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

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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