CLV assignment
Professor Michaela Draganska
Quantifying Customer Value
Customer Lifecycle
Why do we care about the value of customers?
TYPICAL USES FOR CLV CALCULATIONS
Acquisition Development Retention
CLV calculations have become a key managerial tool
Should we extend a gift of appreciation to first-time customers?
How much can we pay a salesperson to acquire a customer?
How much should we spend on an ad campaign to acquire customers?
Does it pay to reduce the average call center response time from 8 to 2 minutes?
Should we proactively lower service fees for at- risk customers?
What features will most appeal to existing customers?
Which incentives should we offer customers to increase order size?
Why do we care about the value of customers?
TYPICAL USES FOR CLV CALCULATIONS
Acquisition Development Retention
CLV calculations have become a key managerial tool
Should we extend a gift of appreciation to first-time customers?
How much can we pay a salesperson to acquire a customer?
How much should we spend on an ad campaign to acquire customers?
Does it pay to reduce the average call center response time from 8 to 2 minutes?
Should we proactively lower service fees for at- risk customers?
What features will most appeal to existing customers?
Which incentives should we offer customers to increase order size?
Incremental Break-Even Analysis
A mobile phone service provider has 5 million customers. The new CMO has proposed a major advertising campaign which she believes
could lead to the acquisition of 1 million new customers in the coming year at a cost of $400 million.
Is this a good idea?
Incremental Break‐Even Analysis
Break‐Even Unit Volume = Fixed Cost / Unit Contribution = $400,000,000 / $250
= 1.6 million new customers
Margin Structure
Unit End‐User Price $300/year
Unit Variable Cost $50/year
Unit Contribution $250/year
Lifetime Value (LTV) of the Customer
Year 1 Year 2 Year 3
$ $ $
Customer Retention Costs
$ $$ $$$$
Customer Profit Contributions
Customer Attrition
$$
$$
$$
$$
$$
Customer Acquisition Costs
Customer Lifetime Value: Example
Customer Acquisition Costs = $400
$250 $250 $250 $250 $250
Year0 Year1 Year2 Year3 Year4 Year5
Contribution
A mobile phone service provider has 5 million customers. The new CMO has proposed a major advertising campaign which she believes
could lead to the acquisition of 1 million new customers in the coming year at a cost of $400 million.
Is this a good idea?
Step 1: Simple Customer Lifetime Value
Customer Acquisition Costs = $400
$250 $250 $250 $250 $250
Year0 Year1 Year2 Year3 Year4 Year5
Contribution
• Assume no customer attrition • Assume value of money does not change with time (no discounting) • CLV = 5 x $250 = $1,250 • CLV net of acquisition costs = $1,250 ‐ $400 = $850
Step 2: Accounting for Customer Churn
Customer Acquisition Costs = $400
$250 $250 $250 $250 $250
Year0 Year1 Year2 Year3 Year4 Year5
Contribution
Retention Factor .8 .83 .84.82
• Assume probability of losing a customer is .2 each year (retention rate = 80%) • CLV = $250 + $200 + $160 + $128 + $102 = $840 • CLV net of acquisition costs = 840 ‐ 400 = $440
1.0
Expected Contribution EC $250 x .8 $250 x .64 $250 x .51 $250 x .41$250
Step 3: Accounting for Customer Churn & Time Value of Money
Customer Acquisition Costs = $400
$250 $250 $250 $250 $250
Year0 Year1 Year2 Year3 Year4 Year5
Contribution
Discount Factor 1/(1+0.1) 1/(1+0.1)31/(1+0.1)2 1/(1+0.1)4 1/(1+0.1)5 EC x DF $250/1.1 $200/(1.1)2 $160/(1.1)3 $128/(1.1)4 $102/(1.1)5
Retention Factor .8 .83 0.84.82
• Assume probability of losing a customer is 0.2 each year (retention rate = 80%) • Assume value of money decreases with time (discounting included) • CLV = $227 + $165 + $120 + $87 + $64 = $664 • CLV net of acquisition costs = $664 ‐ $400 = $264
1.0
Expected Contribution EC $250 $200 $128 $102$160
m = margin i = discount rate r = retention rate AC = acquisition cost assuming infinite time horizon
AC ri
r mAC
i
rm
i
rm LV
1)1(1 2
2
Lifetime Value of a Customer
CLV ≈ Return/Churn = $250 / (1 ‐ .8) = $1,250
CLV ≈ Return/(Churn + Discount Rate) = $250 / (.2 + .1) = $833
Simple rules are often all you need
Simple Rules Often Used for Quick Estimates
Why do we care about the value of customers?
TYPICAL USES FOR CLV CALCULATIONS
Acquisition Development Retention
CLV calculations have become a key managerial tool
Should we extend a gift of appreciation to first-time customers?
How much can we pay a salesperson to acquire a customer?
How much should we spend on an ad campaign to acquire customers?
Does it pay to reduce the average call center response time from 8 to 2 minutes?
Should we proactively lower service fees for at- risk customers?
What features will most appeal to existing customers?
Which incentives should we offer customers to increase order size?
Berkeley Home Improvement Example
- Berkeley Home Improvement (BHI) is the chief local competitor to Home Depot specializing in materials for home improvement
- BHI runs a “SaverCard” program where consumers earn credits for free home improvement classes (1 hour per $200 spent)
- BHI has determined from their customer information file that for the average SaverCard carrier:
• Revenue is $200 per year
• Cost of goods sold (COGS) is 60% of gross revenue, i.e. $120 per year
• Marketing costs
‣ Cost of attended home improvement seminars is $25 per year
• Attrition is 30% per year
The CLV of a BHI SaverCard customer is $86
CUSTOMER VALUE CALCULATION
Customer Lifetime Value (LTV): $86 ($35 + $22 + $14 + $9 + $6)
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $200 $200 $200 $200 $200
Product/Service Costs $120 $120 $120 $120 $120
Marketing Costs $25 $25 $25 $25 $25
Customer Profit $55 $55 $55 $55 $55
Probability of being active
70% 49% 34% 24% 17%
Profit expected on average
$39 $27 $19 $13 $9
Present Value of Exp. Profits
$35 $22 $14 $9 $6
BHI is considering a free home delivery program for its SaverCard customers
- Heard about success of a home delivery program at industry convention
- Idea:
• Offer free home delivery for all purchases above $150 to SaverCard customers
• BHI heard presentation by Boston hardware chain at a convention that this program decreased customer churn by 5% points and increased spending by $60 per year
• Cost of home delivery is $30 per occasion
• Based on an analysis of average order size BHI estimates that a customer will qualify for home delivery on average 0.9 times per year
HOME DELIVERY IDEA FOR BHI
Should BHI consider offering a free home delivery program for its customers?
Let’s consider the LTV of a SaverCard customer that is offered free home delivery
CUSTOMER VALUE CALCULATION
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $200 $200 $200 $200 $200
Product/Service Costs $120 $120 $120 $120 $120
Marketing Costs $25 $25 $25 $25 $25
Customer Profit $55 $55 $55 $55 $55
Probability of being active
70% 49% 34% 24% 17%
Profit expected on average
$39 $27 $19 $13 $9
Present Value of Exp. Profits
$35 $22 $14 $9 $6
Revenues are expected to change from $200 to $260
CUSTOMER VALUE CALCULATION
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $260 $260 $260 $260 $260
Product/Service Costs $120 $120 $120 $120 $120
Marketing Costs $25 $25 $25 $25 $25
Customer Profit $115 $115 $115 $115 $115
Probability of being active
70% 49% 34% 24% 17%
Profit expected on average
$81 $56 $39 $28 $19
Present Value of Exp. Profits
$73 $47 $30 $19 $12
Revenues are expected to change from $200 to $260
CUSTOMER VALUE CALCULATION
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $260 $260 $260 $260 $260
Product/Service Costs $120 $120 $120 $120 $120
Marketing Costs $25 $25 $25 $25 $25
Customer Profit $115 $115 $115 $115 $115
Probability of being active
70% 49% 34% 24% 17%
Profit expected on average
$81 $56 $39 $28 $19
Present Value of Exp. Profits
$73 $47 $30 $19 $12
Cost are 60% of revenues, so they will change as well
CUSTOMER VALUE CALCULATION
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $260 $260 $260 $260 $260
Product/Service Costs $156 $156 $156 $156 $156
Marketing Costs $25 $25 $25 $25 $25
Customer Profit $79 $79 $79 $79 $79
Probability of being active
70% 49% 34% 24% 17%
Profit expected on average
$55 $39 $27 $19 $13
Present Value of Exp. Profits
$50 $32 $20 $13 $8
What about marketing costs?
CUSTOMER VALUE CALCULATION
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $260 $260 $260 $260 $260
Product/Service Costs $156 $156 $156 $156 $156
Marketing Costs $25 $25 $25 $25 $25
Customer Profit $79 $79 $79 $79 $79
Probability of being active
70% 49% 34% 24% 17%
Profit expected on average
$55 $39 $27 $19 $13
Present Value of Exp. Profits
$50 $32 $20 $13 $8
At $30 per delivery and 90% chance of a delivery per year, marketing costs are expected to rise by $27
CUSTOMER VALUE CALCULATION
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $260 $260 $260 $260 $260
Product/Service Costs $156 $156 $156 $156 $156
Marketing Costs $52 $52 $52 $52 $52
Customer Profit $52 $52 $52 $52 $52
Probability of being active
70% 49% 34% 24% 17%
Profit expected on average
$36 $25 $18 $12 $9
Present Value of Exp. Profits
$33 $21 $13 $9 $5
Finally, what about customer churn?
CUSTOMER VALUE CALCULATION
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $260 $260 $260 $260 $260
Product/Service Costs $156 $156 $156 $156 $156
Marketing Costs $52 $52 $52 $52 $52
Customer Profit $52 $52 $52 $52 $52
Probability of being active
70% 49% 34% 24% 17%
Profit expected on average
$36 $25 $18 $12 $9
Present Value of Exp. Profits
$33 $21 $13 $9 $5
BHI expects churn to decrease from 30% per year to 25% per year
CUSTOMER VALUE CALCULATION
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $260 $260 $260 $260 $260
Product/Service Costs $156 $156 $156 $156 $156
Marketing Costs $52 $52 $52 $52 $52
Customer Profit $52 $52 $52 $52 $52
Probability of being active
75% 56% 42% 32% 24%
Profit expected on average
$39 $29 $22 $16 $12
Present Value of Exp. Profits
$35 $24 $16 $11 $8
We can now calculate the new CLV
CUSTOMER VALUE CALCULATION
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $260 $260 $260 $260 $260
Product/Service Costs $156 $156 $156 $156 $156
Marketing Costs $52 $52 $52 $52 $52
Customer Profit $52 $52 $52 $52 $52
Probability of being active
75% 56% 42% 32% 24%
Profit expected on average
$39 $29 $22 $16 $12
Present Value of Exp. Profits
$35 $24 $16 $11 $8
CLV with home delivery program: $94 ($35 + $24 + $16 + $11 + $8)
Current CLV: $86 ($35 + $22 + $14 + $9 + $6)
The home delivery program might be worth the expense
- Increases cost of SaverCard program from $25 to $52
- Increases revenue per active customer from $200 to $260
- Decreases profit per active customer from $55 to $52
- However, has positive effect on customer churn: from 30% to 25%
HOME DELIVERY ECONOMICS
The decrease in customer churn makes up for lower profits per active customer
Implementation will depend on fixed cost of administering program
Why do we care about the value of customers?
TYPICAL USES FOR CLV CALCULATIONS
Acquisition Development Retention
CLV calculations have become a key managerial tool
Should we extend a gift of appreciation to first-time customers?
How much can we pay a salesperson to acquire a customer?
How much should we spend on an ad campaign to acquire customers?
Does it pay to reduce the average call center response time from 8 to 2 minutes?
Should we proactively lower service fees for at- risk customers?
What features will most appeal to existing customers?
Which incentives should we offer customers to increase order size?
Example: DVD by mail rental subscription service
- Large DVD by mail provider
- 4 million customers in 2006
- High recurrent revenue
- Revenue sharing with movie studios,
pay $1.5 per rental
- 50 cent shipping cost
Plan Montly Price ($) Customers Av. Mo. Usage 1 9.99 5.2% 2.3 2 14.99 10.6% 3.8 3 17.99 53.6% 5.1 4 23.99 20.1% 6.1 5 29.99 3.2% 7.3 6 35.99 1.8% 8.5 7 41.99 1.0% 11.1 8 47.99 4.5% 13.3
100.0%
3 at-a-time membership plan is the most popular one
- Churn rate is 14.95% per year
- After 4 years, 1/2 of a cohort has churned
PLAN POPULARITY AND USAGE
OVERALL CHURN PROBLEM
The customer service team makes an interesting discovery for the 3 at-a-time plan subscribers
CHURN RATES BY CUSTOMER BEHAVIOR
Should we pro-actively encourage low-usage customers to downgrade to the 2-at-a-time plan (average usage is 3.8 movies)?
The company needs to collect some information before a CLV calculation is possible
- What is the monthly revenue loss from downgrading?
• $3
- What will the churn rate of customers be who downgrade to the 2 at-a-time plan?
• 41% for at-risk group
• 19% for current 2-at-a-time plan subscribers
• Realistic to assume full decrease? Usage low even for 2-at-a-time plan
• Do sensitivity analysis: How much does churn have to fall to make this retention initiative work?
FACT DISCOVERY FOR DOWNGRADING TEST
We can now calculate the CLV
CLV FOR AT-RISK GROUP: STATUS QUO
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $216 $216 $216 $216 $216
Product/Service Costs $48 $48 $48 $48 $48
Marketing Costs $0 $0 $0 $0 $0
Customer Profit $168 $168 $168 $168 $168
Probability of being active
59% 35% 21% 12% 7%
Profit expected on average
$99 $58 $35 $20 $12
Present Value of Exp. Profits
$90 $48 $26 $14 $7
$17.99/month *12
We can now calculate the CLV
CLV FOR AT-RISK GROUP: STATUS QUO
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $216 $216 $216 $216 $216
Product/Service Costs $48 $48 $48 $48 $48
Marketing Costs $0 $0 $0 $0 $0
Customer Profit $168 $168 $168 $168 $168
Probability of being active
59% 35% 21% 12% 7%
Profit expected on average
$99 $58 $35 $20 $12
Present Value of Exp. Profits
$90 $48 $26 $14 $7
2 DVDs /month *12 months
$1.50 royalty $0.5 mailing
We can now calculate the CLV
CLV FOR AT-RISK GROUP: STATUS QUO
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $216 $216 $216 $216 $216
Product/Service Costs $48 $48 $48 $48 $48
Marketing Costs $0 $0 $0 $0 $0
Customer Profit $168 $168 $168 $168 $168
Probability of being active
59% 35% 21% 12% 7%
Profit expected on average
$99 $58 $35 $20 $12
Present Value of Exp. Profits
$90 $48 $26 $14 $7
41% churn rate
We can now calculate the CLV
CLV FOR AT-RISK GROUP: STATUS QUO
CLV Status quo: $184
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $216 $216 $216 $216 $216
Product/Service Costs $48 $48 $48 $48 $48
Marketing Costs $0 $0 $0 $0 $0
Customer Profit $168 $168 $168 $168 $168
Probability of being active
59% 35% 21% 12% 7%
Profit expected on average
$99 $58 $35 $20 $12
Present Value of Exp. Profits
$90 $48 $26 $14 $7
What is the LTV for a customer to whom we offer to downgrade?
CLV FOR AT-RISK GROUP: OPTIMISTIC CHURN RATE
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $180 $180 $180 $180 $180
Product/Service Costs $48 $48 $48 $48 $48
Marketing Costs $7 $0 $0 $0 $0
Customer Profit $125 $132 $132 $132 $132
Probability of being active
81% 66% 53% 43% 35%
Profit expected on average
$101 $87 $70 $57 $46
Present Value of Exp. Profits
$92 $72 $53 $39 $29
$14.99/month *12
What is the LTV for a customer to whom we offer to downgrade?
CLV FOR AT-RISK GROUP: OPTIMISTIC CHURN RATE
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $180 $180 $180 $180 $180
Product/Service Costs $48 $48 $48 $48 $48
Marketing Costs $7 $0 $0 $0 $0
Customer Profit $125 $132 $132 $132 $132
Probability of being active
81% 66% 53% 43% 35%
Profit expected on average
$101 $87 $70 $57 $46
Present Value of Exp. Profits
$92 $72 $53 $39 $29
no change
What is the LTV for a customer to whom we offer to downgrade?
CLV FOR AT-RISK GROUP: OPTIMISTIC CHURN RATE
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $180 $180 $180 $180 $180
Product/Service Costs $48 $48 $48 $48 $48
Marketing Costs $7 $0 $0 $0 $0
Customer Profit $125 $132 $132 $132 $132
Probability of being active
81% 66% 53% 43% 35%
Profit expected on average
$101 $87 $70 $57 $46
Present Value of Exp. Profits
$92 $72 $53 $39 $29
$1 mailing cost $6 processing cost
= $7
What is the LTV for a customer to whom we offer to downgrade?
CLV FOR AT-RISK GROUP: OPTIMISTIC CHURN RATE
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $180 $180 $180 $180 $180
Product/Service Costs $48 $48 $48 $48 $48
Marketing Costs $7 $0 $0 $0 $0
Customer Profit $125 $132 $132 $132 $132
Probability of being active
81% 66% 53% 43% 35%
Profit expected on average
$101 $87 $70 $57 $46
Present Value of Exp. Profits
$92 $72 $53 $39 $29
19% attrition rate (average for 2-at-a-time plan)
What is the LTV for a customer to whom we offer to downgrade?
CLV FOR AT-RISK GROUP: OPTIMISTIC CHURN RATE
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $180 $180 $180 $180 $180
Product/Service Costs $48 $48 $48 $48 $48
Marketing Costs $7 $0 $0 $0 $0
Customer Profit $125 $132 $132 $132 $132
Probability of being active
81% 66% 53% 43% 35%
Profit expected on average
$101 $87 $70 $57 $46
Present Value of Exp. Profits
$92 $72 $53 $39 $29
CLV downgrading idea: $284
CLV Status quo: $184
How much do we have to reduce churn to make up for the loss in monthly revenue due to downgrading?
CLV FOR AT-RISK GROUP: BREAK-EVEN CHURN RATE
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $180 $180 $180 $180 $180
Product/Service Costs $48 $48 $48 $48 $48 $48
Marketing Costs $7 $0 $0 $0 $0
Customer Profit $125 $132 $132 $132 $132 -$48
Probability of being active
67% 45% 30% 20% 14% 33%
Profit expected on average
$84 $59 $40 $27 $18 -$16
Present Value of Exp. Profits
$76 $49 $30 $18 $11 $184
CLV downgrading idea: $184
CLV Status quo: $184
Need 33% churn or less
(down from 41%)
To summarize
Look forward: Move from profits to LTV to determine customer value
Consider the CLV value drivers:
• Increased retention rate
• Increased sales
• Reduced direct costs
• Reduced marketing costs
Employ CLV calculations to evaluate and plan marketing actions for
• Acquisition, Retention, Development
The foundation for CLV calculations is a customer-centric view of the firm