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Customer Lifetime Value: A Review

Article in Social Behavior and Personality An International Journal · August 2012

DOI: 10.2224/sbp.2012.40.7.1057

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SOCIAL BEHAVIOR AND PERSONALITY, 2012, 40(7), 1057-1064
© Society for Personality Research
http://dx.doi.org/10.2224/sbp.2012.40.7.1057

CUSTOMER LIFETIME VALUE: A REVIEW

WEN CHANG
Fudan University and Hsing Wu Institute of Technology
CHEN CHANG
Jin-Wen University of Science and Technology
QIANPIN LI
Edith Cowan University

The concept of regarding customers as assets that should be managed and whose value should
be measured is now accepted and recognized by academics and practitioners. This focus on
customer relationship management makes it extremely important to understand customer
lifetime value (CLV) because CLV models are an efficient and effective way to evaluate a
firm’s relationship with its customers. Assessment of CLV is especially important for firms
in implementing customer-oriented services. In this paper we provide a critical review of the
literature on the development process and applications of CLV.

Keywords: customer lifetime value, customer profitability analysis, shareholder value,

customer equity, activity-based costing.

Customer profitability refers to the revenues less the costs that one particular
customer generates over a given period. As such, this variable relates to the
supplier’s value of having one particular customer, not the customer’s value
of having a particular supplier. In the marketing-related literature there are two
temporal forms of customer profitability. In an historical sense, a customer
profitability analysis (CPA) is similar to the firm’s profit and loss statement. The
main difference is that a customer profitability analysis refers to one particular

Wen Chang, Department of Accounting, Fudan University, and Department of Accounting

Information, Hsing Wu Institute of Technology; Chen Chang, Department of Financial and Tax
Planning, Jin-Wen University of Science and Technology; Qianpin Li, School of Accounting,
Finance, and Law, Edith Cowan University.
Correspondence concerning this article should be addressed to: Wen Chang, Department of
Accounting Information, Hsing Wu Institute of Technology, No. 101, Sec. 1, Fenliao Rd., LinKou
District, New Taipei City 244, Taiwan, ROC. Email: 084012@mail.hwc.edu.tw

1057
1058 CUSTOMER LIFETIME VALUE

customer, whereas a profit and loss statement refers to all customers. A history-
oriented customer profitability analysis can be made at several levels. A common
point of departure is to calculate the gross contribution margin, that is, sales
revenue less all product-related expenses for all products sold to an individual
customer during one particular period (Wang & Splegel, 1994). Then – depending
on the availability of data – sales, general, and administrative expenses traceable
to the individual customer are subtracted (Cooper & Kaplan, 1991). The result of
this calculation is the operating profit generated by the customer. An extension
of this line of thinking is the computation of customer return on assets, that is,
customer profitability divided by, for example, the sum of accounts receivable
and inventory (Rust, Zahorik, & Keiningham, 1996).
Customer profitability is also referred to in a future sense in the literature. In
this case, it often takes the form of the output from a net present value analysis.
The output is sometimes referred to as the lifetime value of a customer (Petrison
& Blattberg, 1997; Rust et al., 1996). It has been defined, for example, as
the stream of expected future profits, net costs on a customer’s transactions,
discounted at some appropriate rate back to its current net present value. A
similar concept is customer equity, which is seen as a function of the customer’s
volume of purchases, margin per unit of purchase, and acquisition, development,
and retention costs traceable to this customer (Blattberg & Deighton, 1996;
Wayland & Cole, 1997).
In today’s competitive environment, marketers face increasing pressure to
make marketing activities more accountable (Rust, Lemon, & Zeithaml, 2004).
Findings in resent research on customer lifetime value (CLV) offer a useful
framework in which marketing actions are explicitly related to financial metrics.
The CLV framework is a measure of how changes in customer behavior (e.g.,
increased purchase, retention) could influence customers’ future profits, or their
profitability to the firm. The CLV framework helps bridge marketing and finance
metrics
Reinartz and Kumar (2000) identified three main reasons that interest in
customer lifetime value research has increased recently. First, firms are becoming
increasingly interested in customer management processes, for which an
understanding of the concept of CLV is a prerequisite. Second, the Marketing
Science Institute has elevated the topic to a capital research priority. Third,
empirical evidence is particularly scarce in the domain of CLV.

Literature Review

Background of CPA
No two customers are the same, even when they are in receipt of an identical
product. Profitability varies greatly among customers because of service
 CUSTOMER LIFETIME VALUE 1059
commitment, but conventional accounting methods rarely reveal such differences
(Smith, 1993). CPA has many functions. For example, during the process
of implementing the CPA, the structure of costs of activities can be clearly
understood and some useful controls can be put in place on those activities that
are creating limited sources. The most important benefit that can emerge from
the application of CPA is that managers can identify the real sources of profit
and take full advantage of CPA-related information to make strategic marketing
decisions. When managers make marketing decisions such as segmentation,
customer targeting, customer development, or customer retention strategies,
the information provided by CPA can enable them to allocate limited resources
to the right people at the right time. Numerous researchers have indicated that
CPA should be implemented in an environment where an activity-based costing
(ABC) system could be better developed. Cooper and Kaplan (1991), Wayland
and Cole (1994), and Smith and Dikolli (1995) indicated that the use of an
ABC analysis could help managers to determine what resources customers had
consumed and allocate these resources accurately and appropriately. Also, when
implementing CPA, accurate and sufficient information about customers is
indispensable. Mulhern (1999) and van Raaij, Vernooij, and van Triest (2003)
indicated that it is likely that CPA could be widely adopted in the future, because
such activity measurement systems are affordable and attainable. Many of the
data already exist in some form within the organization. Therefore, ABC can be
extremely valuable to an organization, providing information on the range, cost,
and consumption of operating activities.
The customer relationship is one type of intangible asset (Doyle, 2000;
Srivastava, Shervani, & Fahey, 1998). Hogan, Lemon, and Rust (2002) suggest
that customer equity is a means of growing shareholder value, but conventional
accounting researchers have treated marketing expenditure as costs rather than
investments in intangible assets. Fornell (2000) clearly indicated that maximizing
shareholder value results from maximizing customer asset value, where:
shareholder value = net present value of expected cash flow =
value of the customers + value of acquired customers.
Customers are viewed as a company’s most important asset, because ultimately,
cash flows are based on customer-generated revenues and the investments made
to generate those revenues. Therefore, to achieve continued growth of total cash
flows, a company must continually increase customer-generated cash flows
(Hansotia, 2004). A new insight into calculating CLV shows that firms should
determine the profitability of each customer over the relationship lifetime by
calculating the net present value of future cash flows. Theoretically, retaining
customers means that the profits generated by them tend to accelerate over time
(Reichheld & Sasser, 1990). Evidence of this is that lifetime (or loyal) customers
increase a firm’s profitability because these customers are willing to pay a
1060 CUSTOMER LIFETIME VALUE

premium price for products and give the company referrals. The company also
gains profit from retaining existing customers rather than having to attract new
ones, and increases its revenue growth through increase in sales to that customer.
Managers should allocate resources in proportion to the CLV of each customer.
Thus, if customers with a negative CLV yield no investment, the company will
not be interested in their retention (Ambler, 2002). In other words, CLV models
are a systematic way to understand and evaluate a firm’s relationship with its
customers. Furthermore, the impact of CLV on a firm’s performance is a factor
for managers to consider when they want to evaluate the value derived from their
customers.
Researchers have noted that many traditional marketing metrics, such as brand
awareness/attitude and market share, are not sufficient to evaluate returns on
marketing investment (Rust et al., 2004; Srivastava et al., 1998), but assessment
of CLV makes it possible to link long-term financial returns explicitly to
marketing actions. Second, in recent research, scholars have shown that all
customers are not equally profitable (Reinartz & Kumar, 2000, 2003). It is
advantageous for managers to understand CLV at the individual level in order to
be able to allocate resources accordingly.

Measuring Customer Lifetime Value

CLV is a measure of the profit streams generated by a customer across the
entire customer life cycle. It may seem that measuring customer profitability is
a straightforward process; however, it is actually quite complex. The required
data and skills include: (a) datasets across specific time spans and with specific
content; (b) statistical techniques to forecast and model future customer behavior
in terms of spending frequency, spending rate, and length of time the customer
will patronize the firm; and (c) analysis to fully comprehend the limitations of
the models used and implications of the assumptions built into the CLV models.
Many models have been developed for determining CLV, with each having
different assumptions and different bases. Most of these models can be broadly
classified into: (a) scoring models, (b) probability models, and (c) econometric
models. In scoring models simple scores are created based on consumers’
purchase characteristics (e.g., the recency, frequency, and monetary value – or
RFM – model). In probability models consumer behavior is viewed as the
expression of an underlying stochastic process that is determined by individual
characteristics (e.g., the negative binomial distribution [NBD] model). In
econometric models consumer behavior is explained as a function of a set of
covariates.
However, the two basic steps for evaluating CLV are: (a) project the net cash
flows that the firm expects to receive from the customer over time, and (b)
calculate the present value of that stream of cash flows. Factors of CLV models
 CUSTOMER LIFETIME VALUE 1061
can generally be classified into three categories: revenue, costs, and retention rate
(Reinartz & Kumar, 2000). In various other models retention rates are not taken
into consideration (see e.g., Jackson, 1989; Mulhern, 1999; Niraj, 2001).
One CLV model, developed by Gupta and Lehmann (2003), is based on the
following assumptions: (a) margins are constant over time, (b) retention rate is
constant over time, and (c) the length of the projection period is infinite. This
model can be expressed as follows:

( 1 + ri – r
CLV = m
(
That is to say, CLV is equal to margin (m) multiplied by a factor r divided by
(1 + i – r). The factor is called margin multiple. The margin (m) can be defined as
the average margin for each customer, that is revenue minus operating expenses
divided by the number of customers. When firms use this formula they can
estimate the value of their customer base from published information in annual
reports and other financial information. A general formulation for customer
lifetime value, developed by Mulhern (1999), in which retention rates are not
taken into account, is as follows:

Ji Ki
T  (pijt – cijt) –  mcikt
CPi =  j=1 k=1
t=1 (1 + r)t

where CPi = the profit of customer i to a firm; pijt = the price of purchase j made
by customer i in period t; cijt = the unit cost of purchase j made by customer i in
period t; mcikt = variable marketing cost, k, for customer j in period t; and r = the
discount rate for money established to reflect the riskiness of cash flow.
In other CLV models customer retention rates are integrated and often
marketing or customer retention costs are set out separately (see the models of
Berger & Nasr, 1998; Blattberg & Deighton, 1996; Blattberg, Getz, & Thomas,
2001; Dwyer, 1997; Gupta, Lehmann, & Stuart, 2004; Reinartz & Kumar, 2000;
Rust, Zeithaml, & Lemon, 2000). Berger and Nasr (1998) offer five models
based on different assumptions to illustrate the methods for calculating CLV
by discounting the difference between the revenues and both cost of sales and
promotion expenses incurred to retain customers, not including acquisition costs
and fixed costs.
No generally accepted superior approach has yet been identified (Jain & Singh,
2002).
1062 CUSTOMER LIFETIME VALUE

Applications of CLV
The benefit from CLV calculations is twofold: understanding the potential
value of customers, and prompting firms to learn more about the patterns of
individuals or groups of customers. This information allows the firm to devise
optimal strategies for each customer, eliminate wasteful costs, and create a
long-term perspective of the potential relationship with customers. Firms can
tailor strategies to deal with different customer segments that exhibit differences
in buying characteristics at any given time, and they can customize different
strategies for the same customer depending on the stage of relationship between
the customer and the firm. In other words, the main benefit derived from CLV
analysis is that the manager can take advantage of the analysis of results to predict
the future profitability of customers and make more appropriate marketing
strategies and decisions relating to customers (Guracaronu & Ranchhod, 2002).
CLV models offer insights into managing the existing customer base. For
example, classifying customers into high-, medium-, and low-value customers
not only allows differentiation of products/services according to expected
customer value but provides an objective basis to direct retention efforts toward
high-value customers. In addition, knowledge of CLV can be used to develop
a profile of high-value customers which can then be applied to a prospect list
to make customer acquisition efforts more efficient and effective (Hansotia &
Wang, 1997).
Customer management activities at firms involve making consistent decisions
over time, about: (a) which customers to select for targeting, (b) the level of
resources to be allocated to the selected customers, and (c) securing the link
between firm actions and customer profitability (Kumar, Venkatesan, Bohling,
& Beckmann, 2008).
Blattberg and Deighton (1996) used this approach to suggest a way to optimize
customer acquisition and retention investments. Blattberg et al. (2001) suggested
that this modeling approach could be the basis for planning customer acquisition,
relationship development, and customer retention strategies. Berger and Nasr
(1998) demonstrated how the basic CLV model could be expanded, for example,
to allow incorporation of different promotion expenditures.
The lifetime value of the customer has a number of potential applications when
making marketing decisions, such as helping a firm determine how much it can
afford to spend to acquire customers. Sometimes the best customers might cost
more to obtain, but will generate much higher returns than will those customers
that are less costly to obtain. The CLV model can be used to assist the firm
in quantifying this tradeoff and examining the consequences of a change in a
customer’s buying behavior in terms of the long-term profitability of the account.
 CUSTOMER LIFETIME VALUE 1063
Conclusion

In this study, we have reviewed a number of CLV models and discussed the
needs for use and benefits of CLV. Because empirical evidence is particularly
scarce in the CLV domain we believe that significant research is still needed to
reach any definite conclusion about the effects of increased CLV. Through this
study, we hope we have provided a wider and deeper view of research on CLV.

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