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FH Schmalkalden

FB Wirtschaft

„Customer Lifetime Value Calculation and Maximization“

von

Kathleen Paeger
Matrikel-Nr.: 241801

Erstellt im Rahmen des Schwerpunktes Controlling:

Prof. Dr. Peter Schuster


Sommersemester 2009

Anschrift der Bearbeiterin:

Ernst-Thälmann-Straße 16
98593 Floh-Seligenthal

Abgabe: 14. Juli 2009


Table of Content

1. Introduction........................................................................................ 1
2. Basic Model....................................................................................... 2
2.1. “Lost-for-good” model...................................................................3
2.2. “Always-a-share” model ............................................................... 4
3. Extension of the Model ...................................................................... 6
3.1. Market potential ........................................................................... 7
3.2. Resource potential ....................................................................... 9
4. CLV Maximization............................................................................ 13
4.1. Customer Selection.................................................................... 13
4.2. Customer Segmentation ............................................................ 13
4.3. Optimal Resource Allocation ...................................................... 15
4.4. Purchase Sequence Analysis..................................................... 16
4.5. Targeting Profitable Prospects ................................................... 18
5. Evaluation of the Model ................................................................... 20
6. Conclusion....................................................................................... 22
References............................................................................................ 23
1. Introduction

Customers are critical assets of any company. Without customers a firm has no
revenues, no profits and no market value.

Recently, the concept of customer lifetime value is gaining increasing importance in


literature and practice. Companies have had enormous success after implementing
customer lifetime value calculation and corresponding database techniques.
(Gupta/Lehmann, 2008 p.255)

Companies have realized that with an increasing duration of a customer relationship


the generated profit per customer and year is increasing as well. To build long-term
relationships companies operate systems for customer retention. However, the
question arises, how much should a company invest in a customer relationship and
which customer is worth spending money. On the one hand the amount spending is
dependent on available resources; on the other hand the expected future surplus is
of vital importance. Therefore, a company has to know how valuable their existing
customers are before they are able to predict their potential.

This thesis will answer important questions of companies for example what value a
customer has for a company, the influence of specific key drivers, and which
qualitative determinants have to be considered beside the common quantitative
determinants. Can customers be evaluated based only on their past purchase
behavior and if not which measure is the most suitable in identifying the future value
of the customer? Oftentimes customer oriented companies realize that their
customers are valued more than the profit they bring in every transaction. In fact their
value has to be based on their contribution to the company across the duration of
their relationship with the firm. In other words, the value of a customer is the value
the customer brings to the company over his or her lifetime. Some recent studies
(Reinartz/Kumar, 2003) have already proven that past contributions from customers
may not always reflect their future worth to the company. Hence, there is a need for a
metric which will display future profitability of the customer to the firm (Berger/Nasr,
1998): Customer lifetime value calculation.
1
2. Basic Model

Kumar (2006, p.9) defines customer lifetime value (CLV) as the sum of cumulated
cash flows – discounted using the weighted average cost of capital – of a customer
over his or her entire lifetime with the company.

Customer lifetime value is increasingly recognized as one of the most important


measures of the worth of a customer, as it takes into account not only the customer’s
current value but the expected value over their projected lifetime with a company. So,
it can be defined as the potential value of a customer for a company over the
relationship duration related to a specific point in time, usually the present day (Bruhn
et al. 2000, p.172). For this purpose the expected cash flows generated by a
customer during his or her relationship are discounted by a determined discount rate
to present day. This results in a perspective’s movement from single transactions to
a long-term relationship between supplier and customer within the relationship
framework. CLV is mainly determined by the following factors:

 Number of transaction per period


 Value of single transactions
 Discount rate
 Relationship duration (customer retention)

We differentiate between two basic models to calculate customer lifetime value: The
so-called “lost-for-good” model (resp. customer retention model) and on the other
hand the “always-a-share” model (resp. customer migration model) (Dwyer 1997).
Both models will be described below.

2.1. “Lost-for-good” model

The first approach, “lost-for-good”, assumes that when a customer terminates a


relationship, he or she does not come back to the company and has to be acquired
again. This model especially applies to relationships with a contractual setting as in
financial services or relationships based on subscriptions. A very important factor
within this model is the customer retention rate. The retention rate describes the
probability that a customer relationship persists in the next period. If the retention rate
equals to zero, the relationship ends after the considered period. With a customer
retention rate of one the continuity of a relationship is assured for example within a
contractual setting (Bruhn et al. 2000, p.174). The following formula demonstrates the
basic approach for a CLV calculation of a “lost-for-good” model:

where

CLV = customer lifetime value


i = customer
t = time period
d = discount rate
CMi,t = predicted contribution margin from customer i in period t
Mi,t = predicted marketing costs for customer i in period t
Ri = retention rate for customer i.

The length of the considered planning period depends heavily on the considered
branch. Oftentimes five periods are suggested for consideration, because with a
longer planning period the uncertainty of forecast increases (Dwyer 1997, p.9). In
branches with long transaction cycles ten periods for a planning period are
appropriate (Berger/Nasr 1998, p.21). In case of a long planning period Blattberg et
al. (2001, p.210) suggest a compromise to choose a relatively high discount rate so
that cash flows far in the future have a lower impact, which is appropriate to
uncertainty.

The used imputed discount rate is consequently of vital importance for a forecast.
The level of discount rate is determined by the level of capital market interest,
inflation rate, cycle period and individual risk assessment. As mentioned before the
customer retention rate is of vital importance for CLV calculation in the “lost-for-good”
model.
An estimation of the retention rate can be carried out in two ways: On the one hand
based on customer surveys within marketing research (behavior tendency) and on
the other hand based on monitored customer behavior in the past (actual behavior
figures). Actual figures referring to the monitored customer behavior in the past allow
often more accurate forecasts. Following determinants are mentioned as indicators
for customer retention (Reinecke/Dittrich 2006, p. 333):

 Purchase intensity (number of transactions per period)


 Frequency of contacts (number of contacts from customer per period)
 Relative duration since last transaction
 Average sale per transaction
 Share of wallet (percentage of customer’s expenses for a product that goes to
the company selling the product)
 Number and type of customer complaints
 Number of recommendations

Because of the assumption that when a customer terminates a relationship, he or she


does not come back to the company the approach is questionable. The approach
systematically understates CLV. To resolve this problem, researchers use the
“always-a-share” model.

2.2. “Always-a-share” model

In contrast to the “lost-for-good” model the “always-a-share” approach assumes, that


a customer frequently switches between different suppliers without terminating the
relationship definitely. Therefore, the term “customer migration model” is
synonymously used. Future purchase decisions of a customer are considered as a
stochastic process. It is assumed that the customer’s choice of a supplier follows a
probability mechanism. Instead of the customer retention rate within the “lost-for-
good” model the possibility of choosing the supplier for each transaction is of vital
importance in the “always-a-share” approach. Hence, the “always-a-share” approach
calculates CLV with the predicted frequency of a customer’s purchases given his or
her previous purchases. It is a better way of projecting future customer activity. A
CLV function, which incorporates predicted frequency, contribution margin, and
variable costs, can be expressed as follows: (Venkatesan/Kumar 2004, p.108):

where

CLVi = lifetime value of customer i,


CMi,y = predicted contribution margin from customer i in purchase occasion y,
d = discount rate
ci,m,l = unit marketing cost for customer i in channel m in year l,
xi,m,l = number of contacts to customer i in channel m in year l,
frequencyi = total number of transactions within planning period
n = number of years to forecast, and
Ti = predicted number of purchases made by customer i until the end of
the planning period

In contrast to the “lost-for-good” model the periods are not cumulated, but the number
of transactions. Therefore, y is the predicted total number of transactions within the
planning period. So the discount rate’s exponent considers the number of transaction
per period. And if frequencyi = 1 (one transaction per period) the above formula
equals the traditional CLV-formulas (Rust et al. 2004, p. 114.)

Comparing both approaches it is to state, that neither of them is to favor over the
other. The appropriateness of the approaches primarily depends on the considered
branch. Especially in branches characterized by a contractual setting like financial
services or telecommunications, normally the lost-for-good-model is better suited for
calculation. In case of consumer goods on the contrary the always-a-share approach
depicts reality the best (Calciu/Salerno 2002, p.126; Dwyer 1997, p.9.).

With the calculation of the customer lifetime value it has to be considered, that
besides of the monetary components within the formulas there exist additional
determinants, which influence the value of a customer. These will be explained in
detail in the following chapter.
3. Extension of the Model

The customer’s economic relevance for a company is not certainly only limited to his
or her profit generated today or in the future. Customer’s contribution to company’s
profit turns out to be more complex. On the one hand there is the profit resulting from
the business transactions with the customer referred to as market potential of a
customer in the following. And on the other hand the customer virtually acts as
resource of the company. Thus, it is described as resource potential of a customer.

Accordingly, for an extensive evaluation of a customer the quantitative criteria are not
sufficient. Sales volume and contribution margin are available for the past and the
present, but there will be forecast problems for an estimation of the future value.

Tomczak and Rudolf-Sipötz (2006) point out that with an appraisal of customer
lifetime values it is to consider, that besides the quantifiable components of the basic
model there exist more components, soft factors. These factors are not measureable
in terms of monetary criteria, but have to be considered within the analysis because
they make a significant contribution to the customer value in excess of financial
importance of a customer relationship and provides valuable information, if individual
customers are evaluate in comparison with each other. Hence, a customer
relationship can not only be determined by monetary facts, but soft facts have to be
incorporated into customer valuation with adequate criteria even though they do not
affect customer’s contribution margin directly. Because these additional components
are caused by customer behavior, they must be added to the customer lifetime value.
So the basic calculation of customer lifetime value has to be expanded by information
about customer behavior and necessitated to consider all determinants of potentials
(Table 1).
Table 1: Determinants of customer value (Source: Tomczak/Rudolf-Sipötz, 2006, p. 132)

It should be mentioned that indeed within the literature diverse potentials are
discussed but there is a lack of adequate conceptualization and operationalization of
these determinants.

3.1. Market potential

The so far considered monetary potential of a customer in the basic model is also
referred to as market potential. The market potential of a customer is the sales
success, which a customer generates for a company at present and in the future as a
purchaser of goods and services in a business relationship. Both in past and today
companies still orientate their decision mainly on actual data.

Potential yield: The potential yield of a customer represents the current monetary
contribution of a customer to company’s success. A suitable figure is the customer
profitability and customer contribution margin calculation, which considers the
proceeds and costs resulting from the relationship. Although this figure is not
convincing as the value of a customer for a company, it provides the only basis,
which investments for a relationship are undertaken. Still problematic in practice is
the costs-by-cause principle. The reasons for differences in costs and revenues are
manifold. As cost drivers are to name e.g. amount of orders and frequency of
purchase (Tomczak/Rudolf-Sipötz, 2006, p. 132).
Development potential: The expected future revenues are more important than the
potential yield. As a description of the development potential the expected
contribution margin potential of a customer as sole information is not sufficient. In fact
the development of a customer – his or her growth – is of larger interest. Because a
customer who contributes negatively at present to the success of a company can
achieve very well a positive contribution margin in the future. Here, reference is made
to the customer life cycle. Similar to the product life cycle business relations pass
through several phases, which help to predict the demand over time. But at the same
time situational influencing factors show the limitations of the concept. Therefore it is
difficult, almost impossible to predict the development of an individual customer. But
even if the total demand is known or determined, the following question is about
which share of wallet a company is able to realize because of its strengths and
weaknesses and which is covered by the competitor. The probability of how high the
share can be depends on the loyalty potential of a customer and underlies a specific
forecast uncertainty (Tomczak/Rudolf-Sipötz, 2006, p. 133).

Cross-buying potential: The development potential discussed before is very closely


related to a customer’s cross-buying potential. It describes the extent to which a
customer makes additional dealings from other than the previous fields of the
provider’s service offering.

Determining factors of the cross-buying potential are the customer’s willingness to


cross-buy besides of the customer needs. Therefore a customer, who does not want
to be dependent of a single supplier, shows low willingness to cross-buy. In addition
other factors can be critical as well for customers, who do not want to purchase from
the same supplier, e.g. the desideratum of variety-seeking.

There is a broad consent about the necessity of improving exhaustion of a customer


throughout cross-selling. And although the concept of cross-selling is anchored in the
everyday language of managers and sales department it is deficient in
implementation. Determination and concretization of the cross-buying potential is
very difficult in practice. Also within the literature only a few approaches are
discussed (Cornelsen, 2000, p. 172).

Loyalty potential: Oliver (1997, p.392) defines loyalty as a deep commitment to


repurchase a product or inquire service consistently in the future despite situational
influences and marketing efforts having the potential to cause switching behavior. So
this driver defines, if a customer inquires services in the future.

In general two dimensions of loyalty potential are identified: dedication-based


relationship maintenance and constraint-based relationship maintenance.
(Bendapudi/Berry 1997, p.17) The first view comprehends trust, commitment, and
customer satisfaction whereas the constraint-based relationship is defined by
dependency within the relationship and the existence of alternatives.

Despite of the positive effect of dependency on relationship continuity is has to be


considered, that a customer will try to drop out of the relationship dependence which
feels negative according to this high dependence. So trust is crucial for loyalty
potential and it reduces the opportunistic behavior. Also commitment is considerable.
Commitment describes the strong inner bond, which covers stability (willingness to
maintain the relationship) and readiness to make sacrifices (acceptance of temporary
disadvantages). In particular, customer satisfaction and the confidence of the
customer should be named as key determinants.

3.2. Resource potential

The market potential describes the profit-oriented view of customers and his or her
direct contribution to the success of a company. The second determining factor refers
to the customer as a resource of the company and comprises the indirect contribution
margin by acting often active and passive as company’s resource. Reference,
information, cooperation and synergy potential are related to the resource potential.

Reference potential: The reference potential of a customer is determined by the


number of potential customers reached in a specific period because of his or her
recommendation, ability of influencing, frequency and intensity of contact, and
degree of social networks. The customer is able to influence with positive, neutral or
negative information about a supplier or product. And we have to differentiate
between active (e.g. recommendations) and passive reference potential (e.g. acting
as lead user).
Indicators, which are adequate to represent the reference potential of a customer, are
manifold and related to the number of reference recipient, personality and know-how
of the reference bearer, his or her willingness to recommend and effect of the
reference (Cornelsen, 2000, p.200).

Information potential: The information potential contains all information, which a


customer offers a supplier and can be used by the company. This information is of
strategic as well as operative relevance. A substantial criterion is that the term
information potential always refers to an information stream from a customer to the
company, while the reference potential is based on the communication between a
customer and his social environment (Cornelsen, 2000, p.224).

In the same way information are manifold, so are source of generation. The simplest
and in practice most frequent established method is the customer survey. Within
almost all companies data warehouse respectively marketing information systems
provide the opportunity to collect information of the customers, to evaluate them and
to use them for company’s decision. In daily business an active complaint
management is helpful to use continuous such information potentials.

The information potential is not only limited to the communication between end
customer and company. Quite the contrary, especially the business-to-business area
represents a lot of possibilities. For example an involvement of the customer in the
product development enables a company to tap the full information potential.

For an evaluation of the customer’s information potential we have to take into


account the willingness to provide information and to give feedback, as well as the
content and quality of the information. Objective of a customer value management is
to name and structure the different areas of information and to support the
information stream actively. Therefore, an intensified exhaustion of the information
potential of a customer can be achieved (Kleinaltenkamp/Dalke, 2006, p.236).

Cooperation potential: The cooperation or integration potential of a customer


describes the readiness and ability to contribute production factors in the production
of goods and services for limited time. Part of the cooperation potential are all
synergies and potentials to enhance value, which can be realized throughout an
intensified cooperation and integration into the value-added chain of suppliers and
demanders within a limited period.
There are various areas of application along the value-added chain for example
research, development, logistics, organization and marketing. In the course of the
increasing movement of the value-added chain towards the customer the cooperation
potential is particularly to find in the business-to-business and service sector,
because customer and supplier are often involved in the production of goods and
services at the same time.

In the presented conceptualization of the customer value especially the exchange of


tangible resources (real capital and human resource) mostly defines the cooperation
potential. By contrast the information streams are a constitutive characteristic of the
information potential.

Despite of the importance of the factor cooperation potential in the business-to-


business sector there are more applications in business-to-customer business. For
example, an implementation of an online banking service depends on the willingness
of a customer to cooperate. This includes the will and the ability to use it and the
customer’s know how (Tomczak/Rudolf-Sipötz, 2006, p. 137).

Synergy potential: Besides the external synergy possibilities of the cooperation


potential there might be internal company synergies relevant, too. Focusing on key
accounts might result from the need of internal coordination or from an expectation of
general relief of internal coordination. The internal synergy potential covers all
economies of scope of the customer base, where a customer – active or passive –
causes interactions.

A significant indicator for a high synergy potential is a high share of wallet of a


customer with the company. Therefore a strong dependency of the customer is given,
whereby changes within the relationship affect company’s profit significantly.

An important economy of scope is not only a high share of wallet for each customer,
but also important sales relationships of a customer to subsidiaries, even if the
customer has a marginal economic relevance for the supplier. Characteristics of such
a high synergy potential are for example centralized decision processes for
investments, production or procurement. (Belz/Senn, 1995, p.47)
Another example is economies of scale. This effect results from an increasing size of
the company respectively increasing number of customers with the possibility of cost
reduction in several business sectors e.g. manufacturing and distribution.

As a conclusion of the basic and extended model and as mentioned before, in the
literature there are several CLV approaches discussed, but to this day no single CLV
approach and, most importantly, no single calculation model exists which covers all
relevant CLV components that have been identified so far. For example some of the
approaches include effects of the resource potential while neglecting retention rates
or vice versa. (Bauer et al., 2003, p.53)
4. CLV Maximization

4.1. Customer Selection

Several customer valuation techniques (e.g. ABC analyses, scoring models,


customer portfolio methods) have shown that not all loyal customers are profitable.
So it is important to figure out which customers bring maximum profit, because these
are worth to retain and improve company’s profitability. Valuing each customer and
identifying customer- and firm-specific drivers of profitable long-term relationships are
the first steps to determine profitable customers. Studies of Reinartz and Kumar
(2000, 2003) and Venkatesan and Kumar (2004) have shown that CLV calculation is
superior to scoring models when it comes to customer selection. The superiority of
the CLV model was thereby explained, that the predictions about future profits and
customer purchase behavior based on past data most likely correspond to the actual
future results and were more precisely than other scoring methods. These studies
clearly show that CLV-method is a better metric in selecting the most profitable
customers. These results from two separate studies using database from business-
to-customer and business-to-business firms provide substantial support for the
superiority of CLV framework over other metrics for customer scoring and customer
selection.

4.2. Customer Segmentation

Segmentation is a strategy to manage marketing efforts directed at customers. It


marks a change from mass marketing to targeting marketing activities to specific
groups of customer. Incorporating customer profitability into segmentation strategies
enables an organization to improve the effectiveness and efficiency of their marketing
campaigns. (Lemon/Mark, 2006, p.56) So a development of customized marketing
strategies for each segment, which means differential treatment of customers, is one
way to manage customers according to their profitability.

Companies are building on traditional bases of segmentation such as geographic,


demographic, socioeconomic, attitudinal, and behavioral to incorporate customer
past and projected purchase data into customer segmentation models. In order to
understand why certain customers are more profitable than others, firms need to
understand the variables, which differentiate each segment from the other and
explain why certain customers are more profitable than others. Some of the
exchange and customer demographic variables are amount of purchase, degree of
cross-buying, average interpurchase time, number of product returns, ownership of
loyalty instrument, mailing effort by the firm, location and income of customers.
(Kumar, 2006, p. 614)

Reinartz and Kumar examined in their study (2003) the different impact of each
variable on the customer lifetime duration and how they affect CLV. The customers
are grouped into segments based on these exchange and demographic/firmographic
variables and afterwards the profile of the segments are analyzed. Profiling helps
firms to better understand the customer composition of each segment, the
characteristics of the most valuable customers, what are the best marketing channels
to reach them, and how frequent do they purchase. The analysis can be used to
identify the customer segments on which companies should concentrate on and to
evaluate the efficiency and effectiveness of their marketing programs. For instance, if
number of marketing touches is found to be a key driver of high CLV, firms can easily
identify segments which are low on the number of touches on an average and target
those segments in increasing the number of marketing touches through the most
effective channels thereby improving the profitability of the segment.

Thus, a mixture of segment level marketing to improve the key drivers and customer
level strategies on marketing communication can improve the customer lifetime value
of a segment.

For managing for example loyalty and profitability simultaneously, a segment-based


approach is used to tailor the most suitable marketing messages to these segments.
But this is only one example of an approach a firm can follow. While designing and
implementing a customer segmentation firms can use CLV with any other metric that
fits to their type of business (Kumar, 2006, p. 615).

4.3. Optimal Resource Allocation

After evaluating the usefulness of CLV for customer selection and the help of
customer segmentation to identify the most profitable customer, the strategy is
described how to allocate resource optimal to maximize CLV. Most companies are
constrained by a restricted budget and the resources are not sufficient to allocate to
all customers. Because of customer selection and segmentation the firm knows in
which customer they have to invest to get the highest outcome. However, many firms
continue mass marketing and spend their resources on unprofitable customers as
well because they have not yet identified how much resource they have to spend on
each customer (Venkatesan/Kumar, 2004). With the introduction of CLV framework it
is now feasible to allocate resource on an individual customer level. Venkatesan and
Kumar (2004, p.23) have developed a framework that enables firms to determine
optimal marketing strategies across various channels to each customer within the
database, while at the same time continuing to maximize financial performance of the
firm. The model allows customer level actions and help manager choosing the right
channel to communicate to a customer and expending the right amount of resources
across channels of communication for each customer to improve the result.

Venkatesan’s and Kumar’s model (2004) to optimize resource allocation uses the
CLV equation as the objective function and the purpose of the model is to find the
level of contacts across various channels with each individual customer that would
maximize CLV. Their first step was to estimate the responsiveness of customers to
marketing contacts whereas each CLV is related to the cash flow of each customer,
the expected interpurchase time and costs and frequency of marketing contacts.
Using these coefficients, the level of channel contacts for each customer which would
maximize the CLV can be determined. The frequency of channel contacts to a
customer across various channels is under the supplier’s control and therefore can
be used to maximize CLV with respect to marketing costs and responsiveness of the
customer in terms of purchase frequency and contribution margin.
(Venkatesan/Kumar, 2004, p.120).

The results from Venkatesan and Kumar’s study (2004) demonstrate the
effectiveness of resource allocation strategies and the importance of considering
individual customers’ responsiveness to marketing activities as well as marketing
costs across various channels when making resource allocation decisions. It
illustrates that there is potential for increasing CLV, and therefore profit, by proper
customer selection and optimal resource allocation strategies. Manager can make
use of the resource allocation model to design more effective marketing strategies
and it can be a basis for evaluating the potential benefits of customer relationship
management and it provides accountability for strategies geared toward managing
customer as assets (Kumar, 2006, p. 618).

4.4. Purchase Sequence Analysis

While optimizing resource allocation to increase the profitability of the firm, it is still
possible to refine the marketing strategy further and determine what exactly the
customers are looking to buy and when they might be purchasing each type of
product or service.

Firms offer a range of products, so it is almost impossible to determine what product


a particular customer is going to buy next. It would be useful for a firm to predict the
relative probabilities of different product categories being bought at different times
from a given firm, given the varying purchase patterns of each of its customers. This
information are very valuable, because the firm would be able to contact customers
at appropriate time intervals, about products they are more likely to be purchased in
the near future, resulting in a customer specific communication strategy. Some
companies try to predict the future purchase behavior given the past purchases and
preferences and then make recommendations for products most suitable to the
customer. These recommendations are based on the products purchased in the past
by a particular customer who bought the same products. The more accurately the
product recommendations match with customer’s preferences, the more likely the
customer is to make another purchase. A firm having this knowledge has a significant
advantage over the competition (Kumar, 2006b, p.24).

A purchase sequence model developed by Kumar et al. (2006) captures the


differences in the durations between purchases for different product categories by
incorporating cross-product category variables. The basic concept of this framework
is that often times there are interdependences in product purchases and similarities
in purchase pattern of customers. Purchases of certain products are dependent on
the product purchases in the past and a customer who bought a particular product is
unlikely to buy the same product immediately. So there is a natural ordering of
product purchases, for example purchases of accessories follow the main product.
After recognizing the interdependences of product purchases and purchase
propensities across product categories as well as in the purchase timing, customer
level predictions can be developed to target the right customer, with the right product
at the right time.

Customers also seem to follow purchase pattern similar to other customers, because
they observe other customer, whom they trust or because of word-of-mouth effects
according to their reference potential and resulting from communication with other
customers. In either case, the customer purchases a product relying on the
information processed by customers whom they trust. As a result the firm is able to
model behavior and predict the probability of purchase timing and sequence.

The study by Kumar et al. (2006) illustrates the effectiveness of the purchase
sequence model using data from a business-to-business firm. The results indicate
that the model is able to prioritize customers by indicating the probability to purchase
different products and to predict the expected profits. Therefore, knowing the
sequence and timing of purchases by individual customers, a company is able to
develop the best and more effective marketing strategy to contact customers. It helps
in increasing cross-buy ratio and revenue, apart from decreasing marketing costs,
thereby leading to a higher profitability and an incremental return on investment
compared to firm’s traditional contact strategies. This also helps firms to develop
cross- sell and up-sell strategies (Kumar, 2006b, p. 25).The main advantage of this
analysis is that a company can therefore contact customers with time and product
specific offerings rather than contact the customers with multiple product offerings in
each time period.
4.5. Targeting Profitable Prospects

It is already explained how companies can maximize their profitability from existing
customer by prioritizing, selecting and implementing individual level strategies.
However, a company who wants to grow and be competitive has to target profitable
prospects, acquire them and nurture relationship with them. The challenge is to
acquire only profitable customers, because acquiring unprofitable customers will only
cause additional costs in the long run and not acquiring a profitable customer will be
a lost opportunity. The first step is to determine profitable potential customers and
also which passive customers are worthwhile to win back. The question is how to
determine these customers with only limited information about their prospects and
which marketing campaigns is the most effective to acquire the profitable customers.
Customer profile analysis and segmentation of the existing customers answers this
question. They provide as the information about demographic variables, what
channels of communication are most suited to them, and what marketing campaigns
are most effective to win them. Profiles of existing customer should be the basis for
the prospect pool and archived customer information should be used to find potential
customers with matching profiles as those customers who currently have a positive
CLV. There is a high probability that these prospects with characteristics similar to
the existing customers become high-value customers in the future (Kumar/Petersen,
2005, p.514).

The findings of the former profile analysis and optimal resource allocation help to
identify the right marketing activities and to efficiently manage their restricted
marketing budget when attracting new prospects. Another important aspect is to
consider acquisition and retention as two independent activities. Firms need to link
acquisition expenditures to retention expenditures to avoid underspending and
overspending, whereas underspending is more detrimental and results in smaller
return on investments than overspending (Reinartz et al., 2005, p.77).

Blattberg and Deighton (1996) show that firms need to link acquisition efforts to
retention efforts to avoid underspending and overspending on acquisition or
retention. The research by Thomas et al. (2004) show a balanced allocation of
acquisition expenses and retention expenses leads to higher customer profitability.
But when firms have to trade off between expenses for both, a suboptimal allocation
of retention expenses will have a greater impact on long-term customer profitability
than suboptimal acquisition expenditures will have. Even a small deviation of the
optimum spending can result in extensive consequences on the firm’s overall
profitability. Their study reveals that acquisition and retention costs of profitable
customers can be either high or low having compared the profits generated by the
customer with the expenditures of acquisition and retention. With this approach it is
easy to determine at which point extra spending on customer retention starts to reap
diminishing returns. A customer segmentation into four groups (high/low acquisition
costs and high/low retention costs) illustrated that profitable customers are present in
each field whether acquisition costs are high(low) and retention costs are low(high) or
both costs are low(high). Thus, to maximize financial performance, firms need to
carefully pick customers from each of these four cells rather than going after only
customers who are inexpensive to acquire or retain.
5. Evaluation of the Model

In comparison to static investment appraisals this dynamic approach for customer


valuation enables a company to consider the development of a relationship over a
customer lifetime and to quantify the monetary value. Only over time it is evident if
customer retention actions are able to generate the expected profit or in other words
if a retention of a customer increases the customer value in the long run or if a
retention leads to losses. An isolated static calculation is not able to reflect a
customer’s future potential in an adequate way.

But problems of this model have to be mentioned as well. The accurate allocation of
costs and revenues on different periods of a relationship constitutes an obstacle to
overcome as well as the consideration of non-monetary determinants.
(Hempelmann/Lürwer, 2003, p.336)

Accountants should not have a problem with familiarization in the method because
similar approaches are already known for example net present value calculations of
product investments. The most important obstacles are the level of the discount rate,
reinvestment assumption and uncertainty of cash flow estimation. One difference to
the common approaches is that the duration of a business relationship is a lot harder
to estimate than expected useful life of machines. But be aware, that with an
approach of very long relationship duration not every relationship will finally end up
with a positive contribution margin. It is more essential than ever to get information
about the course of a relationship instead of rely on past figures. (Weber/Willauer,
2000, p. 30)

Prior research has typically relied on past purchase behavior and marketing actions
to predict future behavior. They overcome the obstacle of future uncertainty through
incorporating retention rate and discount rate. For most companies it is impossible to
perfectly predict the cash flows associated with an individual customer, but they can
calculate the expected value of the cash flows (adjusting for risk) associated with an
individual customer conditional on the customer’s characteristics, the company’s
planned marketing strategies and environmental factors (Zeithaml et al., 2006).
Kumar et al. (2006b, p. 90) agree with the last statement. The current CLV models
mainly factor customers‘ past purchase behavior and firms’ efforts to build long term
relationships in to predict future customer contribution. But this supposes a relatively
stable past and predictable future customer behavior. Under certain circumstances
this assumption may be true for the majority of customers, but others does not
continue past purchase behavior therefore a prediction of future behavior based on
the past is hardly possible. One possible approach to improve the CLV model is to
identify measures, which are more forward-looking and more effective in helping
firms anticipate customer changes before they occur and thereby provide
opportunities to build and maximize CLV. This comes along with an improvement of
customer behavior prediction. Currently available customer metrics may be
insufficient, because they only reflect the past.
6. Conclusion

Although the CLV approach is classified as relative useful and its superiority is
proven only a few companies use the approach to evaluate customers. Obviously in
practice there is a lack of feasible calculation methods for lifetime valuation while
another reason is the inertia to move away from the accepted practices. But
nevertheless the achievement of customer lifetime value calculation is to view
customers in terms of long-term relationships rather than transaction because a
short-term view could lead to misinterpretations. Hence, CLV concept is the
appropriate tool to help companies developing the long-term perspective and deriving
the best suited marketing strategies to get the most out of their customer.

Nevertheless, further research is expected in the fields of CLV measurement and


improvement of the CLV calculation, better understanding of CLV key drivers and
further convincing evidence concerning the importance of using CLV for optimal
marketing concepts. However, considering the dynamic nature of the purchase
behavior of customers future models are also expected to draw a better picture of the
impact of customer potentials in determining the lifetime value of customers.

But with more and more companies implementing the CLV concept for resource
allocation and other customer specific strategies to increase company’s profit, CLV is
expected to gain wide spread acceptability as the preferred metric for resource
allocation.
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