You think personalization is a sure-fire way to increase profits? It might be. After all, it costs less to keep a customer than to attract one in the first place. But sometimes numbers can be misleading. Cliff takes a closer look at the tale they tell.
It’s commonly thought that investing in loyalty-building features such as personalization is a sure-fire way to increase profits. This is because it costs less to keep a customer than to attract one in the first place. However, a deeper look into the economic value of web site enhancements might have you changing your priorities.
The process of deciding to invest in improving a web site is difficult. Generally, there is agreement that increasing customer satisfaction leads to increased customer retention. But the difficult question facing marketers is how to accomplish this so it has a positive effect on the bottom line.
Many times managers consider very different approaches, so they turn to using a cost-benefit analysis to compare proposals.
While the concept of cost-benefit analysis is simple benefits should be larger than costs it is sometimes difficult to calculate the costs and projected benefits. This is because the increased profits from enhancing a web site normally occur over a long period of time, which requires making projections about future revenue and expenses.
One of the metrics used today when dealing with the benefits of enhancing a web site is customer lifetime value. This can be calculated by multiplying the typical profit per sale by the average number of orders each customer will place over the next few years. This gives an idea of how much a customer is worth. But it doesn’t take into account the fact that profits received several years from now are not as valuable as the same profits received this year.
While compound interest for a savings account increases the amount in the future, receiving money in the future has the opposite effect. The concept called “time value of money” says that money received in the future is worth less today because of interest and risk.
Using the present value of future profits to calculate the value of customers produces a more accurate estimate of the true value of the investment.
This is done by first calculating the present value of the increased profits expected to be received over the next few years. Then, compare the present value of increased future profits to the cost of enhancing the web site to achieve those profits. If the present value of future profits is higher than the costs today, it’s likely that the investment will pay off.
For example, assume a marketing manager has two proposals to add personalization to the company’s site.
The first plan calls for investing $1 million to achieve almost $2 million in profits over the next five years:
|
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
|
Number of New Customers
|
2,000
|
5,000
|
12,000
|
18,000
|
25,000
|
|
Number of Orders Per Year
|
2.0
|
3.0
|
4.0
|
4.5
|
5.0
|
|
Average Profit/Order
|
$4
|
$5
|
$6
|
$7
|
$8
|
|
Additional Profit
|
$16,000
|
$75,000
|
$288,000
|
$567,000
|
$1,000,000
|
The second plan calls for investing $100,000 to receive $345,000 over the same five years:
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
|
| Number of New Customers |
1,000
|
2,000
|
3,000
|
4,000
|
5,000
|
| Number of Orders Per Year |
2.0
|
2.5
|
3.0
|
3.5
|
4.0
|
| Average Profit/Order |
$4
|
$5
|
$6
|
$7
|
$8
|
| Additional Profit |
$8,000
|
$25,000
|
$54,000
|
$98,000
|
$160,000
|
Without considering the time value of money, it would appear that the first plan would be better.
But don’t try to sell that idea to a CFO!
Although the first plan appears to be the better plan, when the Net Present Value calculator in Microsoft Excel is used to adjust for the time value of money, the picture changes. The second plan actually will produce a positive value compared to the loss from the first plan:
|
Plan 1
|
Plan 2
|
|
| Total Profit Increase |
$1,946,000
|
$345,000
|
| Net Present Value of Profit |
$907,000
|
$167,000
|
| Cost of Implementation |
$1,000,000
|
$100,000
|
| Net Gain (Loss) |
($93,000)
|
$67,000
|
These two examples use very different costs and benefits to illustrate how the time value of money can affect decisions. But they resemble some of the economic evaluations we’ve seen as companies look for justification to spend millions of dollars to enhance their web operations.
Of course, economics are just one part of the decision-making process. Many times the nontangible factors, such as customer goodwill and distribution channel support, should be considered along with an economic analysis.
When it comes to making decisions about online marketing, combining economic analysis with experience leads to the best decisions possible in this uncertain world.
