Customer lifetime value (CLV)Customer lifetime value Share-of-wallet (SOW): at the aggregate level,...

Customer lifetime value (CLV)

Customer lifetime value

Outline▪ The concept of customer lifetime value

(CLV)

▪ Comparison of CLV with related metrics

▪ Analyzing CLV

▪ Extensions of CLV analysis

▪ Drivers of CLV

▪ Uses of CLV metrics


Customer lifetime value (CLV)

▪ the discounted cumulative cash flows that a

customer brings to the firm over the entire duration

of the relationship with the company (Kumar 2006);

▪ takes into account both revenues and costs and

emphasizes relationships, not transactions;

▪ allows firms to assess the true worth of customers

and to target their marketing efforts to the most

profitable customers;


Comparison of CLV with other metrics

▪ RFM method:

□ Recency: time since last purchase

□ Frequency: number of purchases within a given time

period;

□ Monetary value: average purchase amount per

transaction;

▪ How RFM is used:

□ Assign weights to R, F, and M and then calculate the

value of each customer; rank customers by value;

□ Only available for historical customer data;

□ Sensitive to the specification of the weights used;


Example RFM analysis

A

Purchase

number

B

R (months

since last

purchase)

C

R points

D

Weight

of R

E

Weighted

R points

F

F

G

F points

H

Weight

of F

I

Weighted

F points

J

M

K

M

points

L

Weight

of M

M

Weighted

M points

N

RFM

score

O

John 1 2 20 0.5 10 1 3 0.2 0.6 40 4 0.3 1.2 24.9

2 4 10 0.5 5 1 3 0.2 0.6 120 12 0.3 3.6

3 9 3 0.5 1.5 1 3 0.2 0.6 60 6 0.3 1.8

Jordan 1 6 5 0.5 2.5 2 6 0.2 1.2 400 25 0.3 7.5 11.2

Judy 1 2 20 0.5 10 1 3 0.2 0.6 90 9 0.3 2.7 30.4

2 4 10 0.5 5 1 3 0.2 0.6 70 7 0.3 2.1

3 6 5 0.5 2.5 2 6 0.2 1.2 80 8 0.3 2.4

4 9 3 0.5 1.5 1 3 0.2 0.6 40 4 0.3 1.2

R points:

=IF(C2<=2,20,IF(C2<=4,10,IF(C2<=6,5,IF(C2<=9,3,IF(C2<=12,1,0)))))

F points:

=G2*3

M points:

=IF(K2<=250,0.1*K2,25)


▪ Share-of-wallet (SOW):

□ at the aggregate level, it is the proportion of category

value accounted for by a brand or firm within a certain

base of buyers;

□ at the individual level, it is the proportion of category

value accounted for by a brand or firm within all

category purchases of the buyer;

▪ Example: Lisa spends $500 per month on groceries

and she spends $300 at Wegman’s. Wegman’s

SOW is what?

▪ Problem that good data on purchases of other

brands or at other stores are often hard to come by.


(cont’d)


▪ Past customer value (PCV): total contribution

toward present profits based on all past transactions

𝑃𝐶𝑉𝑖 =

𝑡=1

𝑇

𝐺𝐶𝑖𝑡 ∗ 1 + 𝑑 𝑡

□ GCit = gross contribution of the ith customer’s

transaction at time t

□ T = number of time periods prior to the current time

□ d = discount rate (e.g., 15% per year, 1.25% per

month)


(cont’d)


Example of PCV

Jan Feb Mar Apr May Total

Purchase amount 800 50 50 30 20 950

GC (purchase

amount x .3)240 15 15 9 6 285

Multiplier (1+d)^t 1.064 1.051 1.038 1.025 1.013

PCV 255.38 15.76 15.57 9.23 6.08 302.01

Bill has made regular purchases at Best Buy between

January and May. Assuming a gross margin of 30% and a

monthly discount rate of 1.25%, what is Bill’s PCV at the

end of May?

PCV is calculated for all customers and PCV scores are

used to prioritize customers.


How does CLV differ from

traditional metrics?

▪ RFM, SOW and PCV are backward looking and do

not take into account future revenues and future

costs of servicing customers (depending on how

long customers will be active) ;

▪ CLV takes into account the probability that a

customer will be active in the future and thus future

revenues as well as the costs of marketing to

customers in order to retain them;


Analyzing CLV

Assume that we have estimates of the average

contribution margin per customer per period (M); then

the average CLV of a customer is:

𝐶𝐿𝑉 =

𝑡=0

𝑇𝑀

1 + 𝑑 𝑡𝑟𝑡

□ r = constant rate of retention of customers per period

□ d = constant discount rate

□ t = time period

□ T = total number of time periods considered

This assumes there is no discounting in the first period

and all customers contribute in the first period.


Example CLV calculation

Margin per period: 120

Retention rate: 30%

Discount rate: 10%

Number of periods: 8

Year 1 2 3 4 5 6 7 8 CLV

Margin 120 120 120 120 120 120 120 120

Discounted Margin 120.00 109.09 99.17 90.16 81.96 74.51 67.74 61.58

Likelihood of retention 100.0% 30.0% 9.0% 2.7% 0.8% 0.2% 0.1% 0.0%

Discounted

Margin*likelihood120.00 32.73 8.93 2.43 0.66 0.18 0.05 0.01 165


Example CLV calculation in ME

Last period / Next period Active customers Lost customers

Active customers 30% 70%

Lost customers 0% 100%

Segments / Segment description

Number of customers

Gross marginsMarketing costs, next

period

Active customers 1 $120 $0

Lost customers 0 $0 $0


Customer Lifetime ValueContractual

Individual's customer lifetime value (discount rate 10%), per segment.

Segments / Segment descriptionNumber of customers

Gross marginsMarketing costs,

next periodCustomer lifetime

value

Active customers 1 $120 $0 $165Lost customers 0 $0 $0 $0

Customer Base's Lifetime Value

Customer base's lifetime value (discount rate 10%) and discounted net margins, over 8 periods.

Margins and costs / Periods

N+1 N+2 N+3 N+4 N+5 N+6 N+7 N+8

Gross margins $120 $36 $11 $3 $1 $0 $0 $0Marketing costs $0 $0 $0 $0 $0 $0 $0 $0Net margins $120 $36 $11 $3 $1 $0 $0 $0

Discount factor (10%) 1.00 0.91 0.83 0.75 0.68 0.62 0.56 0.51

Discounted net margins

$120 $33 $9 $2 $1 $0 $0 $0

Discounted net margins (cumulated)

$120 $153 $162 $164 $165 $165 $165 $165

Example CLV calculation in ME (cont’d)


Retention Rate (Active customers)

Retention rate of a customer currently in the "Active customers" segment.

Segments / Periods N+1 N+2 N+3 N+4 N+5 N+6 N+7 N+8

Active customers 1.00 0.30 0.09 0.03 0.01 0.00 0.00 0.00

Lost customers n/a 0.70 0.91 0.97 0.99 1.00 1.00 1.00

Example CLV calculation in ME (cont’d)


Analyzing CLV (cont’d)

▪ With certain simplifying assumptions, we can get a

general solution for CLV:

□ Constant contribution margin, discount rate and retention

rate

□ Infinite time horizon

𝐶𝐿𝑉 =

𝑡=0

∞𝑀

1 + 𝑑 𝑡𝑟𝑡 = M

1 + 𝑑

1 + 𝑑 − 𝑟

▪ Example: Margin per period = 120, d = .1, r = .3

𝐶𝐿𝑉 = 1201+.1

1+.1−.3=165


When does the customer pay?

Timing of

payments

Beginning of

period𝑪𝑳𝑽 = 𝑴

𝟏 + 𝒅

𝟏 + 𝒅 − 𝒓

End of period 𝑪𝑳𝑽 = 𝑴𝟏

𝟏 + 𝒅 − 𝒓

If customers pay at the beginning of the period, the

contribution margin for the first period does not have to be

discounted.

[assuming there is no churn during the first period]


When does the customer leave?


After next payment

(no churn during first period)

Before next payment

(already churn in first period)

𝑪𝑳𝑽 = 𝑴𝟏 + 𝒅

𝟏 + 𝒅 − 𝒓𝑪𝑳𝑽 = 𝑴

𝟏 + 𝒅 𝒓

𝟏 + 𝒅 − 𝒓

𝐶𝐿𝑉 = σ𝑡=0∞ 𝑀

1+𝑑 𝑡 𝑟𝑡 vs. σ𝑡=0

∞ 𝑀

1+𝑑 𝑡 𝑟𝑡+1

[assuming there is no discounting during the first period]


Four CLV formulas


After next payment Before next payment

When

does the

customer

pay?

Beginning

of period

𝑪𝑳𝑽 = 𝑴𝟏 + 𝒅

𝟏 + 𝒅 − 𝒓𝑪𝑳𝑽 = 𝑴

𝟏 + 𝒅 𝒓

𝟏 + 𝒅 − 𝒓

End of

period

𝑪𝑳𝑽 = 𝑴𝟏

𝟏 + 𝒅 − 𝒓𝑪𝑳𝑽 = 𝑴

𝒓

𝟏 + 𝒅 − 𝒓


Example: Comparing the four formulas



When

does the

customer

pay?

Beginning

of period165$ 50$

End of

period150$ 45$

Margin per period: 120

Retention rate: 30%

Discount rate: 10%


How to get these numbers in ME?



When

does the

customer

pay?

Beginning

of period

Do not apply discount

factor to period 1

Contractual

Do not apply discount

factor to period 1

Transactional

End of

period

Apply discount factor

to period 1

Contractual

Apply discount factor

to period 1

Transactional


In-class exercise

▪ Andrew is a regular customer at Otto’s brew pub in SC.

He usually goes there once a week and has 2 pints

(assume a price per pint of $5 and a gross margin for

Otto’s of 80%).

▪ Assume that Andrew will be in SC for five years (use 4

weeks per month and 48 weeks per year).

▪ Using month as the discount period and a monthly

discount factor of 1%, what is Andrew’s CLV to Otto’s?

▪ Repeat the calculations under various scenarios that

Andrew may not remain a loyal Otto’s customer.

Specifically, assume monthly retention rates of .99, .95,

and .90. What’s the likelihood that Andrew will still be a

customer after one year under these scenarios? How

does CLV change?


Extending CLV analysis

▪ Gross contribution margins GM (revenues minus

variable costs) and marketing or customer retention

costs RC (contact costs to retain customers, costs of

loyalty programs, etc.) can be considered separately;

▪ Margins and costs need not be constant over time;

▪ Customer acquisition costs (AC) can be considered:

□ Only applies to new customers

□ Free trial period, sign-up incentives, etc.

□ Acquiring customers can be expensive

𝐶𝐿𝑉 =

𝑡=0

𝑇𝐺𝑀𝑡 − 𝑅𝐶𝑡1 + 𝑑 𝑡

𝑟𝑡 − 𝐴𝐶


▪ Different customer segments may be considered

which have different contribution margins, marketing

costs, and retention rates

▪ This requires the specification of a switching matrix

which specifies the probability that a customer from

one segment will switch to a different segment in the

next period (including a lost-for-good customer

segment, from which there is no return)

Extending CLV analysis (cont’d)


CLV analysis for three segments:

Office Star data

Segment DescriptionSegment labels and number of customers currently in each segment.

Gross margins relate to current period, while marketing costs are anticipated expenses for next

period based on current segment membership.

Segments / Segment descriptionNumber of

customersGross margins

Marketing costs,

next period

Active Customers 12000 $90 $25

Warm Customers 4000 $0 $15

Cold Customers 3000 $0 $10

Lost customers 6000 $0 $0

Transition Matrix

Transition probabilities of customers from one segment to another across periods.

Each line sums up to 100%.

The very last segment represents customers who are assumed to be lost forever.

Last period / Next periodActive

Customers

Warm

Customers

Cold

CustomersLost customers

Active Customers 75% 25% 0%

Warm Customers 30% 70% 0%

Cold Customers 8% 92%

Lost customers 0% 0% 0% 100%


Customer Lifetime ValueTransactional

Individual's customer lifetime value (discount rate 15%), per segment.

Segments / Segment description

Number of customers

Gross margins

Marketing costs, next

period


Active Customers 12000 $90 $25 $138

Warm Customers 4000 $0 $15 $51

Cold Customers 3000 $0 $10 $7

Lost customers 6000 $0 $0 $0


Office Star data (cont’d)


Number Of Customers Per Segment

Simulations of number of customers per segment, over 20 periods.

Segments / Periods N+1 N+2 N+3 N+4 N+5 N+6 N+7 N+8

Active Customers 10440 8954 7667 6568 5626 4819 4128 3537

Warm Customers 3000 2610 2239 1917 1642 1407 1205 1032

Cold Customers 2800 2100 1827 1567 1342 1149 985 843

Lost customers 8760 11336 13268 14949 16390 17625 18682 19588



Customer base evolution (Enginius)

N N + 1 N + 2 N + 3 N + 4 N + 5 N + 6 N + 7 N + 8 N + 9 N + 10 ... Infinity

Active customers 12000 10440 8954 7667 6568 5626 4819 4128 3537 3030 2595 0

Warm customers 4000 3000 2610 2239 1917 1642 1407 1205 1032 884 757 0

Cold customers 3000 2800 2100 1827 1567 1342 1149 985 843 722 619 0

Lost customers 6000 8760 11336 13268 14949 16390 17625 18682 19588 20364 21029 25000

Total 25000 25000 25000 25000 25000 25000 25000 25000 25000 25000 25000 25000


Customer Base's Lifetime Value

Customer base's lifetime value (discount rate 15%) and discounted net margins, over 20 periods.


N+1 N+2 N+3 N+4 N+5 N+6 N+7 N+8 N+20

Gross margins $939,600 $805,860 $689,985 $591,083 $506,343 $433,748 $371,562 $318,291 $49,699

Marketing costs $390,000 $334,000 $284,000 $243,510 $208,609 $178,696 $153,076 $131,130 $20,475

Net margins $549,600 $471,860 $405,985 $347,573 $297,734 $255,053 $218,486 $187,161 $29,224Discount factor (15%)

0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.06

Discounted net margins

$477,913 $356,794 $266,942 $198,726 $148,027 $110,266 $82,137 $61,183 $1,786

Discounted net margins (cumulated)

$477,913 $834,707 $1,101,649 $1,300,375 $1,448,401 $1,558,667 $1,640,804 $1,701,988 $1,875,428



GM = GM per segment * # of customers per segment at N+1 (summed across all segments)

Marketing costs = Marketing costs per customer per segment * # of customers per segment at N

(summed across all segments)


Retention Rate (Active Customers)

Retention rate of a customer currently in the "Active Customers" segment.

Segments / Periods

N N+1 N+2 N+3 N+4 N+5 N+6 N+7 N+8

Active Customers 1.00 0.75 0.64 0.55 0.47 0.40 0.34 0.30 0.25

Warm Customers n/a 0.25 0.19 0.16 0.14 0.12 0.10 0.09 0.07

Cold Customers n/a 0.00 0.18 0.13 0.11 0.10 0.08 0.07 0.06

Lost customers n/a 0.00 0.00 0.16 0.28 0.38 0.47 0.55 0.61




$0

$20

$40

$60

$80

$100

$120

$140

$160

Active Customers Warm Customers Cold Customers

Lif

eti

me V

alu

e

Lifetime Value per Segment


0

2000

4000

6000

8000

10000

12000

N+1 N+2 N+3 N+4 N+5 N+6 N+7 N+8 N+9 N+10N+11N+12N+13N+14N+15N+16N+17N+18N+19N+20

Period

Number of Customers per Segment

Active Customers

Warm Customers

Cold Customers


0

100000

200000

300000

400000

500000

600000

700000

800000

900000

1000000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

Period

Profits and Costs


Gross margins

Marketing costs

Net margins


Drivers of CLV

▪ If CLV is calculated for individual customers, the

drivers of CLV can be investigated;

▪ Previous research has identified various

determinants of CLV:

Driver Measure Impact

Spending level Average monthly spending +

Cross-buying # of different product categories purchased +

Focused buying Purchase within one category only -

Loyalty instrument Customer’s participation in a loyalty program +

Mailing efforts # of mailings by the company +

income Customer’s income +

Reinartz and Kumar (2003)


Benefits of using CLV metrics

▪ the most profitable customers can be selected for special

retention efforts (not necessarily those generating the

most revenue, those who have been with the company

the longest, etc.)

▪ customers can be grouped into segments based on their

CLV and the segments can then be profiled using

various drivers of CLV

□ Cross-classify CLV with relationship duration

□ Cross-classify CLV (future profitability) with PCV (historical

profits)

▪ resource allocation can be optimized based on the

responsiveness of customers to marketing contacts

▪ new prospects can be targeted based on profiles that are

similar to existing high CLV customers


Segmentation by CLV and relationship

duration

Butterflies

Aim for transactional

satisfaction

True Friends

Establish attitudinal

and behavioral

loyalty

Strangers

Minimize investment

in these customers

Barnacles

Measure size and

share of wallet; if

SOW is low, cross-

sell, otherwise

control costs

Low

relationship duration

High

relationship duration

High

CLV

Low

CLV

(Kumar 2006)


Rising Stars

Invest to deepen

relationship

True loyalists

Invest to

nurture/defend/

retain

Total misfits

No relationship

investment

Falling angels

Optimize (minimize)

marketing costs

Low

PCV

High

PCV

High

CLV

Low

CLV

Segmentation by past and future profitability

(Kumar 2006)


Review: CLV

A cell phone provider has acquired 10,000 new customers

who have decided to sign up for unlimited cell phone

service for at least one year for a monthly fee of $80. The

variable costs of providing the service are $10 per customer.

Payment is due at the end of each month. What’s the net

present value of the profits from this customer base for the

first year? Assume a yearly discount rate of 12 percent.

What would we need to know to calculate the net present

value of the profits over five years?


Review: CLV

A catalogue marketer groups its customers into two

segments: premier and regular. There are 1000 customers of

each type. The contribution margins of the two segments are

$100 and $50, respectively.

The retention rates of premier and regular customers are

60% and 50%, respectively. Each period 30% of premier

customers become regular customers and 10% are lost

forever. Also, 10% of regular customers become premier

customers and 40% are lost forever.


Review: CLV


Computing the ROI of marketing investments

▪ Assume that without a certain marketing investment gross

profit is $100,00, whereas with the investment it is $200,000

(where the investment of $50,000 has not been considered in

the gross profit calculation):

𝑀𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔 𝑅𝑂𝐼 =𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔

▪ Assume that without a certain marketing investment gross profit is

$100,00, whereas with the investment it is $150,000 (where the

investment of $50,000 has already been subtracted from the initial

gross profit):

𝑀𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔 𝑅𝑂𝐼 =𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑣𝑎𝑙𝑢𝑒

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔

Customer lifetime value (CLV)Customer lifetime value Share-of-wallet (SOW): at the aggregate level,...

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Transcript of Customer lifetime value (CLV)Customer lifetime value Share-of-wallet (SOW): at the aggregate level,...