Customer lifetime value (CLV)

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;

R (months since last purchase) Example RFM analysis A Purchase number B R (months since last purchase) C R points D Weight of R E Weighted R points F G F points H Weight of F I Weighted F points J M K M points L Weight of M Weighted M points N RFM score O John 1 2 20 0.5 10 3 0.2 0.6 40 4 0.3 1.2 24.9 5 120 12 3.6 9 1.5 60 6 1.8 Jordan 2.5 400 25 7.5 11.2 Judy 90 2.7 30.4 70 7 2.1 80 8 2.4 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)

Comparison of CLV with other metrics (cont’d) 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.

Comparison of CLV with other metrics (cont’d) Past customer value (PCV): total contribution toward present profits based on all past transactions 𝑃𝐶𝑉 𝑖 = 𝑡=1 𝑇 𝐺𝐶 𝑖𝑡 ∗ 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)

Example of PCV 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? Jan Feb Mar Apr May Total Purchase amount 800 50 30 20 950 GC (purchase amount x .3) 240 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 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 𝑇 𝑀 1+𝑑 𝑡 𝑟 𝑡 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 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*likelihood 32.73 8.93 2.43 0.66 0.18 0.05 0.01 165

Example CLV calculation in ME Segments / Segment description Number of customers Gross margins Marketing costs, next period Active customers 1 $120 $0 Lost customers Last period / Next period Active customers Lost customers 30% 70% 0% 100%

Example CLV calculation in ME (cont’d) Customer Lifetime Value Contractual Individual's customer lifetime value (discount rate 10%), per segment. Segments / Segment description Number of customers Gross margins Marketing costs, next period Customer lifetime value Active customers 1 $120 $0 $165 Lost customers 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 Marketing costs Net margins Discount factor (10%) 1.00 0.91 0.83 0.75 0.68 0.62 0.56 0.51 Discounted net margins $33 $9 $2 Discounted net margins (cumulated) $153 $162 $164 $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 Lost customers n/a 0.70 0.91 0.97 0.99

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 𝑡 𝑟 𝑡 =M 1+𝑑 1+𝑑−𝑟 Example: Margin per period = 120, d = .1, r = .3 𝐶𝐿𝑉= 120 1+.1 1+.1−.3 =165

When does the customer pay? If customers pay at the beginning of the period, the contribution margin for the first period does not have to be discounted. Timing of payments Beginning of period 𝑪𝑳𝑽=𝑴 𝟏+𝒅 𝟏+𝒅−𝒓 End of period 𝑪𝑳𝑽=𝑴 𝟏 𝟏+𝒅−𝒓 [assuming there is no churn during the first period]

When does the customer leave? 𝐶𝐿𝑉= 𝑡=0 ∞ 𝑀 1+𝑑 𝑡 𝑟 𝑡 vs. 𝑡=0 ∞ 𝑀 1+𝑑 𝑡 𝑟 𝑡+1 When does the customer leave? After next payment (no churn during first period) Before next payment (already churn in first period) 𝑪𝑳𝑽=𝑴 𝟏+𝒅 𝟏+𝒅−𝒓 𝑪𝑳𝑽=𝑴 𝟏+𝒅 𝒓 𝟏+𝒅−𝒓 [assuming there is no discounting during the first period]

When does the customer leave? Four CLV formulas When does the customer leave? After next payment Before next payment When does the customer pay? Beginning of period 𝑪𝑳𝑽=𝑴 𝟏+𝒅 𝟏+𝒅−𝒓 𝑪𝑳𝑽=𝑴 𝟏+𝒅 𝒓 𝟏+𝒅−𝒓 End of period 𝑪𝑳𝑽=𝑴 𝟏 𝟏+𝒅−𝒓 𝑪𝑳𝑽=𝑴 𝒓 𝟏+𝒅−𝒓

Example: Comparing the four formulas Margin per period: 120 Retention rate: 30% Discount rate: 10% When does the customer leave? After next payment Before next payment When does the customer pay? Beginning of period 165$ 50$ End of period 150$ 45$

How to get these numbers in ME? When does the customer leave? After next payment Before next payment 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

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 𝑇 𝐺𝑀 𝑡 − 𝑅𝐶 𝑡 1+𝑑 𝑡 𝑟 𝑡 −𝐴𝐶

Extending CLV analysis (cont’d) 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)

CLV analysis for three segments: Office Star data Segment Description Segment 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 description Number of customers Gross margins Marketing costs, next period Active Customers 12000 $90 $25 Warm Customers 4000 $0 $15 Cold Customers 3000 $10 Lost customers 6000 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 period Active Customers Warm Customers Cold Customers Lost customers 75% 25%   0% 30% 70% 8% 92% 100%

CLV analysis for three segments: Office Star data (cont’d) Customer Lifetime Value Transactional Individual's customer lifetime value (discount rate 15%), per segment. Segments / Segment description Number of customers Gross margins Marketing costs, next period Customer lifetime value Active Customers 12000 $90 $25 $138 Warm Customers 4000 $0 $15 $51 Cold Customers 3000 $10 $7 Lost customers 6000

CLV analysis for three segments: 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 Warm customers 4000 3000 2610 2239 1917 1642 1407 1205 1032 884 757 Cold customers 2800 2100 1827 1567 1342 1149 985 843 722 619 Lost customers 6000 8760 11336 13268 14949 16390 17625 18682 19588 20364 21029 25000 Total

CLV analysis for three segments: Office Star data (cont’d) Customer Base's Lifetime Value Customer base's lifetime value (discount rate 15%) and discounted net margins, over 20 periods. Margins and costs / 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 $29,224 Discount 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) $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)

CLV analysis for three segments: Office Star data (cont’d) 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 0.19 0.16 0.14 0.12 0.10 0.09 0.07 Cold Customers 0.00 0.18 0.13 0.11 0.08 0.06 Lost customers 0.28 0.38 0.61

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 Low relationship duration High 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 High CLV Low CLV (Kumar 2006)

Segmentation by past and future profitability Low PCV High PCV Rising Stars Invest to deepen relationship True loyalists Invest to nurture/defend/ retain Total misfits No relationship investment Falling angels Optimize (minimize) marketing costs High CLV Low CLV (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

Review: CLV

Review: CLV

Review: CLV

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