Measuring Customer Lifetime Value: An Application in Credit Card Industry

Chun-Wei Chang
Governors State University

Olumide Ijose
Governors State University

ABSTRACT

Finding the most profitable customers and managing profitable relationship are always
the critical issues in the field of customer relationship management (CRM). Customer
lifetime value (CLV) is one of the popular concepts in CRM to help firms select and
target potential and the most profitable customers. However, company may feel it is not
practical because of the difficulty in computation. In this paper, the authors illustrate
how to measure customer lifetime value by considering individual heterogeneity step by
step and offer an application in the credit card industry. Based on strategic segmentation
by taking into account both customer lifetime value and current share of wallet,
companies can allocate resources, differentiate marketing initiatives, and refine
marketing contacts and promotions. In addition, the article presents the framework of the
cycle of customer lifetime value and offers managerial insights for implementing the
framework outlined in this research.

Introduction
It is commonly accepted that 80 percent of a company’s sales come from 20 percent of its
customers (Dubinsky and Hansen, 1982) and as such identifying those customers and creating a
win-win relationship with them is critical to firms. Since acquiring new customers is much more
expensive than retaining current ones, measuring and maximizing customer lifetime value (CLV)
which can help a company identify the most profitable customers has become an increasingly
important capability in Customer Relationship Management (CRM) in recent years. The
measurement of CLV provides a guideline to answer the following questions: What is the best
strategy for providing differentiated marketing efforts to customers? Who should receive
preferential treatment? Who should receive the least expensive marketing communications and
be directed to the inexpensive channels? How should markets be strategically segmented as
customers become more heterogeneous and how best can resources be allocated to customer
segments? Not only can CLV help firms prioritize and select customers (Kumar et al., 2004;
Reinartz & Kumar, 2003), it also can be used to support merger and acquisition decisions
(Blattberg, Malthouse, & Neslin, 2009; Gupta, Lehmann, & Stuart, 2004; Kumar et al., 2004)
and is a tool for evaluating a firm’s customer equity value by aggregating the CLV of a
company’s current and potential customers (Gupta et al. 2004).

Any company that keeps complete customer transaction records can use the information to
measure CLV and formulate strategies for identifying potential customers and providing further

7
value to current customers. The credit card industry is one of the industries that keeps the most
accurate historical transaction records and demographic information. As an example, published
data from Financial Supervisory Commission in Taiwan (2015) shows that banks issued an
average of 27 million new credit cards per year from 2009 to 2013 (Table 1). However, the
number of credit card in circulation1 and the number of effective cards2 did not grow in a linear
manner; in addition, the usage rate that is, the ratio of effective cards to cards in circulation, in
the time period, averaged 62.85 percent without much fluctuation. This suggests that customers
typically use a certain number of credit cards no matter how many cards they own. Further, it
implies that a credit card company has a lot of inactive customers who cost the bank nontrivially
to maintain the accounts and relationship. All of the banks try to aggressively stimulate
customers’ demand to use their cards and increase the number of active customers, including
sending promotional letter, developing reward programs like cash back, points or extra bonus,
and so on. Therefore, understanding customer value, identifying the most profitable customers,
maintaining the loyalty of the golden 20%, and managing customer-firm relationship are
important issues for the credit card industry.

Table 1 Credit Card Usage Statistics in Taiwan

Number of Total Number of Credit
Total Number of Effective Usage
Year Issuance (in Card in Circulation (in
Cards (in Millions) Rate
Millions) Millions)
2009 25.04 30.57 18.83 61.60%
2010 25.37 30.71 19.53 63.60%
2011 27.42 32.85 20.76 63.19%
2012 28.18 34.08 21.50 63.09%
2013 29.62 35.95 22.56 62.78%

In the following section, we review previous research related to customer lifetime value and
describe the methodology to calculate future cash flow. Then we describe the empirical
application in the credit card industry. The credit card transaction database provided from a
leading bank in Taiwan is used to illustrate the steps for accessing CLV and demonstrates how to
segment and target customers based on the framework of the CLV approach. In the last section,
we discuss contributions from our research to the discipline and to practitioners, and conclude
with a discussion of the paper’s limitations and directions for future research.

Customer Lifetime Value

CLV is a forward-looking metric to evaluate customer profitability and analogous to lifetime

value (Keane & Wang, 1995), customer valuation (Wyner, 1999), and customer lifetime
valuation (Dwyer, 1989). Kotler and Armstrong (2013) defined CLV as the value of the entire
stream of purchases a customer makes over a lifetime. It can also be defined as the present value
of the future cash flow related to customers (Pfeifer, Haskins, & Conroy, 2005), the net present

1
Number of credit card in circulation is the difference between number of issuance and number of termination.
2
Effective cards are cards which have transactions in the latest 6 months. Cards which are inactive more than 6
months cannot be considered as effective cards.

8
value of the difference between benefit and cost associated with each customer, or the sum of
discounted cash flows generated by an individual during the relationship (Berger & Nasr, 1998).

The quality of a firm’s resources is directly related to its ability to create sustainable competitive
advantage. A key resource in this regards is a firm’s customers and their buying habits. The
resource based view (RBV), posits that a resource must be valuable, rare, inimitable, and non-
substitutable (Barney, 1991). To be valuable, a resource must be able to protect a firm from
competitive attacks and a firm should be able to leverage it to take advantage of competitive
opportunities. A resource is rare, when it is difficult to come by, inimitable when it is difficult to
imitate and non-substitutable when it is difficult to replace (King & Zeithaml, 2001; Winter,
1987). A firm’s customers are a clear fit with the RBV’s definition of a resource, as a customer
base can be leveraged to take advantage of opportunities and to defend market share, firms work
hard to attract customers, and there is no economic way to substitute for customers in a market
transaction or to imitate the purchasing capability of customers.

The sophisticated explanatory power of the RBV in relation to the value customers create for
firms is central to the work of marketing theorists. In essence, the RBV approach provides a
compelling framework for exploring and explaining the relationship between customers buying
decisions and firm level value creation. In particular, firms can create a competitive advantage by
leveraging their marketing activities in ways that turn customers into relational market based
assets. Srivasfava, Fahey and Christensen (2001) contend that the quality of a firm’s relational
based assets and its ability to exploit the resource is a critical component of ability to deliver
superior performance. This ability is based on a firm’s capability in creating and nurturing long
term relationships with customers, a concept described as customer relationship management
(CRM) in the literature.

The nexus between a customer’s long-term relationship and value creation has been well
documented in the literature and is partly a function of the exchange efficiencies that accrue from
the repeated business transactions of satisfied customer (Morgan & Hunt, 1994; Reichheld &
Sasser, 1990). In essence, long term satisfied customers represent a win-win value proposition
that can strategically translate into greater bargaining power in exchange relationships with
suppliers and can be the basis for creating formidable barrier to entry to potential competitors.
This capability can become the basis for differentiation based on pricing that supports customer
loyalty behavior and contributes to creating a sustainable competitive advantage for a firm.

The concept of Customer Relationship Management (CRM) is likewise a key driver of CLV. The
practice of CRM views customer transactions as continuous rather than discrete events. CRM
views customer relationship as long term exchanges that are more valuable to the firm and the
customer, due to the creation of time-based exchange efficiencies between a firm and its
customers (Reichheld and Sasser, 1990). Examining historical records of customer transaction to
facilitate an understanding of customer needs, wants and buying behavior, is key to
understanding the value of a specific customer and to sustaining a long-term this relationship.
The ability to understand and anticipate customer needs has been demonstrated to be positively
related to creating sustainable competitive advantage and to having a direct effect on business
performance, because customer contribution to profitability can be expected to increase with
time (e.g. Plakoyiannaki, 2005).

9
The origin of CRM as a professional activity and a research topic goes back to the seminal work
of Dwyer, Schurr & Sejo (1987). The researchers demonstrated the criticality of the relationship
aspect of the buyer-seller relationship to business performance and argued that it should be a
primary focus of marketing research. Further research has identified a strategic and an
operational component to CRM. As a strategy, CRM is engaged with the process of “acquiring,
retaining, and partnering with selective customers to create superior value for the company and
the customer (Parvatiyar & Sheth, 2001). In essence, Parvatiyar and Sheth call for capabilities
that enable a firm to analyze customer transactions and to develop mutually beneficial long-term
relationship with those that are deemed to be the most productive of the costs of the attention
such a strategy inherently entails. The payoff or strategic CRM is seen as the ability to cross sell
new products and services to such customers and to profitably leverage customer equity (CE)
effects on a long-term basis. From an operational perspective, CRM facilitates effective and
efficient day-to-day interactions to customers in a manner that is mutually beneficial (Van
Bruggen and Wierenga, 2005). The attributes of CRM as a source of competitive advantage can
be readily justified by RBV. Specifically, CRM being a firm-specific resource that is based on
differentiators such as trust, customer service, reliability and reputation is valuable, rare, hard to
imitate and difficult to substitute for. A firm would have to formulate and implement its own
unique strategy to attract and retain customers to be in competition with a rival and that may be a
difficult undertaking depending on the characteristics of the industry specific competitive
environment and the prevalent macro factors. In addition, CRM seeks to align customer
preferences to firm innovation and by identifying the most profitable customers and allocating
resources to serve them, optimize profitable long-term relationships with them.

The nexus between the CRM and CLV frameworks is thus clear: CRM represents a database of
customer buying decisions, while CLV presents a range of analytical tools that can be used to
examine the database for decisional purposes. CLV analytics are a powerful tool for sorting,
slicing, dicing, and examining CRM databases to achieve the goals and objective of CRM. It
facilitates the discovery of buyer behavior, the prediction of customer value, the segmentation of
customers into groups and subgroups based on a set of criteria, and an assessment of the
combined value of a total customer base. Though academic research as demonstrated that
customer relationships build on CLV are more profitable than those build on other techniques,
for example, socioeconomic characteristics (e.g. Ventakasen and Kumar, 2004), the value of
CLV is ultimately a function of the quality of the CRM database, firm level criteria guiding
segmentation and the quality of the internal resources and capabilities available to a firm in data
analysis, innovation and customer relationship management.

CLV is also considered as the best metric to manage customer profitability and provides greater
insight than traditional backward-looking metrics such as RFM (Recency, Frequency, and
Monetary value), past customer contribution, and share of wallet (SOW) (Kumar & Rajan, 2009)
for the following reasons: (1) it can assess customer profitability at the individual level. (2)
Forecast the future cash flow structurally. (3) RFM assesses customers based on the recency
(time of most recent purchase) and frequency (number of prior purchases) of their buying
behavior and the monetary value of their purchases, in terms of the average value of each
transaction. Aside from being backward looking, RFM metrics do not account for latent
behavioral differences (Morrison and Silva-Risso, 1995).

10
In general, CLV framework includes four main components: expected spending amount,
marketing expenses, retention rate, and discount rate. Each of the components can be assessed at
the individual level to generate individual level CLV as shown in equation (1).

(𝑛𝑒𝑡 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑖𝑡 )× 𝑟𝑡
𝐶𝐿𝑉𝑖 = ∑𝑇𝑡=1 (1)
(1+𝑑)𝑡
where 𝑛𝑒𝑡 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑖𝑡 is the cash flow per customer and is defined as the difference between
expected revenue generated by customer i and expected costs of goods sold and marketing
expenses in time period t, d is the per-period discount rate, and r is the retention rate per period.
If the retention rate r is not taken into account or assumed to be constant over time in the
calculation of CLV, equation (1) can be simplified as follows,

(𝑛𝑒𝑡 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑖𝑡 )
𝐶𝐿𝑉𝑖 = ∑𝑇𝑡=1 (2)
(1+𝑑)𝑡
The details about the components of CLV can be expressed as below if we distinguish the costs
into variable costs and fixed marketing costs.

∑𝐽𝑗=1(𝑃𝑖𝑗𝑡 −𝐶𝑖𝑗𝑡 )−𝑚𝑐𝑖𝑡

𝐶𝐿𝑉𝑖 = ∑𝑇𝑡=1 (1+𝑑)𝑡
(3)
where
𝐶𝐿𝑉𝑖 = lifetime value of customer i
𝑃𝑖𝑗𝑡 = selling price of product j purchased by customer i at time t
𝐶𝑖𝑗𝑡 = unit cost of product j purchased by customer i at time t
𝑚𝑐𝑖𝑡 = marketing cost for customer i at time t
d = discount rate
𝐽 = number of the product variety

In short, the formulas above explain the concept of calculating CLV by summing the present
value of cash flow generated by a customer. Although those components in CLV and the benefits
from measuring CLV have been proposed in most previous literature, there is little research on
how to forecast future cash flow generated by a customer. Interestingly, one of the challenges for
a company to implement CLV metric is the difficulty of estimating future cash flow over time.
Some of the research suggests a simplified formula which assumes a constant cash flow and uses
current cash flow as a proxy of future cash flow. This simplified formula cannot provide a
convincing and precise lifetime value of each individual customer. Some applications which use
modified cash flow adjusted by the probability of a customer being active every period don’t
offer a direct solution to this issue either. As such, firms still don’t have an acceptable basis to
accurately forecast how much a customer can be expected to contribute to sales in the following
years. In addition, it is not an easy task to estimate individual level CLV if customers are not
homogeneous. Most of the business models cannot evaluate customer preference and value
precisely because those models are built on the basis of homogeneous consumers (Allenby and
Ginter 1995). In this research, Hierarchical Bayesian method which takes into account individual
heterogeneity and group information is applied to forecast the future cash flow of each individual
customer over time.

11
Forecast the Future Cash Flow

A linear regression model with multiple predicted variables can simply estimate a future value
linearly, which implies each individual will follow a similar pattern. For example, if the
coefficient of age is positive, the predicted purchase amount will increase with age during a
customer’s lifetime. The critical issue is that the change in the predicted purchase amount with
age will be the same for all of the customers. The linear regression model works well if
customers are homogeneous and react to marketing stimuli and environmental changes in the
same way. However, it is not an appropriate assumption in reality. In order to forecast future
cash flow of each individual customer precisely, we need to use a more refined model rather than
linear regression to account for individual heterogeneity. One of the purposes of this study is to
use a refined formula to calculate future cash flow and then get precise individual level CLV
which helps us to provide managerial insight, not to show how to derive a statistical
methodology. The reason why the company would rather use a linear regression to make a
prediction is the difficulty to derive and apply Hierarchical Bayesian methodology. In this
section, the formula which is shown below and used to forecast purchase amount made by each
customer can be generalized to all practical applications.

In a specific year, the predicted cash flow per customer 𝜃̂𝑗 (𝑗 = 1, … 𝑛) derived from
Hierarchical Bayesian is represented as follows,
−1
𝑛𝑗 1
𝜃̂𝑗 = [𝜎̂−2 + 𝜏̂2 ] [𝜏̂ −2 (𝑋𝑗 𝛽̂ ) + 𝑛𝑗 𝜎̂𝑗−2 ̅̅̅]
𝑦.𝑗 (4)
𝑗

Where
𝑛𝑗 = number of transactions made by customer j,
𝜎̂𝑗−2 = variance of purchase amount for customer j,
𝑋𝑗 = demographic information of customer j,
𝛽̂ = a vector of coefficient of 𝑋𝑗 ,
𝜏̂ −2 = mean square error (MSE) of the regression model,
𝑦.𝑗 = average purchase amount made by customer j in the beginning period.
̅̅̅

We will discuss the framework of CLV and illustrate how to apply the framework in the real-
world case in the next section.

Application in Credit Card Industry

Data
The data of this study is provided by a large bank which issues VISA and MasterCard credit
cards in Taiwan. Customer transaction information is fully captured and integrated. A complete
purchase history for a particular customer can be queried by the company’s system. We
randomly select 5,000 customers and keep customers with no missing values in the records. This
provides 4675 customers each with a complete purchase history which consists of 224,112
transactions from January 2011 to January 2013.

12
There are two types of the information in the data:

(1) Demographics which include customer id, age, income, occupation, zip code, family size,
and marital status; and
(2) Transaction records which include purchase amount, store location and name, and date of
purchase incidence.

Due to the fact that different types of occupations may have different impacts on customers’
purchase power and patterns, we categorize occupations into four groups based on the stability of
income source. The first group is “middle class with stable income” which includes jobs such as
civil servant, teachers, and white collar employees. The second group is called “middle class /
nouveau riche” which includes white collar managers and professional people with high income.
The group, “other”, includes retired people and people who don’t have stable income source,
such as housewife and students. The last group is freelancer. It doesn’t mean that people who
have stable income source make more money than those who have unstable income source.
Sometimes, disposable income for people with unstable income source is higher than those white
collar employees with stable income source.

Ministry of Labor in Taiwan has classified all the districts into eight zones based on degrees of
urbanization. Zip code is available in our data to help us identify the degree of urbanization
where a customer lives: one represents the highest degree of urbanization and eight is the least
urbanization. Table 2 shows that most of the customers are below 35 years old (77%), have
stable income (57%), live in areas with higher degree of urbanization, and are single at the time
of card issuance. People who live at zones with highest urbanization seem to make more credit
card transactions and spend more money (Table 3). Credit card machine and system are not
always available in areas with less urbanization, thus, cash payment is the only acceptable way to
make a purchase. It makes sense that people who live in urban area have higher chance to make a
purchase by credit card because credit card transaction is not popular for most of the areas with
less urbanization in Taiwan.

Table 2 Descriptive Statistics

Age Percentage
24 and below 25%
25-30 32%
30-35 20%
35-40 12%
40-45 6%
46 and above 5%

Degree of Urbanization
1 28%
2 34%
3 19%
4 8%

13
 5 7%
6 3%
7 1%
8 0%

Job Type
Middle Class -Stable Income 57%
Middle Class - nouveau riche 18%
Other 21%
Freelancer 4%

Marital Status
Married 33.30%
Single 66.70%

Table 3
Average Purchase
Degree of Urbanization Average Purchase Frequency
Amount
1 3467.57 51.20
2 3261.13 47.53
3 3487.03 43.79
4 3334.95 42.98
5 3274.37 35.70
6 3348.77 38.47
7 3236.00 36.78
8 2576.64 38.00

Average 3370.18 46.25

Accessing CLV

Step 1: Linear Regression

The values of 𝛽̂ and 𝜏̂ −2 in (4) are estimated from linear regression model (5) as follows.

𝑌𝑗 = 𝑋𝑗 𝐵 + 𝜀𝑗 , 𝜀𝑗 ~𝑖𝑖𝑑 𝑁(0, 𝜏 2 ), 𝑗 = 1, ⋯ ,4675 (5)

Where

𝑌𝑗 = log value of average purchase amount made by customer j from calibration data
𝑋𝑗 = a vector of demographic information of customer j

14
The covariates 𝑋𝑗 include age, square of age, income, age-income interaction term, degree of
urbanization, marital status, number of children in the household, and types of occupation. The
mean square error (MSE) 0.451 estimated from the linear regression model (5) will be used to
replace 𝜏̂ −2 , and the estimates 𝛽̂ shown in table 4 will be applied in equation (4) to get the
predicted cash flow over time. In this study, we use empirical Bayes method which means the
prior distribution is estimated from the data. The procedure of linear regression is only to provide
the parameters 𝑋𝑗 𝛽̂ and 𝜏̂ −2 in the prior distribution which helps us derive the posterior
predicted cash flow (4). Therefore, it is not necessary to adhere to the significant coefficients
only.
Table 4 Regression Estimates
Estimate Std. Error Pr(>|t|)
Intercept 10.16000 1.1890 < 2e-16 *
age -0.15650 0.0394 7.18E-05 *
age^2 -0.00003 0.0002 0.8633
Income -0.20010 0.0933 0.0320 *
age x income 0.01280 0.0031 3.09E-05 *
Urbanization -0.01013 0.0069 0.1435
Married -0.00961 0.0237 0.6855
Number of Children 0.03552 0.0469 0.4489
Middle Class - Stable Income -0.01001 0.0254 0.6937
Middle Class/Nouveau Riche 0.00448 0.0324 0.8901
Freelancer 0.01998 0.0562 0.7220

Step 2: Forecast Future Cash Flow

𝑛𝑗 , 𝜎̂𝑗−2 , and ̅̅̅

𝑦.𝑗 which are part of the important elements of (4) can be acquired directly from the
data. Table 5 which is not a real data and only for illustration purpose shows how to process the
original transaction records to get the needed information 𝑛𝑗 , 𝜎̂𝑗−2 , and 𝑦 ̅̅̅.
.𝑗 Customer A made 5
purchases with average amount $264 and sample variance 8463.5, and customer B made 3
purchases with an average of $579 and variance 12688. Those values that account for individual
differences are what we need to compute the future cash flow per individual.

We have already had the information which is required to be plugged in (4) so far. With
increasing a customer’s age by 1 to 20, the cash flow from next year to 20 years later can be
calculated. For the following analysis, year 1 represents the first year of the predicted cash flow,
and year 20 means twenty years after the initial year.

15
 Table 5
Transaction Records
Customer Transaction
id amount
A 379
A 220
A 340 Customer id Variance
A 223 A 5 8463.5 264
A 158 B 3 12688 579
B 321
B 109
B 149

Step 3: Comparing Future Cash Flow among Customers

Table 6 lists some customers who can represent different scenarios. The 11th customer is 21
years old, single with no children, works as a freelancer, and lives in an area with middle level of
urbanization. This customer reaches the highest predicted cash flow in year 9 and decreases year
by year from that point (Figure 1). It is interesting to see that the trend of the 12th customer is
different from customer 11. It is going upward instead of having a reversed U-shape (Figure 2).
The traditional linear regression approach will provide similar pattern for all customers, whereas
Hierarchical Bayesian method can account for individual differences to adjust the predicted
value.

Table 6
Number
Degree of Marital
Customer id age of Occupation
Urbanization Status
Children
11 21 1465 4 Single 0 Freelancer
Nouveau
12 22 4096 2 Married 0
Riche
Nouveau
16 53 30220 3 Married 0
Riche
526 24 1296 2 Single 0 Stable
1423 24 1000 2 Single 0 Stable
1639 43 1465 1 Single 0 Other

16
Figure 1
2364

2362

2360

Predicted 2358
Purchase
Amount 2356 customer 11
2354

2352

2350
1 3 5 7 9 11 13 15 17 19
Year

Figure 2
5000

4500

4000

Predicted 3500
Purchase
Amount 3000 customer 12
2500

2000

1500
1 3 5 7 9 11 13 15 17 19
Year

The next scenario explores the impact on CLV when customers have similar demographic
information except household income. Customers 526 and 1423 are 24 years old, single, live in a
city with higher degree of urbanization, and are in the occupational category classified as
“middle class with stable income”. Customer 1423 has higher annual income and lower variance
of purchase amount than customer 526. The predicted cash flow for customers with higher
purchase variances will be adjusted more by the mean of group information, and therefore the
trend for the next 20 years will vary and reveal more gap year by year (Figure 3).

17
Figure 3

Then, we compare customers who have the same job types but have huge difference in their
ages. Table 6 shows that customer 16 is 31 years older than customer 12. The average purchase
amount of customer 16 at initial period is around 7.4 times greater than that of customer 12.
After the adjustment from the model, the purchase amount will not increase but decrease after a
certain age. Therefore, when customer 12 is 35 years old while customer 16 is 66 year old, the
purchase amount of customer 12 will outnumber the purchase amount of customer 16 from year
13 (Figure 4).

Figure 4
5000

4500

4000
Predicted
Purchase 3500
Amount customer 12
3000 customer 16

2500

2000
1 3 5 7 9 11 13 15 17 19
Year

18
The next scenario illustrates the trend from a customer whose current age is much higher than the
mean age of the data which is 29.8 years old. Customer 1639 is 43 year old, lives in Taipei city
and does not have a stable source of income. We can see the trend is decreasing year by year
when a customer passes a certain age and does not have a stable income source (Figure 5).

Figure 5
2240
2230
2220
2210
Predicted
Pruchase 2200
Amount customer 1639
2190
2180
2170
2160
1 3 5 7 9 11 13 15 17 19
Year

This subsection shows some examples which have various predicted purchase patterns after the
adjustment from the mechanism of Hierarchical Bayesian. Equation (4) can be expressed as a
weighted average of the prior mean and the observed value, with weights proportional to the
precisions which are the inverse of the variances. For example, if the data are perfectly precise,
the weights to the observed data will be higher and the posterior distribution will be concentrated
at the observed value.

Step 4 Compute Individual CLV

Predicting the future cash flow which is the most complicated part is done in step 2. The last
step is to incorporate the discount rate or market interest rate in order to bring future cash flow
into present value. Table 7 shows CLV with 1%, 2%, 5% and 10% annual discount rate for
selected customers, respectively. In Figure 6, it shows that customer 1423 has the highest CLV;
whereas customers 11 and 1639 have the smallest and second smallest CLV no matter what is
the value of discount rate. Although customer 1423 has the lowest initial average purchase as
shown in table 6, he/she provides the highest CLV among these six customers. It is possible that
customer 11 has lower CLV because he/she doesn’t live in the big city with greater chances to
use credit cards. Customer 1639 is older and has decreasing trend of predicted cash flow;
therefore, his/her predicted lifetime value is not high obviously.

19
 Table 7
CLV with
Customer CLV with 1% CLV with 2% CLV with 5% 10%
id discount rate discount rate discount rate discount
rate
11 42603.54 38604.65 29423.66 20101.17
12 63928.72 57416.91 42646.06 28018.54
16 65453.35 59141.26 44706.82 30169.31
526 43938.93 39781.47 30247.63 20590.21
1423 80800.67 72360.57 53287.81 35459.03
1639 39890.30 36161.63 27595.81 18887.10

Figure 6

CLV for Selected Customers

90000.00
80000.00
70000.00
60000.00
50000.00 CLV with 1% discount rate
CLV
40000.00 CLV with 2% discount rate
30000.00 CLV with 5% discount rate
20000.00
CLV with 10% discount rate
10000.00
0.00
11 12 16 526 1423 1639
Customer id

Step 5: Segmentation and Targeting

We can segment customers based on their CLV which is calculated in step 4 and identify the
golden 20% of the customers. Segmentation can also help firms identify customers who will
bring the least contribution during their lifetime. In addition, we can incorporate the dimension
of current value or current share of wallet into CLV framework. The 2 x 2 matrix in table 8
offers 4 segments. Customers who have high current value and high CLV are definitely the most
valuable customer, whereas customers with low current and lifetime value are the least valuable
customers. Customers with low current value but have high CLV can be categorized as potential
customers, whereas customers with high current value but low CLV may imply a firm loses
customer loyalty gradually. As such, this segment can be classified as “loyalty crisis”.

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 Table 8
Current Value
Low High

High Potentialities Most Valuable Customers

CLV
Less Valuable
Low Loyalty Crisis
Customers

There may be an evolution of customer lifetime cycle in this framework as shown in Figure 7. A
customer may start to be a potential customer who does not contribute too much when he/she
holds the credit card in the beginning but may have higher value in the future. This customer
may gradually become the most valuable customers when time goes by. If the value cannot be
accumulated and the customer is inactive gradually, he/she will go to the segment of loyalty
crisis and become less valuable customers eventually. Firms need to show great initiative in
contacting those customers who are inactive gradually and those who switch to other banks.
Understanding what drives customers away and what are customers’ needs and wants, are always
the core issues in marketing management. It is necessary for firms to monitor the rate of losing
customers and the percentage of non-loyalty customers. It means that a firm loses customer
loyalty and cannot satisfy its customers when the churn rate is getting higher and higher. Waiting
for customers’ responses passively is not a wise decision. Firms need to actively conduct
marketing activities to influence customer behavior and keep customers in the stage of high
current and lifetime value.
Figure 7

CLV
High
Potentialities Most Valuable Customers

Low High
Current Value

Less Valuable Customers loyalty Crisis

Low

21
Conclusions and Limitations
In this research, we discuss the importance of CRM and how CLV framework can help firms
monitor and manage customer relationship profitably. CLV approach is a forward-looking
metrics which provide greater insight than those backward-looking metrics. Using CLV
approach, firms are able to:

 Assess customer profitability at the individual level.

 Forecast the future cash flow structurally.
 Identify the most valuable and least valuable customers.
 Segment and target the markets by applying the 2x2 CLV framework which incorporates
current status and future contributions.
 Understand the evolvement along the customer lifetime cycle
 Refine the strategy of resource allocation and tailor marketing strategies.

In our empirical application, we use credit card transaction database provided from a leading
bank in Taiwan to illustrate steps for accessing CLV by applying hierarchical Bayes
methodology. Hierarchical Bayesian method can account for individual differences to adjust the
predicted value. The purposes of this study is to use a refined Bayesian formula to calculate
future cash flow and then get precise individual level CLV which helps us to provide managerial
insight, not to show how to derive a statistical methodology. In other words, the predicted cash
flow can be seen as a weighted average of the prior mean and the observed value, with weights
proportional to the precisions which are the inverse of the variances. If the data are perfectly
precise, the weights to the observed data will be higher and the posterior distribution will be
concentrated at the observed value. In the empirical application, we show how age group,
category of occupation, and level of urbanization affect the predicted cash flow. Not all of the
customers change their future cash flow in a linear manner.

In addition, we demonstrate how to segment and target customers based on the framework of the
CLV approach. Customers may also evolve along the customer lifetime cycle. Firms need to
retain the most valuable customers and try to make customers who are currently at other stages
move toward the stage of the “most valuable customers”. For those who are inactive gradually,
firms need to show great initiative in contacting them and understand what drives customers
away, instead of waiting for their responses passively. In other words, firms need to actively
conduct marketing activities to influence customer behavior and keep customers in the stage of
high current and lifetime value.

There are a few limitations in this study. The current formula to calculate CLV assumes a
constant retention rate among all customers. Future extension to this study would be to expand
the model and calculate individual retention rate over time. In addition, the current database only
provides customer transaction record and demographics. It doesn’t provide the information of
customer-frim interactions, e.g., marketing communications and promotional efforts. By
incorporating the covariate of marketing efforts while accessing CLV, firms can understand the
impact of marketing strategies on CLV, and further find an optimal level of marketing
communications and the most effective promotion strategies. Further study can also test the
impact of various media of communications on CLV. For example, marketing communications

22
through emails may have different impacts from those through direct mails. Measuring the
impact sizes of promotion activities in each segment can help a firm develop a segment-specific
communication strategy.

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