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drvkumar.com © Dr. V Kumar
1
Dr. V Kumar
Richard and Susan Lenny Distinguished Chair Professor of Marketing,
Executive Director, Center for Excellence in Brand & Customer Management,
Director of the Ph.D. Program in Marketing
J. Mack Robinson College of Business
Georgia State University
Customer Relationship Management- CRM
Day 2: Customer Loyalty, Profitability, and CLV
drvkumar.com © Dr. V Kumar
Loyalty and Profitability
2
drvkumar.com © Dr. V Kumar
Evolution of Loyalty Programs
3
Airlines
Hotels
Early 80’s
Retail
Early 90’s
Mid 90’s
Late 90’s
Mid 80’s
Credit Card
21
st
Century
Financial Services
VIRTUALLY
EVERY
INDUSTRY!!!
drvkumar.com © Dr. V Kumar
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Airline Loyalty Programs-
How Do They Work?
drvkumar.com © Dr. V Kumar
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drvkumar.com © Dr. V Kumar
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Frequent Flyer Programs
Airline
Frequent Flyer Program
drvkumar.com © Dr. V Kumar
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What Should the Programs Reward?
Loyalty…..of course!
drvkumar.com © Dr. V Kumar
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What Are The Major Airlines
using to Compute Mileage Points?
Airline Miles flown Number of
round trips
made
American
Airlines
√ -
United √ -
Continental √ -
Delta √ -
US Airways √ -
Southwest - √
drvkumar.com © Dr. V Kumar
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Southwest – Rapid Rewards - Back to the Future
• Earning Rewards
– 1 free award ticket for every 8 roundtrips (16 credits) (or 4 roundtrips
purchased online) in 12 consecutive months
– Companion Pass for 1 year- After 100 credits
– Can use only preceding 12 months for credit (each credit is valid for 12
months only, after which it expires if unused)
drvkumar.com © Dr. V Kumar
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Net Income Over The Years
-600
-400
-200
0
200
400
600
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
$

(
M
i
l
l
i
o
n
s
)
Year
Continental Airlines
drvkumar.com © Dr. V Kumar
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Net Income Over The Years (Contd.)
0
200
400
600
800
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
$

(
M
i
l
l
i
o
n
s
)
Year
Southwest Airlines
drvkumar.com © Dr. V Kumar
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Key Implications
• Airline performances in recent years have been affected by a
variety of reasons
• Indiscriminate frequent flyer miles is but one of the factors
• Standing out from the crowd also pays dividends (Southwest)
drvkumar.com © Dr. V Kumar
Examples of Loyalty Programs in India-
Jet Privilege
• Dynamic tier review (12-month, 18-month, 24-month)
• Fast-track upgrade
• SMS updates
• Earn miles on code-share carriers
• Redeem miles with tickets/gifts/partners
• Purchase miles in case of shortfall
13
drvkumar.com © Dr. V Kumar
Jet Airways - Jet Privilege
• ―Freddie‖ awards from 2004 to 2007 and APAC
―Program of the Year‖ in 2006 and 2007
• Information easily available on the Web
• Easy enrollment: Online/in-person counters
• Book and pay by Web, IVR, mobile
• Tele, Web, kiosk, SMS check-in
• Online tools for miles, status, and upgrade calculations
• 44 destinations to earn/redeem miles from/to
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drvkumar.com © Dr. V Kumar
• Activities
◦ Build a Sun community on campus
◦ Share knowledge about latest Sun on campus
◦ Activities such as starting a Sun user-group, demonstrating Sun
technology to fellow students, promoting Sun events and
contests, and blogging
◦ 105 strong over 3 years in India
◦ Rewards
◦ Free training
◦ Discounts on Sun certification exams
◦ Access to the latest technology
◦ Promotion to Student Tech Lead
◦ INR 6.5k p.m.
Examples of Loyalty Programs in India-
Sun Campus Ambassador Program
15
drvkumar.com © Dr. V Kumar
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87%
85%
50%
45%
35%
Insurance Publishing
Credit
Card
Industrial
Distribution
Software
Frederick Reichheld‘s The Loyalty demonstrated
that a small improvement in customer retention can
have a disproportionately large effect on customer
lifetime value
Impact of a Five Percent Increase in
Retention on Customer NPV
drvkumar.com © Dr. V Kumar
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Loyalty - At What Cost?
drvkumar.com © Dr. V Kumar
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Loyalty - - At What Cost?
• Welf Ebeling, chief operating officer for The Leading Hotels of the World group,
ran the Breidenbacher Hof, a swanky hotel in Düsseldorf.
• One fine day he noticed that some of his most loyal customers constantly
telephoned the concierge with impossible requests.
• These ―attention-seekers‖ were often less profitable than other loyal customers
who made fewer demands but spent more.
• Companies tend to assume that loyal customers are cheaper to serve and
willing to pay more than others, and also good at attracting new business
• Let us discuss the case studies of a high-tech corporate-services provider, a
French grocery group, a German broking house and an American mail -order
company and try to find the correlation between loyalty and profitability
drvkumar.com © Dr. V Kumar
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Loyalty - - At What Cost? (Contd.)
• Across the 4 different industry categories
– Employ cross-sectional, longitudinal profitability
tracking for customer cohorts
– Ensure that complete purchase and service
behavior is tracked on the individual account level
over time
drvkumar.com © Dr. V Kumar
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Examining The Myths Surrounding Loyalty
Myth # 1:
The costs of serving loyal customers are lower
Myth # 2:
Loyal customers pay higher prices for the same bundle of goods
Myth # 3:
Loyal customers engage in more positive word-of-mouth
Myth # 4:
Relationships with loyal customers are more profitable
drvkumar.com © Dr. V Kumar
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Myth # 1: The Costs Of
Serving Loyal Customers Are Lower
• Empirical results for all four industries indicate
– a greater heterogeneity across customers in costs to serve
– a very weak linkage of costs to serve and the duration of a
customer relationship
Assuming that interaction cost decreases over time when in fact it
doesn’t, gives a false sense of loyalty benefits
drvkumar.com © Dr. V Kumar
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Myth # 2: Loyal Customers Pay
Higher Prices For The Same Bundle Of Goods
• Examined the case of a leading grocery retailer in France to
measure consumer‘s attitudinal and behavioral loyalty towards the
supermarket
• The high attitudinal and high behavioral loyalty cell was termed the
top loyalty group and the low attitudinal and the low behavioral
loyalty cell was termed the bottom loyalty group
• Analyzed the average price these customers paid for products in
various grocery categories across all four cells
drvkumar.com © Dr. V Kumar
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Comparison Of The Average Price Paid
Across Groups
0
0.5
1
1.5
2
2.5
3
3.5
4
Beverages Household
Cleaning
Epic.
Sucree
Epic. Salee Fresh
Products
Dairy
A
v
g
.

p
r
i
c
e

i
n

€
Top loyalty quartile
Bottom loyalty quartile
Differences are
not statistically
significant
drvkumar.com © Dr. V Kumar
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Loyal Customers Pay Higher Prices For The Same Bundle Of
Goods- Across Other Industry Categories (Contd.)
• General merchandise catalog retailer -The average price paid for a
SKU was highest for non-loyal customers, who paid approximately
9% higher prices than the loyal customers in the same product
category
• High-tech firm -On the average, the loyal customers paid about 5%
to 7% lower than the non-loyal customers depending on the product
category
• Therefore, we find no empirical evidence for the assumption that
loyals are less price-sensitive
drvkumar.com © Dr. V Kumar
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Theoretical Arguments In Favor Of Our
Empirical Findings
• Loyal customers are more likely to learn about product offerings,
compare quality standards and develop solid reference prices
• Competitive pressure amongst vendors not to price discriminate
on the basis of customer loyalty, due to the fear of loosing a very
important segment
• Price of products and services in most B-to-C markets is fixed
• The notion of charging de facto higher prices to loyal customers
goes against a natural human desire for fair treatment
drvkumar.com © Dr. V Kumar
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Myth # 3: Loyal Customers
Engage In More Positive Word-of-mouth
French grocery retailer –
2.77
4.46
3.05
4.25
0
1
2
3
4
5
Low High
Attitudinal Loyalty
R
a
t
i
n
g

(
1
-
5
)
Low Behavioral Loyalty
High Behavioral Loyalty
Engagement in active Word-of-mouth
Customers are not engaging in spreading positive word-of-mouth about the company based on how
often or how much they buy (i.e. behavioral loyalty). It is the attitudinal loyalty that counts
drvkumar.com © Dr. V Kumar
27
Loyal Customers Engage In More Positive Word-of-
mouth Across Other Industry Categories
• Similar results were observed in the case of the high
tech firm
– Among the customers with higher attitudinal loyalty, the
intention to recommend was greater for the high behavioral
loyalty group than the low behavioral loyalty group
drvkumar.com © Dr. V Kumar
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Loyal Customers Engage In More Positive Word-of-
Mouth Across Other Industry Categories (Contd.)
• For the customers with lower attitudinal loyalty, there
was no difference in the intention to recommend
between the high and low behavioral loyalty group
• Thus in terms of word-of-mouth management it does
not matter how often customers buy but what matters
is what they think about you!
drvkumar.com © Dr. V Kumar
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Myth # 4: Relationships With Loyal Customers Are
More Profitable
• This hypothesis presumes that bottom-line results are better
for loyal customers
• Unless the relationship between profits and customer loyalty is
measured, there is no way to know for sure
Therefore it is important to know “How strong is this correlation?”
drvkumar.com © Dr. V Kumar
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Lifetime Duration – Profitability Association
Short Long
Lifetime
Duration
High
Low
Lifetime
Profit
Conceptual Model
In reality, is this relationship observed?
IV
III
II
I
drvkumar.com © Dr. V Kumar
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Association between Profitability and
Longevity of Customers
Source: “The mismanagement of customer loyalty”, Werner Reinartz, V Kumar. Harvard Business
Review
drvkumar.com © Dr. V Kumar
32
Correlation Measure Across Industries
Industry Correlation Sample Size
B-to-B high tech 0.28-0.31 4128
Grocery retail 0.45 250
General merchandise
direct mail
0.17-0.22 9105
Direct brokerage 0.29 3014
In reality we observe low correlations across all industry categories
drvkumar.com © Dr. V Kumar
33
The Reality!
• The link between loyalty and profitability is weaker than ordinarily
assumed
• Not all loyal customers are worth a resource intensive interaction
• Short-life customers are not always bad
• Low share of wallet customers are also not bad
drvkumar.com © Dr. V Kumar
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What Happens If The Loyalty-profitability Space
Is Badly Understood ?
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10000.00
12000.00
14000.00
16000.00
18000.00
20000.00
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35
Month
(
$
)

S
e
g
m
e
n
t

P
r
o
f
i
t
Short life, low
revenue
(Segment 4)
Short life, high
revenue
(Segment 3)
The firm incurs losses on two short-life segments after about 20 months into
the relationship. This is a result of over investing due to backward-looking
customer scoring.
A study of a general
merchandise catalog retailer
in the US
Segment Profits ($) for Two Short-life Segments
drvkumar.com © Dr. V Kumar
35
-2000.00
0.00
2000.00
4000.00
6000.00
8000.00
10000.00
12000.00
14000.00
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S
e
g
m
e
n
t

P
r
o
f
i
t

(
$
)
Month
Aggregate Profits (Dollars) for Long-Life Segments
Long life, low
revenue
(Segment 2)
Long Life, high
revenue
(Segment 1)
What Happens If The Loyalty-profitability Space
Is Badly Understood ? (Contd.)
Segment Profits ($) for Two Long-life Segments
drvkumar.com © Dr. V Kumar
What happens if the Loyalty-Profitability space is
badly understood ?
36
0
5000
10000
15000
20000
25000
C
u
s
t
o
m
e
r

P
r
o
f
i
t

(
$
)
Month
Customer 1
(Segment II)
Customer 2
(Segment III)
Today
drvkumar.com © Dr. V Kumar
What Drives Profitable Customer Loyalty?
Exchange Characteristics
– Customer‘s spending level - Share of
Wallet
– Cross-buying behavior
– Focused buying behavior
– Average Interpurchase Time
– Merchandise returned
– Ownership of loyalty instrument
– Mailing efforts of the company
– Majority Product category
37
Customer Heterogeneity
–Age
–Spatial Location
–Income
drvkumar.com © Dr. V Kumar
38
Understanding The Drivers Of Customer Loyalty: Relationship
Characteristics That Impact Profitable Lifetime Duration
• We now identify factors under a manager‘s control that explain the
variation in the profitable lifetime duration
• The focus of our inquiry is on variables that determine the nature of the
customer-firm exchange
• Exchange characteristics encompass the set of variables that define and
describe relationship activities in the broadest sense
• The profitable duration of a customer-firm relationship depends,
differentially, on the exchange characteristics at time t, and customer
heterogeneity
Profitable Lifetime Duration
i
= f (Exchange characteristics
it
, Customer
heterogeneity
i
)
drvkumar.com © Dr. V Kumar
39
Analysis
• We used Survival analysis for the analysis of profitable
customer lifetime durations
• It is the method of choice in dealing with duration data, in particular because it
is well suited for the handling of censoring
• The hazard rate is defined as the probability of buying, given that a customer
has not bought until now
• The hazard of a lifetime event of a household i at time t is given as follows:
h
i
(t) = h
0
(t) EXP (β
1
Purchase Amount
it
+ β
2
Cross Buying
it
+ β
3
Focus of Buying
i
+β
4
Average Interpurchase Time
it
+ β
5
(Average Interpurchase
Time
it
)
2
+ γ
1
Returns
it
+ γ
2
Loyalty Instrument
i
+ γ
3
Mailings
it
+ γ
4
Product Category
i
+ δ
1
Population Density
i
+ δ
2
Income
i
+ δ
3
Age
i
)
drvkumar.com © Dr. V Kumar
Building Good Loyalty Programs
40
drvkumar.com © Dr. V Kumar
Key Objectives of Loyalty Programs
• Building true (attitudinal & behavioral) loyalty
• Efficiency Profits
• Effectiveness Profits
• Value alignment
41
drvkumar.com © Dr. V Kumar
Building True Loyalty
• Encompasses both attitudinal and behavioral components of loyalty
• Greater commitment to the product or organization through the
building of true loyalty
• Function of true value provided to the customers
• Involves degree of involvement in the product category, visibility of
the product when using it, or value expressive nature of the product
• Goal of many customer clubs
• Difficult in the case of a low involvement category– e.g.: grocery
shopping
42
Loyalty
drvkumar.com © Dr. V Kumar
Supermarkets - Difficulty in Building True Loyalty
• Despite spending hundreds of millions of pounds on price-cutting
campaigns and loyalty card schemes, supermarkets have only persuaded
a small minority of shoppers to stay loyal
• According to a report from Mintel Research:
– Only 15% of all grocery shoppers are completely loyal to the store where they
do their main grocery shopping
– 29% use one other store
– 22% use two others
– Men are more likely than women to be loyal to a single store
– 46% of men shop in just one or two main stores
43
drvkumar.com © Dr. V Kumar
44
Marketing
Strategy
Efficiency Effectiveness
Loyalty
Program
Is LP the right thing to do with given
resources?
Measured in terms of the immediate profit
consequences (from changing customer‘s
buying behavior via LP) as compared to profit
consequences without LP– net of the LP cost .
How?
Change in buying behavior can be
measured, in:
•Basket size
•Purchase frequency acceleration
•Price sensitivity
•Share of category requirements (SCR) or
share-of-wallet
•Retention
•Lifetime duration
Is LP correctively implemented?
Measured in terms of the profit outcomes of
specific marketing actions In LP (Conversion
rate for a marketing campaign, marketing
communications reach etc).
How?
•Using a LP to have a better learning about
customer preferences over time.significant
gains for both customers and organizations.
•Allows sustainable value creation for
customers through customization of products or
communication
•Customers get more of what they truly want,
and firms are safe in terms of not having to
engage in a costly mass marketing exercise
Sustainable
Competitive
Advantage
drvkumar.com © Dr. V Kumar
Value Alignment
• Goal of aligning the cost to serve a particular
customer with the value he/she brings to the firm
• Allows firms to serve their most valuable customers in the best manner
• The goal of value alignment is particularly critical when there is great
heterogeneity in the customer‘s value and in the cost to serve the
customer
Example: the airline business, the hospitality industry and the financial
services industry
45
drvkumar.com © Dr. V Kumar
Loyalty Program Design Characteristics
• Classified according to:
– Reward structure
– Sponsorship (existence of partner network, network externalities)
• To know if an LP is effective:
– From the consumer‘s perspective, are rewards attainable?
– From the consumer‘s perspective, are rewards relevant?
– From the firm‘s perspective, is the LP design aligned with the
desired goal(s)?
46
drvkumar.com © Dr. V Kumar
47
Representative examples of Program
Failures and Missteps
SAFEWAY
Industry: Grocery Retail (UK)
Program: ABC Card
Launch: 1995
Program Overview:
• Innovative loyalty scheme (ABC
Card) given to study repeat purchase
• Abandoned since information
generated could not justify the high
costs
• Safeway today focuses on weekly
promotions and improved customer
service
LATIN PASS
Industry: Airline
Program: Latin Pass
Launch: 1994
Program Overview:
• Awarded 1 million frequent flyer
miles to customers who visited 10 Latin
American countries, utilized hotel and
car rental services
• 50 customers qualified in a very
short time period
• Abandoned campaign prematurely
due to very high customer costs
($10000 per customer)
drvkumar.com © Dr. V Kumar
Case in Point: Drivers of Airline Preference
1
Market Coverage
2
Price
3
Schedule
4
Frequent flyer program
5
Product attributes
48
Airline travelers that cite five main factors that
drive their choice of airlines:
Council airline
members note
that frequent flyer
programs are only
one of the factors
that determine a
customer‘s choice
of airline
drvkumar.com © Dr. V Kumar
What Did The Programs Assume?
• Loyal customers are more profitable
• Hence, for many years, ‗Miles flown‘ was used as the sole
measure of loyalty and was accepted as a surrogate measure of
profitability
• Rewards were redeemed in proportion to the ‗Miles‘ accumulated
on a customer‘s account
49
drvkumar.com © Dr. V Kumar
The Not-So-Obvious Shortcomings
The ‘Miles’ rewards system:
• Did not account for the revenue that a customer brought in
– Class of travel
– Fare type
• Rewarded a more valuable customer the same as a less valuable
customer
• Ignored the willingness by a customer to pay more for a better
product/service
Hence sooner or later, all this had to change
50
drvkumar.com © Dr. V Kumar
51
Previous Program New Program
Qualification criteria:
Base miles, or flight
segments flown in one
calendar year
Qualification criteria:
Medallion miles earned
based on distance traveled
and fare class purchased in
one calendar year
Delta Airways - Ringing in the changes
•Effective January 2003, the requirements for achieving elite-level status have
changed. You now qualify based on Medallion Qualification Miles—a multiple of
the distance traveled and fare purchased—instead of miles or segments flown, as
in the previous program
•This allows customers willing to pay more for additional benefits to gain status
more quickly
drvkumar.com © Dr. V Kumar
Delta Airlines- Miles Redemption Table
Class of Service Fare Type Medallion Miles
Qualification
Formula:
Using an example of
500 flown miles
Total Medallion
Miles Earned for
Qualification
First, BusinessElite
or business
P, F, A, C, D, J, I 500 x 2 1,000
Economy Y, B, M 500 x 1.5 750
Discounted
coach/economy
H, Q, K, S 500 x 1 500
Deeply-discounted
coach/economy
L, U, T 500 x .5 250
SkyMiles Award/
Special Fares
R, O, N, E 500 x 0 No Medallion
Qualification Miles
earned
52
drvkumar.com © Dr. V Kumar
What Are The Major Airlines Using
To Compute Mileage Points Today ?
Airline Miles flown Class of
service
(Economy, Business,
1
st
Class)
Fare Type Number of
round trips
made
American
Airlines
√ √ - -
United √ √ - -
Continental √ √ - -
Delta √ √ √ -
US Airways √ √ - -
Southwest - - - √
53
drvkumar.com © Dr. V Kumar
Case Study – Revenue Analyses
“Wyndham ByRequest” Member versus Non-member
comparisons
Q1 2001 Q2 2001 Q3 2001 Q4 2001
New Members added 25,000 50,000 55,000 50,000
Members
Total nights 104,491 119,624 127,505 141,669
Total stays 36,116 40,554 45,049 46,197
Total guests 26,616 30,811 35,433 36,955
Total revenue
produced
$12,403,161 $14,090,471 $15,099,372 $14,830,528
Rev/member 466.00 457.31 426.13 401.31
Non-members
Total nights 1,548,501 1,918,634 1,429,460 1,040,763
Total stays 406,536 441,865 392,469 338,459
Total guests 352,977 383,051 336,263 291,399
Total revenue
produced
$163,294,362 $164,863,345 $130,685,357 109,404,522
Rev/Non-member 462.62 430.39 388.64 375.45
54
drvkumar.com © Dr. V Kumar
Co-relation Between Guest Membership,
Loyalty and Revenues
• Only 1 in 5 Guests across business, conference and leisure
segments return to Hilton because of program membership in a
given year
• Wyndham spent approximately US $ 50 Million in FY 2001 to
attract 180,000 new members to ―Wyndham ByRequest‖ Loyalty
Program
Did Wyndham’s aggressive campaign result in proportional
increase in retention and revenue?
55
drvkumar.com © Dr. V Kumar
Brand Preferences and
Business Travel Decision Process
Hotel Selection Decision Elements
Influential in %
2002 2001 2000 1999
Location 91 89 83 86
Previous experience with hotel 89 94 84 86
Value for the price 82 86 76 72
Reputation of hotel/chain 82 80 74 71
Room rate 72 81 75 62
Recommendation of friend/associate 69 70 68 68
Likelihood of upgrade to better accommodation 63 N/A N/A N/A
Brand name 59 53 62 66
Gives both airline mileage and points 51 52 N/A N/A
Airline mileage 37 44 26 25
Recommendation of travel agent 34 35 40 34
Frequent-guest points 29 42 31 26
56
Source – The YP&B Yankelovich Partners National Business Travel Monitor (2000 and 2002)
drvkumar.com © Dr. V Kumar
Total Membership/Program Characteristics by Brand
57
Brand program Established Total
Members
C
How Points
are Earned
based on
Dollar Value
Approximate
Number of
Participating
Properties
Number of
Points
redeemed for
Free Three-Day
Vacation
D
Marriott
Rewards
1983 15.5 10 points per
dollar spent
A
2,100 50,000
Starwood
Preferred Guest
1986 15 2 points per
dollar spent
B
700 21,000
Hilton HHonors 1987 12.7 10 points per
dollar spent
2,100 65,000
Hyatt Gold
Passport
1987 10 5 points per
dollar spent
363 36,000
A – Only room rate at Courtyard, Fairfield Inn and Springhill Suites
B – 3 points for higher-status members
C – In millions
D – Estimated Source - HBR
Dollars Spent
for Free
Three- Day
Vacation
5,000
10,500
6,500
7,200
drvkumar.com © Dr. V Kumar
Segmenting Customers Based On Past
And Future Profitability
58
Rising Stars
ACTION:
- Invest to deepen relationship
- Identify specific up-sell / cross-sell opportunities
- Cultivate attitudinal loyalty
True Loyalists
ACTION:
- Cultivate attitudinal loyalty
- Invest to nurture / defend / retain
- Reward proactively
Total Misfits
ACTION:
- No relationship investment
- Aim to extract profit from every transaction by
migrating the customer to low cost channels
Falling Angels
ACTION:
- Identify specific up-sell / cross-sell opportunities
- Transact through low-cost channels
- Optimize (Minimize) Marketing costs
Historical Profits
(PCV)
F
u
t
u
r
e

P
r
o
f
i
t
a
b
i
l
i
t
y
(
C
L
V
)
Low High
Low
High
drvkumar.com © Dr. V Kumar
The Managerial Implications
• Understand loyalty diversity and profitability diversity
• Manage loyalty and profitability simultaneously
• Make forward-looking customer investment
decisions, including projected customer profitability
59
drvkumar.com © Dr. V Kumar
Customer Loyalty and CLV
60
drvkumar.com © Dr. V Kumar
61
drvkumar.com © Dr. V Kumar
Customer Lifetime Value (CLV)
DEFINITION
• Customer lifetime value 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 (three years in
most cases) with the company.
62
Approach to Measurement
Recurring
Costs
Recurring
Revenues
Net
Margin
Expected Number
of Purchases over
next 3 years
Accumulated
Margin
Acquisition
Costs
Customer
Lifetime
Value
- X
-
Gross
Contribution
Margin
Marketing
Costs
-
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63
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&
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F
A
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IMPROVED
ACQUISITION
IMPROVED
RETENTION
Dynamic
Customer
Management
Based on
CLV
IMPROVED
SHAREHOLDER
VALUE
CLV For Better Customer Management &
Improved Shareholder Value
drvkumar.com © Dr. V Kumar
Why CLV?
• Forward looking metric unlike other traditional measures (that include
past contributions to profit).
• Helps marketers to adopt the right marketing activities ‗today‘ to
increase ‗future‘ profitability.
• It can be used to include prospects, not just current customers.
• It is the only metric that incorporates into one, all the elements of
revenue, expense and customer behavior that drive profitability.
• It enforces the focus on the customer (instead of products) as the
driver of profitability.
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Understanding the different
components of CLV
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drvkumar.com © Dr. V Kumar
Gross Contribution Margin (GC)
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Gross Contribution
Margin (GC)
Revenue obtained
from a customer
in a given purchase
Cost of goods
sold
=
_
drvkumar.com © Dr. V Kumar
Marketing Costs (M)
Development and Retention costs
- costs of programs to increase the value of existing relationships
- costs of loyalty or frequent buyer programs
- costs of campaigns to ‗win back‘ former customers
- costs of servicing customer accounts
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Time period (i)
This refers to the natural "lifetime" of customers
For most businesses, it is reasonable to expect customers to return for many
years (‗N‘ number of years).
drvkumar.com © Dr. V Kumar
Discount Rate (d)
• Profits you receive from your customers come in over several years
• Money received in future years is not worth as much today as
money received today.
• To estimate the value of future money, we must discount it by a
certain percentage.
• This equates the future money to current profits.
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What is a good discount rate?
- Depends on general interest rate.
- Normally proportional to the treasury bill rate.
- In other words proportional to the interest that banks pay on savings
accounts.
drvkumar.com © Dr. V Kumar
CLV Measurement Scenarios
Scenario 1
• One Purchase per Year
• Eg:
Scenario 2
• Multiple Purchases per Year
• Eg:
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drvkumar.com © Dr. V Kumar
Measuring Customer Lifetime Value
Case I- P&C Insurance Company
70
( )
|
|
.
|


\
|
+
¯
=
=
t
d) 1 (
t
r
N
1 t
* M - GC CLV
•Sales take place once a year
•Annual allocation of marketing resources
•Customer Retention rate common over time
•Revenues per customer constant over time
N = Planning horizon in years
GC = Annual gross contribution margin.
M = Marketing costs per year.
d = Annual discount rate (appropriate for marketing investments).
r = Annual retention rate
drvkumar.com © Dr. V Kumar
Measuring Customer Lifetime Value
Case I- P&C Insurance Company
71
( )
¯
=
+ ÷ =
10
1
]} ) 2 . 1 /( ) 75 [(. { * 000 , 5 000 , 26
t
CLV
t t
= $34,681.00
Numerical Example
Consider an online insurance company trying to estimate CLV for a
customer base of 1000 customers.
Annual promotional expense = $5,000
Annual retention rate = 75%
Planning period = 10 years
Annual Gross Contribution = $26,000
Discount rate = 20%
drvkumar.com © Dr. V Kumar
Progression in CLV Measurement
• Case I represents CLV
predictions on an average for
all customers
• Current techniques focus on
predicting CLV for each
individual customer in a
dynamic fashion
Individual
Customers
Customer
Segments
All
Customers
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When is a customer still a customer?
73
Probability (Alive) = t
n
where n is the number of purchases in a given period and
t is the time of the last purchase (expressed as a fraction)
Customer 1: t = (8/12) = 0.6667 and n = 4
Thus: Prob. (Alive) = (0.6667)
4
= 0.197
Customer 2: t = (8/12) = 0.6667 and n = 2
Thus: Prob. (Alive) = (0.6667)
2
= 0.444
Customer 1
Customer 2
x x x
x x
x
Month 1 Month 12 Month 18
Observation period
Holdout period
?
Month 8
drvkumar.com © Dr. V Kumar
Issues At Hand
• Based on the probability estimates, Customer 2 seems to be more
promising
• What else do we need to know?
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Customer 1 Customer 2
Gross Margin $100 $50
Prob (Active) 0.2 0.4
Therefore, Expected Gross Margin =
Gross Margin * Prob (Active)
$20 $20
Now, which customer is more profitable?
drvkumar.com © Dr. V Kumar
Issues At Hand (contd.)
• Consider the marketing communication cost for each of the
customers:
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Customer 1 Customer 2
Expected Gross Margin $20 $20
Marketing communication cost $10 $15
Therefore, Expected Net Margin =
Expected Gross Margin – Marketing Cost
$10 $5
Thus, Customer 1 is more profitable than Customer 2
after accounting for future customer revenue and cost
drvkumar.com © Dr. V Kumar
Calculation of NPV
76
t
T
d
it
ACM
t
it
Alive P
i
GC of NPV
|
.
|

\
|
+
¯
=
=
1
1
*
1
) (
Where
NPV = Net Present Value
GC
i
= estimated expected gross contribution margin for customer i
ACM
it
= average monthly gross contribution margin for month t based on all prior purchases
d = discount rate for month t (15%on a yearly basis)
i = customer
t is the month for which NPV is being estimated
T is the number of months ahead that are included in the forecast
P(Alive) is the probability that customer i is alive in month t
drvkumar.com © Dr. V Kumar
77
24 . 127 $
81 . 55 43 . 71
) 12 . 1 / 1 ( * 100 * 7 . 0
) 12 . 1 / 1 ( * 100 * 8 . 0
1
1
*
1
) ( of NPV
2
1
2
=
+ =
+
=
|
.
|

\
|
+
¯
=
=
t
d
it
ACM
t
it
Alive P
i
GCM
Calculation of NPV: An Example
t
d
it
ACM
t
it
Alive P
i
GC
|
.
|

\
|
+
¯
=
=
1
1
*
1
) ( of NPV
2
ACM
it
= 100 for Year 1 and 100 for year 2
d = discount rate (12% on a yearly basis)
i = agent
Number of years = 2
P(Alive) is the probability that agent i is active = 0.8 for year 1 and 0.7 for year 2.
drvkumar.com © Dr. V Kumar
When To Stop Chasing???
• The important factor in deciding when and which customers to let
go of is the measurement of profitable customer lifetime duration
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• Decision Rule:
– If NPV of Expected contribution margin is less than cost of
mailing, then the firm would decide to terminate the
relationship
• Using the above decision rule, we can establish for every
customer at what point he is subjected to the proposed
termination policy
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drvkumar.com © Dr. V Kumar
P(Alive) and NPV Calculation in Class
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