Published: December 07, 2011 in Knowledge@Wharton

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

The principle underlying these moves is customer lifetime value (CLV), a marketing formula based on the idea of spending money up front, and sacrificing initial profits, to gain customers whose loyalty and increased business will reap rewards over the long term. It is a model that is becoming more and more popular among technology 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 then sign on as new customers. Firms typically expect to recoup their initial investment within three to seven years -- not exactly a lifetime, but a notable period in a business environment where many firms are under intense pressure from shareholders to make investments that lead them to exceed earnings expectations quarter after quarter.

"CLV can apply in any setting, but applies best in a contractual arrangement," Wharton marketing professor Peter Fader says. Most customers 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, "but 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."

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, but 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, but few companies have had the technology to track the customer, know the usage on an individual basis and quantify behavior."

Yet technology companies that deliver services over digital networks and websites have the ability to collect data about how and where consumers are using their services. For example, Amazon provides product recommendations based on a user's purchase history and that of those with similar habits. On Amazon's most recent earnings conference call, chief financial officer Tom Szkutak noted that, since launching the Kindle e-reader, the company has observed that those who own the device also purchase more content, such as e-books or web applications, from the company.

But Wharton experts warn that CLV is not always a winning proposition. Firms may find it difficult to collect and aggregate the data they need to make accurate predictions, and their assumptions about consumer habits from that information could easily turn out to be wrong. "We're at this weird 'Y' in the road where companies are going in different directions. There are no standards on how CLV is calculated and what needs to be reported," Fader says. "We need better standards to make CLV more uniform and give it legitimacy."

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

Old Idea, New Spin

The 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 first on search engine users, and Zynga loses money on players of its games, but 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. But many of the assumptions that are included in a CLV model are out of a firm's control. For example, users may purchase an iPhone from Sprint, but switch to Verizon or AT&T after 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 earnings in 2005, 2006 and 2007 to build out FiOS, the company's speedy, fiber-optic-based broadband Internet and cable TV service. Initially, it cost Verizon $1,400 a 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 customers would not switch to a cable rival before 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. For instance, 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 (which was ultimately aborted) to split its DVD and streaming services into two separate companies outraged customers 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 nearly 3 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 really doesn't have a comparable competitor."

According to Fader, companies should make several bets based on CLV and assume that some will fail. "Some companies will see their first disaster and give up. You need to take the good with the bad."

The Pay Off

Sprint 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 customers 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 at least 2015. On October 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 at least 50% greater than a typical smartphone user, driven primarily by more efficient use of our network and lower churn," Hesse noted. "In addition, [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 also 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, however, 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, but 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 also 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 well 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 then buy more physical goods due to free shipping, as well as apps, videos and e-books, helping Amazon to easily offset the initial loss on the tablet, Bradlow adds.

Research firm IHS iSuppli estimates that the cost of the materials to produce Amazon's Kindle Fire is $201.70. Other analysts indicate that Amazon is losing money on every Kindle Fire sold, but disagree on the exact hit to its bottom line. "A new purchaser of the Kindle Fire is worth more to Amazon than the profit made on the initial hardware," says Wharton operations and information management professor Karl Ulrich. "That purchase may represent a lost sale of Barnes & Noble's Nook, and incrementally more sales of books from the Kindle store."