Customer Lifetime Value

Reshaping the Way We Manage to Maximize Profits

David Bejou, Timothy Keiningham, Lerzan Aksoy

• Publisher: Routledge
• Year: 2006
• Topic: Business
• eBook ISBN:
  9781136791918
• Subtopic: Business General
• Index: Business

Get the competitive edge by effectively managing customer lifetime value

The customer lifetime value (CLV) concept is extensively changing the way today's business is managed. A student or practitioner needs to understand CLV to best gain the competitive edge in business. Customer Lifetime Value: Reshaping the Way We Manage to Maxi

CLV:
The Databased Approach

V. Kumar

University of Connecticut

V. Kumar (VK) is ING Chair Professor in Marketing, and Executive Director, ING Center for Financial Services, School of Business, University of Connecticut, Storrs, CT 06269-1041 (E-mail: [email protected]).

The author sincerely thanks the assistance of Bharath Rajan in the preparation of this document.

SUMMARY. It is becoming increasingly clear from the literature that there is a need for a metric that can objectively measure future profitability of the customer to the firm. This paper traces the emergence of such a metric–the customer lifetime value (CLV) and discusses the two measures of computing CLV–the aggregate approach and the individual level approach. Subsequently, eight strategies that are available to firms for maximizing CLV are discussed. These strategies assist firms in deciding how to: select the best customer, make loyal customers profitable, optimally allocate the resources, pitch the right product to the right customer at the right time, link acquisition and retention to profitability, prevent customer attrition, encourage multi-channel shopping behavior, and maximize brand value. Each of these strategies was successfully implemented by different firms across various industries, resulting in significant increases in the bottom-line. Further, the challenges in implementing a CLV-based framework in a B-to-C organization are also discussed with an illustration. doi:10.1300/J366v05n02_02 [Article copies available for a fee from The Haworth Document Delivery Service: 1-800-HAWORTH. E-mail address: <[email protected]> Website: <http://www.HaworthPress.com> © 2006 by The Haworth Press, Inc. All rights reserved.]

KEYWORDS. Customer Lifetime Value, customer equity, profitability, ROI, customer loyalty, customer acquisition and retention, marketing resource allocation, brand value/brand equity, multichannel shopping, dynamic churn

INTRODUCTION

In the past two decades, the firms tended to focus on either cost management or revenue growth. When a firm adopts one of these approaches it loses out on the other (Rust, Lemon, & Zeithaml, 2004). For instance, if a firm focuses only on revenue growth without emphasis on cost management, it fails to maximize the profitability. Similarly, cost management without revenue growth affects the market performance of the firm. Therefore, balancing the two becomes essential for a firm that expects to create market-based growth while carefully evaluating profitability and return on investment (ROI) of marketing investments. In other words, the key to success lies in optimal allocation of resources/efforts across profitable customers and cost-effective customer-specific communication.

In a customer-centric approach, assessing the value of a firm’s customers becomes important. But what is the value of a customer? Can customers be evaluated based only on their past contribution to the firm? Which metric is better in identifying the future worth of the customer? These are some of the questions a firm has to deal with before assessing the value of its customers. Many customer-oriented firms realize that the customers are valued more than the profit they bring in every transaction. Customers’ value has to be based on their contribution to the firm across the duration of their relationship with the firm. In simple terms, the value of a customer is the value the customer brings to the firm over his/her lifetime. Some recent studies have shown that past contributions from a customer may not always reflect his or her future worth to the firm (Reinartz&Kumar, 2003). Hence, there is a need for a metric that can objectively measure future profitability of the customer to the firm (Berger & Nasr, 1998). Customer lifetime value takes into account the total financial contribution–i.e., revenues minus costs–of a customer over his or her entire lifetime with the company and therefore reflects the future profitability of the customer. Customer lifetime value (CLV) is defined as the sum of cumulated cash flows–discounted using the Weighted Average Cost of Capital (WACC)–of a customer over his or her entire lifetime with the company.

In this article, we first discuss the emergence and measurement of CLV. Then we find how best CLV can be used by comparing it with other traditionally used metrics. Two approaches for measuring CLV, namely the aggregate approach and the individual level approach, are explained in the following section. In the subsequent section, we discuss the strategies that can be used to maximize CLV. We also present organizational challenges in implementing CLV-based framework and we conclude the article by discussing the future of CLV.

THE EMERGENCE OF CUSTOMER LIFETIME VALUE

In order to develop and implement customized marketing strategies, it is essential for companies to understand the exact nature of the various links (e.g., strength, symmetry, and non-linearity), for efficient allocation of resources. However, owing to the complexity and specificity of the links, managers need to understand that loyalty should not be equated with higher profits.

In a series of writings, Frederick F. Reichheld stresses the importance of managing customer retention (Reichheld, Markey, & Hopton, 2000). According to his hypotheses, long-term customers tend to spend more over time, cost less to serve per period over time, have greater propensity to generate word-of-mouth and pay a premium when compared to that paid by short-term customers. Reichheld’s propositions have been tested by Reinartz and Kumar who investigated the profitability of a sample of more than 16,000 individual customers across four industries (Reinartz & Kumar, 2002). The results gave a different picture. The key implication of Reinartz and Kumar’s findings is that caution must be exercised when equating customer retention with customer profitability, leading to the emergence of customer lifetime value (Reinartz & Kumar, 2000). This means that firms ultimately have to make an effort to obtain information on individual or segment level profitability.

The importance of CLV rests on the fact that it is a forward-looking metric unlike other traditional measures that include past contributions to profit. It assists marketers to adopt appropriate marketing activities today, in order to increase future profitability. The computation can also be used to include prospects, not just current customers. Further, CLV is the only metric that incorporates into one, all the elements of revenue, expense and customer behavior that drive profitability. This metric also manages to score over other metrics by adopting a customer-centric approach instead of a product-centric one, as the driver of profitability. The approach for measuring CLV is given in Figure 1.

HOW CUSTOMER LIFETIME VALUE CAN BE USED

As explained earlier, CLV is a measure of the worth of a customer to the firm. Calculation of CLV for all the customers helps the firms to rank order the customers on the basis of their contribution to the firm’s profits (Kumar & Reinartz, 2006). This can be the basis for formulating and implementing customer-specific strategies for maximizing their lifetime profits and increasing their lifetime duration. There are different metrics to measure and manage customer loyalty. Some of the popular metrics used are listed in Table 1.

Though RFM, Past Customer Value, and Share-of-Wallet are commonly used for computing the customer’s future value, they suffer from drawbacks. These methods are not forward-looking and do not consider whether a customer is going to be active in the future. However, CLV measures consider the observed past purchase behavior and extrapolate it to the future to arrive at the future profitability of a customer. This is where the Customer Lifetime Value scores. The CLV metric helps firms address marketing issues with greater confidence. It guides the allocation of resources for ongoing marketing activities for a customer-centric firm. Kumar, Ramani, and Bohling (2004) outline these as follows:

FIGURE 1. A Conceptual Approach to Measure CLV

TABLE 1. Metrics Used for Measuring and Managing Customer Loyalty

Metric	Description
RFM Approach	RFM Approach stands for Recency, Frequency, and Monetary Value. Recency refers to how long it has been since a customer last placed an order with the company, frequency refers to how often a customer orders from the company in a certain defined period and monetary value denotes the amount that a customer spends on an average transaction.
Past Customer Value	It is a model that extrapolates the results of past transactions into the future. In this model, the value of a customer is determined based on the total contribution (towards profits) provided by the customer in the past.
Share of Wallet	It refers to the proportion of category value accounted for by a focal brand or a focal firm within its base of buyers. It can be measured at the individual customer level or at an aggregate level.

Source: Adapted from Kumar, V. & Reinartz, W. J. (2006). Customer Relationship Management–A Databased Approach. John Wiley & Sons, pp. 112-124.

• How do firms decide which customers should be provided with preferential and sometimes personal treatment?

• To which customers should the firms interact through inexpensive channels like the Internet or the touch tone phone, and which customer should be let go?

• How do firms decide the timing of an offering to a customer?

• How do firms decide which prospect will make a better customer in the future, and is therefore worthwhile to acquire now?

• Having got the customer to transact with the firm, what kind of sales and service resources should the firm allocate, to conduct future business with that customer?

• How should firms monitor customer activity, in order to readjust the form and intensity of their marketing initiatives?

MEASURING CUSTOMER LIFETIME VALUE

Lifetime value of a customer can be either calculated as an average CLV using an aggregate approach or individual level CLV using an individual approach.¹

An Aggregate Approach

In the aggregate approach, average...

Table of contents

• Cover
• Halftitle
• Title
• Copyright
• Contents
• About the Editors
• How Customer Lifetime Value Is Changing How Business Is Managed
• CLV: The Databased Approach
• Approaches to the Measurement and Management of Customer Value
• Customer Lifetime Value as the Basis of Customer Segmentation: Issues and Challenges
• Customer Divestment
• Customer Lifetime Value and Firm Valuation
• The Climate for Service: A Review of the Construct with Implications for Achieving CLV Goals
• The Future of Managing Customers as Assets
• Index