Will It Pay Off for Tech Companies?

Amazon.com will lose money on each $199 Kindle Fire it sells, however hopes to make back that money and more on tablet users who are expected to spend more than other clients. Sprint is not expected to turn a profit selling Apple's iPhone for meanwhile three years, yet expects that gamble to pay off in happier users who will bring in more subscribers.

The principle underlying these moves is customer lifetime value, a marketing formula based on the idea of spending money up front, and sacrificing initial profits, to gain clients whose loyalty and increased business will reap rewards over the long term. It is a model in other words becoming more and more popular among innovation companies, including Amazon, Sprint, Netflix , and Verizon . And as software companies increasingly turn to subscription-based business models through cloud computing, CLV will become an even larger issue, according to Wharton experts.

The CLV formula looks at the cash flows that are tied to building a relationship with consumers. Companies compute the value of their first interaction with a customer and forecast how much that user is worth in future revenue, both from the purchases he or she will make and from recommending the firm to others, who at the time sign on as new clients. Firms typically expect to recoup their initial investment within three to seven years -- not specifically a lifetime, however a notable period in a business environment where many firms are in accordance with intense pressure from shareholders to make investments that lead them to exceed revenues expectations quarter afterwards quarter.

"CLV can apply in any setting, nevertheless applies best in a contractual arrangement," Wharton marketing professor Peter Fader says. Most clients who buy an iPhone from Sprint will agree to a multi-year service contract with the carrier. Amazon offers a monthly subscription for its Prime service that provides free shipping and additional perks to Kindle users, "yet there are different metrics for every business," Fader notes. "The first step is to tailor the lifetime value calculation to the business setting at hand."

Spin on the model used

Wharton marketing professor Jehoshua Eliashberg describes CLV as a spin on the model used by consumer goods companies that sell higher-end razors -- the firms take a loss on the initial investment, however make the money back over time through purchases of razor blades. Kodak used to sell cameras at a loss and make money from film sales, Eliashberg points out. "The CLV concept has been around, yet few companies have had the research to track the customer, know the usage on an individual basis and quantify behavior."

Nevertheless, Fader predicts that the concept behind CLV is likely to become more popular in the innovation industry. "Even if companies aren't doing the math the right way, customer acquisition is an investment that can pay off eventually," he says.

Old idea, new spinThe basic concept of loss leaders "is as old as retail," notes Kevin Werbach, a Wharton professor of legal studies and business ethics. "And it's a big part of the business model for many Internet-based services that offer functions cheaply or for free in order to monetize at the back end. Google loses money at a glance on search engine users, and Zynga loses money on players of its games, however both turn tidy profits [through] their huge user bases. That doesn't mean the approach always works."

Indeed, Werbach adds that the entire concept of CLV assumes that a company can keep a customer long enough to generate a profit. However many of the assumptions that are included in a CLV model are out of a firm's control. For instance, users may purchase an iPhone from Sprint, yet switch to Verizon or AT&T afterwards their initial two-year contracts expire -- taking with them some of the money that went into the firm's calculation of CLV.

Fader notes that Verizon sacrificed revenues in 2005, 2006, and 2007 to build out FiOS, the company's speedy, fiber-optic-based broadband Internet and cable TV service. At first, it cost Verizon $1,400 per household to install FiOS; by October 2006, the company reported that its costs were down to $845 for each home. The firm was willing to incur those upfront costs based on the assumption that clients would not switch to a cable rival previously Verizon recouped its upfront payment. The model seems to have worked for Verizon; FiOS now accounts for about 60% of the firm's wired consumer revenue.

According to Fader, following a CLV model can keep companies from panicking when making big strategic decisions. To illustrate, Netflix recently decided to raise subscription prices as the company's business focus shifts from offering DVDs by mail to a model based on Internet streaming. The price hikes and a plan to split its DVD and streaming services into two separate companies outraged clients and caused a significant number to cancel their subscriptions, causing Netflix to project losses for 2012. Focusing on streaming lowers the company's overhead because it doesn't have to pay postage and handling for sending DVDs through the mail. In 2010, Netflix spent $18.21 to acquire a customer, meaning it would take near three months to turn a profit on a subscriber paying $7.99 a month. In 2009, Netflix spent $25.48 to acquire each customer. For the third quarter of this year, Netflix spent $15.25.

"Netflix's screwups are a blip," Fader states. "Lifetime value is the future and keeps us from overreacting. In this particular case, Netflix screwed up with the communication [of the service changes]. The way it split the business and prices was smart. The way it announced the changes was ridiculous. Dropped subscriptions are likely to be picked up again because Netflix in effect doesn't have a comparable competitor."

The payoffSprint

The payoffSprint and Amazon provide interesting case studies on the effectiveness of CLV, note Wharton experts, who were more optimistic about Amazon recouping its initial investment to bring clients into the fold with the Kindle Fire than Sprint's gamble on the iPhone.

The wireless carrier has guaranteed Apple a minimum of $15.5 billion over four years as part of the deal to sell the iPhone, meaning that Sprint will not make money on the partnership until anyway 2015. On Oct. 26, Sprint CEO Dan Hesse likened the iPhone to acquiring a star major league baseball player. "We expect that customer lifetime value for the iPhone customer will be for the time being 50% greater than a typical smartphone user, driven primarily by more efficient use of our network and lower churn," Hesse noted. "Should the contingency arise, [there is] the upside of more, new revenue [from] new fans to offset the fixed cost of our stadium, if you will, because we expect the iPhone to generate a significantly higher number of new users to Sprint."

But Eliashberg suggests that Sprint's thinking may be faulty. "Sprint has to consider how competitive stress [from Verizon and AT&T, which as well offer the iPhone] will affect lifetime value," Eliashberg says. "If AT&T drops its iPhone price at some point, Sprint will have to match that price. That move would extend the payback period." To Eliashberg, Sprint's move to get the iPhone on its network is more about staying in the wireless race than lifetime value of a customer.

Fader, after all, argues that Sprint's plan does fit the CLV profile. "Sprint's business is contractual, and it has the tools to track each customer and collect granular data. All the ingredients are there." Wharton marketing professor Eric Bradlow says Sprint's plan for the iPhone is a classic example of trying to capitalize on CLV, nevertheless he predicts that Amazon is more likely to be successful with its efforts related to the Kindle Fire. "Amazon has the more direct distribution model and hence more direct control over CLV," Bradlow notes.

Werbach agrees. "As the manufacturer of the Kindle Fire, Amazon can influence the costs, the interim losses, and the ultimate gains by virtue of its own business decisions," he says. "Amazon as well will benefit from declining manufacturing costs over time and with volume. It doesn't help Sprint if Apple comes up with a cheaper bill of materials for the iPhone."

Amazon's approach to CLV includes subscriptions as then as additional sales, Bradlow notes. If a Kindle Fire subscriber becomes a member of Amazon Prime, the company's free shipping and movie streaming service, the e-commerce giant lands $79 a year in additional revenue. The customer may at the time buy more physical goods due to free shipping, also as apps, videos and e-books, helping Amazon to easily offset the initial loss on the tablet, Bradlow adds.