BT4211

Data-Driven Marketing
Customer: Lifetime Value, RFM Analysis

February 7, 2018 1
Introduction to CLV

 Customer Lifetime Value (CLV) definition

– Net present value of profits linked to an acquired
customer, less the incremental costs associated with
marketing, selling, production and servicing over the
customer’s lifetime
 Issues to note in definition
– Forecast future sales of a customer
– Compute incremental costs per customer
– Determine relevant discount rate to use for NPV
– Do not include acquisition costs as part of CLV
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Introduction to CLV

 Applications of CLV
– Diagnose health of a business
• Long-run economic view of customers & profitability of firm
– Assist in making tactical decisions
• How much can a firm invest to acquire customers?
• How much service to offer a given customer?
 Customer Equity definition
– CLV less acquisition costs

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Introduction to CLV
 Example

4
Introduction to CLV
 Example

5
CLV Formula

 General formulation

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CLV Formula

 General formulation
– Expected net present value of future profit
contributions
– Computed at individual customer level or for
“average” representative customer using average
parameters
– Discount rate: 10% - 20% usually in practice
– Cost: fixed or variable; future costs are assumed
to be known
– Revenue: assumed to be random or probabilistic
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CLV Model

 CLV is defined at an individual customer level

 CLV Model 1
T
( pt  ct )

– CLV =
 AC
t 0 (1   )
t

– where t = time period, pt = price, ct = cost, AC = acquisition

cost,  = discount rate
– T may be estimated from a retention/duration model
– Discrete or continuous time
– CLV may be over-estimated. Why?

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CLV Model

 Account for possibility of the customer defecting

 Assume constant retention rate
 CLV Model 2
T
( p  c ) r t
– CLV =

t 0
t t

(1   ) t
 AC

– where r = constant retention rate, t = time period, pt =

price, ct = cost, AC = acquisition cost,  = discount rate
– Account for probability of customer retention
– More accurate projection of CLV

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CLV Model

 Assume variable retention rate

 CLV Model 3
T
( pt  ct )st

– CLV =
 AC
t 0 (1   ) t

T
– st = survival rate at time period t =
r
t 0
t

– where rt = variable retention rate, t = time period, pt =

price, ct = cost, AC = acquisition cost,  = discount rate
– Account for probability of customer retention

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CLV Model

 Assume infinite time horizon, constant margin and

constant retention rate
 CLV Model 4

( p  c )r t
mr
– CLV =

t 0 (1   )
t
 AC 
1 r  
 AC

– where r = constant retention rate, t = time period, p =

price, c = cost, m = profit margin,  = discount rate, AC =
acquisition cost
– Easy formulation for quick CLV computations
– Produce reasonably precise CLV estimations unless
retention rate is very high

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CLV Model

 How long is lifetime duration T?

– Lifetime duration is a long-term duration used
managerially
– Direct marketing: about 4 years
– Grocery shopping: infinite time horizon?
– T determined by managerial judgment
– T estimated by prediction models

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CLV Model

 Simple retention model (“Lost-for-good”)

– Assume once a customer has churned, the
customer is lost forever to the company
• Financial services, B2B businesses, phone subscriptions,
pharmaceutical drugs
 Migration model (“Always-a-share”)
– Assume customers might migrate in and out of
being a customer during the normal course of their
lifetimes
• Retailing, catalogs, consumer packaged goods

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Customer Revenue

 Estimation approaches
– Constant revenue per period model
• Average revenue per customer across all periods
– Trend models
• Trend in revenue per period per customer from initial
acquisition period to end of customer’s purchase series
– Causal models
• Dependent variable: log of customer expenditure
• Independent variables: price, other marketing-mix variables
– Stochastic models of purchase rate and volume
• Predict purchase volume for individual customers 23
Discount Rate

 Opportunity cost of capital approach

– Rate of return investors can achieve on another
investment of similar risk
– Key concepts
• Link between appropriate discount rate for CLV and rate
of return investors could make on other investments
– Time value of money
• What investors could expect to make on investments of
similar risk as that of a firm’s customer projects
– Customer projects should have less or equal risk to be investable
• Definition of investors
– Publicly owned companies: shareholders
– Private companies: owners 24
Cost Accounting

 Activity-based costing
– Costs may vary significantly among customers,
depending on variation in customer-specific
marketing efforts, customer orders, after-services
– Link customer activities such as placing orders to
the costs of executing those activities
• Examples
– Catalog mailing
– Filling web orders
– Filling telephone orders
– Data maintenance
– After-sales support
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Cost Accounting

 Variable costs and fixed overheads

– Full costing
• All fixed overhead costs must be allocated to a customer
• Overhead allocations can saddle customers with huge
costs that actually yield negative CLV
– Fixed overhead costs should not be included in CLV
– Else a firm will under-invest in adding new customers
– Variable (marginal) costing
• Only costs that vary with the number of customers and
are directly attributed to customer servicing or marketing
are allocated to a customer
• Link determination of costs to the decision being made
– CLV is NPV of incremental profits and costs 30
CLV Application: Customer
Acquisition

 CLV model for customer acquisition

– Strategy
• Acquire customer if CLV > acquisition cost
• Determine which acquisition strategies provide highest
payouts or are above the hurdle rate
– Lessons
• CLV is a better metric for customer acquisition than
initial year one profit because a firm is likely to lose
money during the acquisition year
• Comparing CLV to acquisition costs allow a firm to
design alternative acquisition strategies and tactics for
acquiring higher/lower CLV customers 31
CLV Application: Customer
Reactivation

 CLV model for customer reactivation

– Assessment metrics for reactivation payback
• Ex-customer’s first-year profitability
• Ex-customer’s CLV for terminated relationship
• Ex-customer’s SCLV for reactivated relationship
– Second CLV of a recaptured customer for duration after
reactivation, but not of terminated relationship with a firm
– SCLV decreases with a customer’s lapsed duration, and is
related to acquisition channel (Griffin and Lowenstein 2001)
– The higher the reactivation price, the longer the tenure of the
reactivated customer (Thomas et al. 2004a)

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CLV Application: Case Example

 B2B multinational firm selling cleaning products

– Van Raaij et al. (2003)
– Six-stage process of customer value analysis and
marketing strategy planning
• Select active customers
• Design customer profitability model
• Calculate customer profit
• Interpret the results
• Develop marketing strategies
• Establish an infrastructure for future applications

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CLV Application: Case Example
 B2B multinational firm selling cleaning products
– Interpret the results

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CLV Application: Case Example
 B2B multinational firm selling cleaning products
– Interpret the results

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CLV Application: Case Example

 B2B multinational firm selling cleaning products

– Develop marketing strategies
• Low dependence, high subsidization cells
– Customers dragging down profits should be dealt with individually
• High dependence, high subsidization cells
– Profitable customers had to be nurtured while the others either
had to be “fired” or at least made marginally profitable
• Focus on individual customers who were either extremely
profitable or unprofitable
– Establish infrastructure for future applications
• Assemble cost information on a customer basis
• Integrate marketing efforts with CLV explicitly in systems 37
CLV Application: Segmentation
 Customer portfolios

Offer lower price with Maintain good service

longer contracts and promote advocacy

Increase price and

reduce service Promote high price plans

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CLV Application: Customer Base
Valuation

Why might the customer base valuations of Amazon and eBay be much
lower than their stock market valuations? 40
CLV Component Drivers

 Key factors affecting CLV components

(Thomas et al. 2004b; Reinart et al. 2005)
– Acquisition rate
• Acquisition expenditure, demographics, size of market
– Customer duration
• Retention expenditure, customer usage rate, cross-
buying, share of wallet
– Profitability
• Acquisition and retention dollars, customer usage rate,
lifetime duration, cross-buying, share of wallet

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Introduction to RFM Analysis

 Overview of RFM analysis

– Recency, Frequency, Monetary Value
– Classify customers into groups according to their
RFM measures
– Relate these classifications to predicted behaviors
such as likelihood of responding to marketing offers
– Send marketing offers to customers with high
propensity to respond, rather than to all customers

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RFM Model

 Definitions
– Recency
• Elapsed time (in days, weeks, months or years) since the
last customer purchase
– Frequency
• Number of occasions a customer has purchased in a
certain time period (e.g., since first purchase, last month)
– Monetary Value
• Dollar value of previous purchases in a certain time
period (e.g., total or average expenditure)

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RFM Model

 Relationships
– Recency: negative relation with response rate

Customers who have not recently

purchased from the firm tend to
have lower probability to respond

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RFM Model

 Relationships
– Frequency: positive relation with response rate
• Customers who have frequently bought a product tend
to have higher probability to respond
– Monetary value: positive relation with response
rate
• Customers who have higher expenditures with the firm
tend to have higher probability to respond

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RFM Model

 Segment-level prediction
– Procedures
• Transform RFM continuous variables into discrete form
• Sort customers into quintiles by recency
– Code of “5” is assigned to top 20% of customers by recency
– Code of “4” is assigned to next 20% of customers, and so on
• Sort customers into quintiles by frequency
• Sort customers into quintiles by monetary value
• Assign each customer with RFM codes of 5, 4, 3, 2, 1
• Segment customers into 125 (5×5×5) groups

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RFM Model

 Segment-level prediction

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RFM Model
 Segment-level prediction
M
F
131
11
12 132
R
13 133
1
14 134

15 135
2
41
3 441
42
442
4 43
443
44
5 444
45
445
Customer Sorted Once Sorted 5 Times per
Database R Quintile Sorted 25 Times per
R Quintile
 Equal number of customers under each RFM cell
 125 cells or RFM codes (5 recency * 5 frequency * 5 monetary value divisions) 48
RFM Model Extension

 ANOVA
– RFM model as three-way ANOVA with all main and
interaction effects
• Assume each of 3 treatments of RFM has 3 levels
• Need to estimate 3 x 3 x 3 = 27 parameters for full model
• ANOVA full model specification

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RFM Model Extension
 ANOVA

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RFM Model Extension

 Alternative response models without discretization of

RFM measures
– Linear and logistic regression
• Dependent variable is customer response (0 or 1)
• Independent variables are customers’ original RFM values
– CHAID model
• CHi-squared Automatic Interaction Detection
– CART model
• Classification and Regression Tree
– Non-linear regression models
• Kernel smoothing, radial-basis function neural nets, multilayer
perceptron neural networks, additive models
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