly of the consumer internet variety, use the LTV model to argue for "get big fast" strategies in which a firm spends aggressively to acquire customers today in expectation of healthy future profits.   Unfortunately, many companies use the tool to justify wildly excessive marketing spending in the near term.  Moreover, as Gurley points out, the people who "own" the tool within a company often are the very same individuals who are petitioning for bigger marketing budgets.  The advocates are the analysts, and their calculations are clearly biased.   Gurley also explains some of the common mistakes people make in their calculations.  Here's an excerpt:

As an example, marketers often divide spend by total customers to calculate SAC rather than just those customers that were “purchased.” If you have organic customers, they shouldn’t be included in the spend calculus. They would have arrived regardless of spend. Also, many people discount “revenues” rather than marginal cash contribution. It is critical to bundle all future variable costs of supporting the customer in order to fairly estimate the future contribution.

I cannot stress this last point enough.  I see students make this mistake a great deal.  For instance, they conduct a break-even analysis, and they divide a fixed cost investment by the revenue per unit that will be generated in the future.  No! That's not right.  You have to divide by contribution margin, not revenue.  For every dollar in revenue that will come in the door down the road, there will be some variable costs.   You have to deduct those variable costs when thinking about value. 

Gurley makes one other key point that cannot be stressed enough.  He explains that, "Organic users typically have a higher NPV, a higher conversion rate, a lower churn, and more satisfied than customers acquired through marketing spend."   Many companies fail to acknowledge that key point. I've hit on a few key points here in this post, but I strongly encourage you to read the entire article.  It's filled with great points about this widely used, and widely misused, analytical tool. 

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Leaders should ask: What do you want to do?

Adam Bryant recently interviewed Bill Flemming, CEO of Skanska USA, for his Corner Office column in the New York Times.  He asked Flemming about his leadership style, and the CEO offered these thoughts:

"When people ask me a question, I don’t always answer it with, “Yes, this is what I want you to do,” or, “This is what I’d do.”  Instead, I’ll ask them, “So what do you want to do?” I don’t want you to just announce the problem to me and expect me to solve it. You tell me what the problem is, you tell me what your proposed solution is, and I’ll give you feedback. I don’t always want to give you an answer on what to do. I want you to think about what your answer’s going to be. I’ll always have an opinion about something, but I want people to form their own opinions."

Flemming's approach has many virtues.  First, he solicits more buy-in and commitment, because he's encouraging his folks to "own" the problems AND the solutions.  Second, he develops his people in this manner, by giving them some responsibility and autonomy and then offering feedback and advice.  Third, he hears new ideas.  If he led with his view, he may very well never hear certain ideas, because some folks would just defer to him.  

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When Management By Walking Around Fails

Anita Tucker and Sara Singer of Harvard Business School have conducted a fascinating new study about how leaders interact with workers on the front lines.  They examined efforts to improve quality, efficiency, and customer satisfaction in hospitals.   The scholars conducted a field study of 56 work areas from 19 randomly selected hospitals and compared the results to 138 work areas in 48 randomly selected control hospitals. They examined an approach called Leadership WalkRounds™ which they describe as "a program of [senior managers] visiting the organization's front-lines to observe and talk with employees while they do their work."  They found that employee perceptions of performance improvement dropped after implementation of the WalkRounds™-based program. The scholars argue that,

"The study provides a cautionary tale that visits by senior managers to the front-lines of the organization will not necessarily increase staff perceptions of performance improvement.  Failure to meet expectations, once raised, can negatively impact organizational climate. Unless such programs are implemented with authentic motivation to identify and resolve issues, they may yield a negative return on the money invested."

Should we be surprised by the findings?   I'm not so sure.  While I've written about executives who effectively engage the front line workers in their organizations, I've also seen many cases where such efforts are counterproductive.  What goes wrong when executives visit with front-line workers?  Here are a few pitfalls that I have seen:

1.   Sometimes, employees perceive the visit as an "inspection" rather than a genuine effort to solicit input and ideas from workers.

2.  Workers perceive that managers have already made up their mind on certain issues, and therefore, that the executives are not genuinely listening and considering their views.   In other words, workers conclude that they aren't being given a legitimate opportunity to influence decisions.  

3.  Senior managers spend too much time talking and not enough time listening.  They focus on communicating messages to the front lines, rather than soliciting feedback.  

4.  Workers change their behavior because of the presence of senior managers. Therefore, managers do not get a sense of what's really going on in the organization. 

5.  Executives fail to follow up in a timely manner on employee ideas or questions.  

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When Should an Entrepreneur Pursue a Freemium Business Model?

Yesterday the Wall Street Journal published an article about how many companies with "freemium" business models have failed to become solidly profitable.  Freemium refers to the idea that some firms give away a basic version of their product or service, in hopes that some significant fraction of consumers will upgrade to the paid version.   According to the Wall Street Journal article written by Sarah Needleman and Angus Loten, "The 'freemium' strategy is turning out to be a costly trap, leaving them with higher operating costs and thousands of freeloaders."  

Of course, some companies have enjoyed spectacular success with a freemium business model.  Take LinkedIn, for example.  Most people use the free version.  However, LinkedIn generates significant revenue and profits by offering a premium service, which has become very attractive to company human resource departments that use LinkedIn as part of their recruitment and hiring strategy. 

What types of firms should consider a freemium strategy?   I think there are two key attributes that entrepreneurs should consider when determining whether a freemium approach suits their business.  First, is there economic value (and early mover advantage) to be derived from a "get big fast" strategy?  Specifically, are there strong network effects in the business?  If so, then attracting high numbers of users can enhance the perceived value to each user.   Second, are the marginal costs of providing the good or service  close to zero?  If so, then adding a new non-paying user doesn't drain the company's finances. If, however, there are some incremental costs that will be incurred, then the firm may have a serious problem with a freemium approach.  The problem, of course, is that many start-ups assume that marginal costs are zero, when in fact there are some hidden costs for each additional user for which they have not accounted properly.

For more on freemium business models, see the video below featuring Chris Anderson, author of Free: The Future of a Radical Price.

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See's Candies Moves East

This week Fortune features an article about the planned eastward expansion of See's Candies.  For folks on the west coast, you are quite familiar with the See's chocolate shops and airport kiosks that sell fresh delicious chocolates.  The company does not have any shops east of the Mississippi though.  That will change over the next few years, according to plans described in the article.  The company, owned by Warren Buffett for the past forty years, aims to expand with up to 30 new stores in the eastern part of the United States in upcoming years. 

The See's expansion offers some interesting challenges.  First, the company will have to introduce themselves to those on the east coast and deal with existing luxury chocolate brands such as Godiva that have a significant share in that region.  Second, the supply chain will be a challenge.  The chocolates do not have preservatives.  Thus, they have a short shelf life.  The company will need a factory close to its east coast locations.  Third, the firm must expand its appeal young mothers, according to its new head of marketing, Tracy Cioffi.  She notes, "We can't focus on great-grandma anymore." 

As I read the article, I kept thinking that the company could learn a great deal from another highly successful California retailer that expanded eastward after many years of focusing on the west coast.  That company would be Trader Joe's.  The firms have much in common:  fiercely loyal customers, longtime employees who enjoy working there, strong profits, and a reputation for quality products.   Trader Joe's found success on the east coast through a careful and methodical expansion strategy, rather than rushing to open tons of new stores all at west.  It appears that See's will do the same.  The article mentions that See's uses pop-up stores to test new locations before committing to a new store.  That makes a great deal of sense too. 

Still, the company will face challenges.  On the west coast, the firm generates a great deal of revenue through on-line and phone orders.  The stores help build the brand, and they encourage people to try the product.  Yet, the company depends on on-line sales to achieve strong profitability.  It will need to do the same on the east coast, but without the long-time customers who know the firm well and have been ordering particular chocolates by phone or on-line for years.

One final note: I learned in the article that Lucille Ball trained at See's plant for her famous chocolate factory scene on the hit show, I Love Lucy.  Here's that classic clip:

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Bouncing Back Productively from Vacation

I've just returned from a fantastic 11-day trip to France with my family, and therefore, I thought it would be very appropriate today to blog about strategies regarding the return to work after vacation.   Lydia Dishman has a terrific article on the subject at Fast Company's website.   Specifically, I thought she had several good tips related to email.   She cites several executives who recommend using the long airplane trip home or the evening before the first day back at work to chug through all those emails that accumulated while you were gone.   Second, Dishman describes a tip from Andrea Wasserman, an executive at Nordstrom.  Wasserman explains that one should take time after a vacation to "ask yourself some honest questions about your tasks and to-do list. 'What activities started to creep into your work day that aren’t a high return on impact or aligned to your strategic goals?'"  Finally, Wasserman also recommends trying to capture the key insights or ideas that came to mind as one relaxed on vacation.  Get those thoughts down on paper before they slip your mind! 

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Taking Best Buy Private

The Wall Street Journal reports this morning on Best Buy founder and ex-Chairman Richard Schulze's plans for the struggling electronics retailer.  As you probably know, Schulze hopes to take the company private.  The paper reports that Schulze "envisions a turnaround plan for the electronics retailer that involves cutting prices to better compete against Amazon and other online retailers while ensuring that the in-store customer-service experience is as good as Apple's according to people familiar with the matter."   Naturally, such a plan to lower prices, while not reducing costs aggressively, will shrink profit margins.

We need to know much more about this turnaround plan before being able to evaluate its prospects thoroughly. However, this initial news has not put investors and analysts at ease (understandably).   The Wall Street Journal cites skepticism from Sanford Bernstein's retail analyst Colin McGranahan, who says, "As long as the top line is slowing you have to cut costs at a similar rate or your cash flow starts to suffer." 

Beyond the simple math problem cited by McGranahan, the strategy may be flawed.  Schulze appears to be trying to compete on price, while offering a premium experience a la Apple.  However, we know that Apple achieves that premium experience by spending generously on branding, training, design, and the like.  There is no free lunch.    They make up for higher costs in some areas by charging premium prices.   Schulze appears to want that premium experience, but if he doesn't get strong pricing, how will he generate decent profits?  The risk here is clear.  Could Best Buy end up stuck in the middle?   They might not have the cost structure to compete with Amazon, nor the premium image and experience to compete effectively with Apple. 

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