1. Customer lifetime value (CLV)

2. 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

3. 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;

4. 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;

5. 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)

6. 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.

7. 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)

8. 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.

9. 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;

10. 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.

11. 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

12. 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%

14. 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

15. 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

16. 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= −.3 =165

17. 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]

18. 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]

19. 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

20. 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$

21. 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

22. 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?

23. 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 𝑑 𝑡 𝑟 𝑡 −𝐴𝐶

24. 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)

25. 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%

28. 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

29. 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

30. 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)

31. 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

35. 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)

36. 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

37. 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)

38. 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)

39. 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?

40. 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.

41. Review: CLV

42. Review: CLV

43. Review: CLV

44. Review: CLV

45. Review: CLV

46. 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