Customer Information Strategy – Professor Dominique Hanssens. Case Submission #1 – October 8, 2010 Study Group #5: Justin Cohen, Doug Daly, Kevin Morra, Brent Morrison, Nancy Sagar
Northern Aero: Maximizing Customer Equity When Jannick Jorgensten became Northern Aero’s Chief Marketing Officer in 2005, his predecessor David Vlock shared what he thought were words of wisdom. “Customers are not loyal anymore,” Vlock said. “It just costs too much money to keep customers loyal today.” Why did Vlock utter these negative prophesies? First, it was a difficult time for the industry. Demand for airline travel had weakened; new competition had appeared, and the internet forced airlines to compete on price. These factors squeezed margins and forced many airlines into the red. Northern Aero’s strategy was to differentiate on service that would build customer loyalty, but the company didn’t have the tools to measure the long-‐term impact of their loyalty investments. As a result, senior management was nervous about making sizeable cash investments today, when the benefits of customer loyalty was so uncertain amidst the volatility. THE CHALLENGE: In this exercise, we address this uncertainty by collecting and analyzing Northern Aero’s data to confidently answer three critical questions: 1. LOYALTY BUDGET: In order to maximize the lifetime value of the customers the airline has already acquired, how much should they spend on customer loyalty & retention? 2. ALLOCATION: How should they segment their customers and allocate their budget among the segments to generate the greatest returns? 3. PERFORMANCE METRICS: How should they determine the return on their loyalty investments, and how do they tie those investments to shareholder value? Study Group 5
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STEP 1: MEASURE CLV AND CUSTOMER EQUITY UNDER THE STATUS QUO Our first step: calculate the value of the current customer base under the existing loyalty program structure and costs. Note that these loyalty program costs don’t include investments that the company considers to be “costs of doing business” that customers expect and demand (such as the platinum lounges). Instead, the program cost figures include only incremental expenses that the company feels they can eliminate if Northern Aero retreats from its loyalty positioning and competes on price leadership. Exhibit A shows the customer lifetime value (which deducts the costs of the loyalty program) for each of Northern Aero’s current segments with a 15% discount rate. An active customer in the most valuable segment, “platinum top 20%”, is worth $3,938 , and the values step down to $167 for “silver low 80%”. Using the CLV figure for each segment, we calculate the economic value of the current customer base by multiplying the CLV for each segment by the segment’s size, and then sum the value of all segments. Total value of customer database with today’s loyalty program: $16,645,319 (shown in Exhibit B).
VOLATILITY AFFECTS CUSTOMER EQUITY AND FIRM BEHAVIOR When different functional areas or teams use inconsistent discount rates or time horizons in their analyses, misalignment and poor decisions can occur. In industries with high volatility and/or very long customer lifetimes (like the airline business), managers may end up with very different metrics that lead to dramatically different decisions.
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For example, by increasing the discount rate from 15% to 40%, Northern Aero sees a 33% drop (from $16.645M to $11.141M) in total customer equity. We can also look at the drop in equity by segment during the 20-‐period projection:
Platinum (low 80%)
Customer equity, Customer equity, 15% discount rate 40% discount rate Difference ($) $ 787,573 $ 627,419 $ (160,154) $ 2,150,538 $ 1,658,738 $ (491,800)
Gold (top 20%)
$ 1,742,019
$ 1,295,535
$ (446,485)
-‐25.6%
Gold (low 80%)
$ 3,682,223
$ 2,599,384
$ (1,082,839)
-‐29.4%
Silver (top 20%)
$ 3,049,827
$ 1,957,013
$ (1,092,814)
-‐35.8%
Silver (low 80%)
$ 4,441,056
$ 2,531,602
$ (1,909,454)
-‐43.0%
Inactive customers
$ 792,082
$ 471,871
$ (320,211)
-‐40.4%
Lost customers
$ -‐
$ -‐ $ -‐
Total
16,645,319
$ 11,141,562
-‐33.1%
Segments Platinum (top 20%)
$ (5,503,757)
Difference (%) -‐20.3% -‐22.9%
The largest drop in value is in the Silver segment, since customers trickle from Platinum to Gold to Silver. Thus, the Silver category continues to have customers longer than Platinum or Gold. This value is spread farther into the future, so it gets discounted more heavily when we use a discount rate of 40% versus 15%. When the future is uncertain, as may be the case in the airline industry (for example due to volatile fuel prices or more frequent terror threats), managers may rightly lose confidence in the accuracy of the model as we move farther into the future. Using a higher discount rate such as 40% would build in the future uncertainty into the model and therefore incent Northern Aero to take a more short-‐term rather than long-‐term view of its customer loyalty program. As a result, Jorgensten would invest only in the most profitable customer loyalty activities: spending more on keeping the top “Platinum” customers happy and virtually firing the low “Silver” and “Inactive” customers. Though this would increase the program’s ROI, it would come at the expense of long-‐term growth.
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STEP  2:  CALCULATE  ROI  &  IRR  The  loyalty  program  is  an  investment  which  generates  incremental  profits  in  the  years  to  come.   We  can  assess  the  usefulness  of  this  investment  in  many  ways,  but  we’ve  chosen  two  methods:   1. Calculating  a  simple  ROI  over  a  twenty  year  period,  or  2. Calculating  Internal  Rate  of  Return  for  the  program.    First,  the  formula  for  calculating  ROI  is  đ?‘…đ?‘‚đ??ź = Â
!"#$%&' !"#$#
.   To  calculate  PROFITS,  we  can  look  at  the Â
difference  in  profits  between  the  current  loyalty  program  and  the  estimated  profits  of  having  no  program  at  all.   We  do  this  across  twenty  periods,  generating  a  profit  value  for  each  year.   We  then  discount  the  profits  back  to  the  present  value  and  get  a  single  present  value  of  the  profits  of  the  program.   This  is  our  PROFIT  figure.    Next,  for  COSTS,  we  can  look  at  the  actual  costs  to  run  the  program  for  each  segment  for  each  year.   We  can  compute  this  by  multiplying  the  cost  per  segment  by  the  number  of  customers  in  that  segment  for  that  year.   We  then  have  the  cost  per  year  for  each  of  the  twenty  years  analyzed.   Next,  we  discount  those  costs  back  to  the  present  value  and  come  up  with  a  single  present  value  for  the  costs  of  the  program  –  this  is  the  denominator  in  the  ROI  equation.  Using  this  methodology,  we  calculate  an  ROI  of  386%  for  the  program  as  shown  in  Exhibit  C  Our  second  method  is  Internal  Rate  of  Return  (IRR),  since  we  can  consider  the  program  as  an  annuity  for  which  we  pay  up  front  and  receive  a  stream  of  cash  flows.   The  IRR  calculation  allows  us  to  compare  this  investment  to  other  potential  uses  of  capital.   Â
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For the cost in the IRR calculation, we use the same cost we computed for the ROI calculation (that is, the present value of all the costs). Next we simply use the undiscounted values of each of the cash flows over the next twenty years to compute the resulting IRR. Result: the IRR for this program is 109% (Exhibit C). In cases like this, it’s valuable to calculate multiple metrics as a check-‐and-‐balance. For example, Northern Aero could be comparing the loyalty program investment against others such as customer acquisition or a capital investment. The company must ensure that they are using the same metrics and methodologies to compare different investments – for example, not mixing up ROI and IRR or using different costs or profit measurements.
STEP 3: OPTIMIZE ZENITH shows how prioritizing the most profitable segments of the customer database yields a much higher overall CLV even with a program budget cut from $655,400 to $560,100. ZENITH recommends cutting the loyalty program for the “silver low 80%” segment altogether, then increasing the investment for the rest of the segments, all of which deliver greater CLV. Their biggest increases are for the “gold top 20%” segment (196% increase in loyalty investment) and the “platinum top 20%” (140% increase). The result: By spending on the most valuable customers, ZENITH’s recommendation improves retention rates in those segments, which garners much greater loyalty program ROI. While over time, due to greater customer retention, the total cost of the loyalty program budget increases over the current program, we get a huge boost to the total customer equity. The improved allocation boosts total customer equity to $21,651,539. We see the impact on equity per segment below:
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Platinum (top 20%)
Number of customers 200
Platinum (low 80%)
800
$2,145
$2,688
$4,065
Gold (top 20%)
1100
$1,100
$1,584
$2,510
Gold (low 80%)
4300
$430
$856
$1,090
Silver (top 20%)
6800
$86
$449
$548
Silver (low 80%)
26600
$16
$167
$191
Inactive c ustomers
18200
$2
$44
$48
0
$0
$0
$0
Segments / Segment description
Lost c ustomers
Gross margins
CLV Original
CLV Total Value Optimized Original
$4,410
$3,938
$6,427
$787,573 $2,150,538 $1,742,019 $3,682,223 $3,049,827 $4,441,056 $792,082 $0 $16,645,319
Total Value Optimized
$1,285,395 $3,251,928 $2,760,600 $4,687,430 $3,725,944 $5,069,135 $871,107 $0 $21,651,539
OUR RECOMMENDATION: PROCEED! ZENITH’s analysis is sound and we would absolutely proceed with this recommendation. The board should be thrilled that we are increasing total customer equity 78% (from $6,311,759 to $11,033,788) merely by shifting our investments from low-‐value to higher value customer segments. There is no short term downside and the long term gains are substantial. In addition, by calculating the ROI and IRR for the optimized program, we can give the board an objective quantitative view of what the loyalty program will return and they can therefore compare it to other investment opportunities to make investment decisions. The ROI for the optimized program is now 477% and the IRR is now 117% (Exhibit D), again supporting our recommendation to move forward with this plan.
ONGOING MANAGEMENT STRATEGIES Just by creating these models, Northern Aero has learned more than just “our customers are different”. They now know how different they are in terms of revenues and profits. As a result, they can make educated decisions on how to allocate their loyalty program dollars and gain a firm grasp on their
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expected ROI. If the ROI was low, they could perhaps use the money more effectively in other projects (such as further automating the flight process). However, if the ROI is high, they may decide to increase the program budget. Going forward, there are numerous tactics Northern Aero could use to improve the loyalty program, its measurement, and their total customer equity: 1. Improve customer acquisition investments. Northern Aero can use CLV to improve targeting in customer acquisition campaigns, and they can compare CLV for customers acquired via different marketing campaigns to better allocate their acquisition budget. 2. Evaluate the acquisition budget: Many companies overinvest in acquisition and underinvest in retention. Yet as long as CLV is still positive after the acquisition costs are deducted, the firm is still better off acquiring new customers. Without that long-‐term view, it is impossible to measure the true ROI of an acquisition campaign. And without a solid model, management decisions are more susceptible to external influences beyond the marketers’ control. For example, terrorist attacks that depress demand across the industry could cause the firm to stop investing in acquisition efforts if they only measure the ROI on a short-‐term basis. 3. Develop more sophisticated segmentation strategies based on behavioral data, length of segments flown, or profitability, then start tracking data for those segments. They can then experiment with their investments in different segments and compute the impact on retention, total customer equity and ROI for the program. By building a model using these prospective segments and testing various loyalty investment levels, Northern Aero can determine whether it an alternate segmentation strategy will improve these key metrics beyond the gains made through the ZENITH recommendations.
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4. Run experiments and measure actual transition rates instead of relying on survey data and simulations to predict a transition matrix. Plugging those actual values back into the model will yield more accurate predictions.
KEY LESSONS David Vlock’s “It just costs too much money to keep customers loyal” proclamation was borne from an inability to quantity the true impact of his marketing team’s investments. Fortunately, Northern Aero’s future is far brighter than he imagined, and this case offers two critical lessons: 1. TIMING IS EVERYTHING: If a company takes a short-‐term view, projected ROI can be considerably lower, and the company misses the opportunity to understand how improvements in retention rates in early years will impact total long-‐term customer equity. 2. ALLOCATION MATTERS: Loyalty programs are expensive if they’re not invested in the most profitable customer segments. In this case, Northern Aero stands to reap significant ROI gains by investing proportionally more funds into the Gold 20% and Platinum 20% segments and dropping the Silver 80% altogether. This analysis lets them spend less, generate greater ROI/IRR and boost customer equity; establishing the proper segmentation strategy and loyalty allocation structure is the key.
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Exhibits EXHIBIT A: CLV BY SEGMENT at 15% discount rate
Customer Lifetime Value
Northern Aero: Current CLV by Segment $4,500 $4,000 $3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0
$3,938 $2,688 $1,584 $856
Platinum (top 20%)
Platinum (low 80%)
Gold (top 20%)
Gold (low 80%)
$449 Silver (top 20%)
$167
$44
Silver (low 80%)
Inactive customers
Existing customer segment definitions
EXHIBIT B: TOTAL CUSTOMER EQUITY AT 15% DISCOUNT RATE Segments / Segment description
Number of customers
Platinum (top 2 0%)
200
Platinum (low 8 0%)
800
Gold (top 2 0%)
1100
Gold (low 8 0%)
4300
Silver (top 2 0%)
6800
Silver (low 8 0%)
26600
Inactive c ustomers
18200
Lost c ustomers
0
Customer lifetime value $3,938
Total Value
$787,573 $2,150,538 $1,584 $1,742,019 $856 $3,682,223 $449 $3,049,827 $167 $4,441,056 $44 $792,082 $0 $0 Total Value $16,645,319 $2,688
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EXHIBIT C: CURRENT LOYALTY PROGRAM ROI & IRR AT 15% DISCOUNT RATE Year Current Program No Program Current Program Gain/Loss of Program Program Costs DCF's IRR PV of Costs PV of Gain ROI
0
1
2
3
4
5
$7,297,040 $6,641,640
$4,777,575 $5,921,711
$2,998,957 $4,844,622
$1,775,869 $3,680,364
$1,017,674 $2,670,538
$569,846 $1,876,837
-‐$655,400 $655,400 ($1,636,310) 109% $1,636,310 $6,311,759 386%
$1,144,135 $443,735 $1,587,870
$1,845,665 $314,712 $2,160,377
$1,904,495 $221,408 $2,125,903
$1,652,864 $153,368 $1,806,232
$1,306,992 $104,623 $1,411,615
EXHIBIT D: ROI AND IRR UNDER NEW OPTIMIZED PLAN Year Optimized Program No Program Optimal Program Gain/Loss of Program Program Costs DCF's IRR PV of Costs PV of Gains ROI
0
1
2
3
4
5
$7,297,040 $6,736,940
$4,777,575 $6,435,696
$2,998,957 $5,778,602
$1,775,869 $4,855,764
$1,017,674 $3,909,545
$569,846 $3,053,054
-‐$560,100 $560,100 ($2,313,043) 117% $2,313,043 $11,033,788 477%
$1,658,121 $566,441 $2,224,562
$2,779,645 $512,617 $3,292,263
$3,079,895 $432,240 $3,512,135
$2,891,871 $348,656 $3,240,527
$2,483,209 $272,648 $2,755,857
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