LTV Enhances Short-Term Benchmark
Though response rate long has been adopted to assess DM effectiveness, this ratio scarcely exploits profitability if not compared with a breakeven rate: the minimum response rate to recoup expenses for the advertisement and merchandise.
Breakeven rate can be defined as either a short-term or long-term benchmark depending on how you address marketing objectives. The former focuses on upfront net balance tied solely to an initial campaign while the latter looks upon an entire direct marketing mix from acquisition to retention programs.
Because retaining customers is usually more profitable than acquiring new ones, few DMers can succeed by ignoring long-term benefits. A long-term breakeven rate provides an insightful benchmark to evaluate a marketing initiative, which lets marketers confidently pursue overall profitability as a strategic whole.
A customer lifetime value is broadly applied to determine a long-term profitability, where future net contributions in dollars are computed from each campaign and then accumulated over time. The following analysis will derive an actionable formula that simply converts a short-term breakeven rate into a long-term rate while embedding a lifetime value principle.
Let's begin with a tough yet common situation in direct marketing. An acquisition response rate falls below a short-term breakeven rate. Should this marketing initiative be abandoned? Not before considering lifetime value.
The challenge is how to establish a link between lifetime value measured in dollars and breakeven rate in arithmetic ratio, which lets us migrate a short-term breakeven rate to a long-term breakeven rate. To settle this critical issue in a practical manner, we will use a real-world example.
In this case, a test with 50,000 mail pieces acquires 1,000 respondents, an initial response rate of 2 percent. This acquisition effort generates $22,000 as gross sales margin (total sales amount after merchandise costs). Accordingly, a unit (or invoice) margin on average equates to $22. If each mail piece costs 51.3 cents, this test costs $25,650 for running the ad. Because the sales volume for breakeven must be at least 1,166, the short-term breakeven rate is therefore obtained as 2.33 percent.
In the example, the 1,000 responses are 166 short of breakeven, which in turn causes an upfront loss overhead of $3.65 [($22,000 minus $25,650) divided by 1,000]. The 2 percent response rate underperforms the short-term breakeven rate of 2.33 percent. Direct marketers in this scenario have difficulty deciding whether to continue, but a long-term breakeven rate engaged on lifetime value provides convincing support and allows a more informed decision.
We will assume historical data tracked across multiple campaigns yield a customer lifetime value of $6.49 in its present value. An overall marketing mix, including initial acquisition and follow-up retention efforts, is better off by $2.84 overhead. You pay $3.65 for now and earn back $6.49 later. To break even in the long haul, you can afford no more than $6.49 to acquire a new customer. This is the starting point for developing a long-term breakeven rate.
According to the lifetime value principle, future net contributions overhead (i.e., lifetime value) should be fully credited to the initial acquisition cost overhead, which consequently translates a short-term breakeven into a long-term breakeven.
Reps = initial responses for reaching a long-term breakeven (i.e., long-term BE)
BE = regular or short-term breakeven
Margin = Unit margin by invoice
Thus, the current deficit, (Reps - BE) * Margin, should be balanced by the future surplus (Reps * lifetime value).
(Reps - BE) * Margin + (Reps * lifetime value) = 0
Solving this equation for Reps,
Reps = (BE * Margin) / (Margin + lifetime value) ...... (1)
Response rate virtually resembles a long-term breakeven in conjunction with lifetime value contribution. In other words, equation (1) reveals how lifetime value adds to a short-term bottom line, in which a long-term breakeven becomes smaller than a short-term breakeven if lifetime value > 0 (with a positive contribution) or larger than a short-term breakeven if lifetime value < 0 (with a negative contribution). A long-term breakeven equals a short-term breakeven if lifetime value = 0, meaning no additional profit is made through customer retention efforts.
Recall, at the first-round campaign, you never know the difference between a long-term breakeven rate and a short-term breakeven rate until lifetime value study is undertaken. As such, a decision maker cannot but count on the short-term breakeven rate (2.33 percent), with which profit sacrifices and strategic damages could be the results.
Now, let's see how lifetime value enhances this short-term benchmark. Plugging lifetime value ($6.49) and other relevant data into equation (1):
Long-term BE = (1,166 * $22) / ($22 + $6.49) = 900
Thus, long-term breakeven rate = long-term BE / Mailings = 900 / 50,000 = 1.8 percent, which is significantly smaller than the short-term breakeven rate of 2.33 percent. With the statistical comparison between the initial response rate (2 percent) and the long-term breakeven rate (1.8 percent), this marketing initiative should be appreciably adopted in favor of a long-term profitability. As illustrated in the figure at right, DMers can strategically leverage marketing opportunity potential by switching a short-term (2.33 percent) to a long-term benchmark (1.8 percent).
This is how lifetime value alters the character of a business, lets you continuously view it as a strategic whole and stimulates possibilities that may be obscured by present accounting methods.