Marketing Strategy: Marketing Principle #2 All Customers Change Managing Customer Dynamics

Marketing Strategy
Chapter 3
Marketing Principle #2
All Customers Change  Managing
Customer Dynamics
© Robert Palmatier 1
Agenda
 Introduction
 Approaches for Managing Customer Dynamics

 Evolution of Approaches for Managing Customer Dynamics
 Lifecycle Approach
 Customer Dynamic Segmentation Approach
 Customer Lifetime Value Approach
 Choice Models
 Framework for Managing Customer Dynamics

 Inputs to Managing Customer Dynamics Framework
 Outputs of Managing Customer Dynamics Framework
 Process for Managing Customer Dynamics
 Managing Customer Dynamics Example
 Takeaways
 Case
© Palmatier 2
All Customers Change
 Another underlying issue facing managers that make marketing decisions difficult
is that all customers change
 Customer’s desires/needs for most products and services change over time or due
to specific events
 Individual consumer needs change (age, experience, and due to trigger events)
 Customers are embedded in industries/markets, which change overtime (PCs
20 years ago and now)
 Customer's needs vary not only due to inherent differences in people

(heterogeneity) but also as people and markets change (dynamics)
 Thus, we need to adapt our “static” segmentation of all customers based on

“generic” needs (MP#1) by focusing on our existing customers and accounting for
their time dependent needs (MP#2)
 Customer dynamics are changes in customer preferences that occur over time
© Palmatier 3
Exercise on Customer Dynamics
 Everyone take a few minutes to describe your or your parents

past car purchases
 Car at 20 _______________
 Top two reasons bought __________ & ____________
 Car at 30 _______________
 Trigger for change _______________
 Car now _______________

 Trigger for change _______________
© Palmatier 4
5 Sources of Customer Dynamics
 Discrete life events
 Typical lifecycle
 Learning effects
 Product lifecycle
 Constantly changing
environmental context
© Palmatier 5
Sources of Customer Dynamics
Description Rate of Examples
Change
Individual level
Discrete life events Immediate A first-time parent often changes their preference for cars,
vacations, and restaurants.
Typical lifecycle or Slow As people age, they become more focused on risk reduction,
maturation as people age less willing to change, and more focused on comfort and health.
Product learning effects Medium Customers might learn, after using a product for a time, that
there are certain specialized or high-tech features they would
like.
Product market level

Product lifecycle Medium During early stages, consumers may purchase more new
features, in later periods, they may get more price sensitive.
Environmental level
Changes in economy, Slow to As the culture around “health food” changes, consumer
government, industry, or immediate preferences in response to dietary concerns (e.g., calories,
culture sodium, carbohydrates, gluten, fat) also change.
© Palmatier 6
Customer Dynamics: A Fundamental
Assumption of Marketing Strategy
 Thus, customer dynamics is a fundamental “problem” that all firms must
address when developing an effective marketing strategy
 Customers change; failure to understand and address these dynamics

will lead to poor business performance
Marketing principle #2: all customers change and an effective

marketing strategy must manage customer dynamics
© Palmatier 7
Example: General Motors
 Buick: failure to manage customer dynamics

 Customers needs changed, customers moved to different suppliers
 Left Buick with a smaller portfolio of older customers
 Brand became associated with the elderly; sales dropped 50%
 Acura: success in managing customer dynamics

 Honda realized its customers were migrating to more expensive cars
 Launched Acura: a higher priced luxury car targeted to those customers
 Within a few years, Acura was one of the best-selling luxury brands in the US
© Palmatier 8
Agenda
 Introduction

 Choice Models

 Takeaways
 Case
© Palmatier 9
Evolution of Approaches for Managing
Customer Dynamics
 Lifecycle Approach uses generic stages of growth and their
position in the lifecycle to determine customer preferences
and associated strategies
 Dynamic Customer Segmentation segments a firm’s
existing customers on the basis of their similar, expected
migration patterns
 Customer Lifetime Value captures the contribution of each
customer according to his or her expected migration path
over the entire lifetime with the firm
© Palmatier 10
Evolution of Approaches for Managing
Customer Dynamics
Slow Speed of Response Fast
All Customers Size of Segment Managed Niche Segment
Lifecycle Approach Dynamic Customer Segmentation Customer Lifetime Value

Captures
Captures the
the contribution
contribution of
of each
each customer
customer
Uses
Uses generic
generic customer
customer stages
stages of
of growth
growth and
and their
their Segments
Segments a a firm’s
firm’s existing
existing customers
customers on
on the
the basis
basis according to his or her expected migration path
position
position in
in the
the lifecycle
lifecycle to
to determine
determine customer
customer of their similar, expected migration patterns. over
over the
the entire
entire lifetime
lifetime with
with the
the firm.
firm.
preferences
preferences and
and associated
associated strategies.
strategies.
•• Customer lifecycle
Customer lifecycle • May use hidden Markov models • Uses discounted cash flows
•• Product lifecycle
•• May use lost
May use lost customer
customer analysis
analysis • Accounts
Accounts for
for expansion
expansion and
and retention
retention
• Industry lifecycle
expectations
expectations
Pros Cons Pros Cons Pros Cons
Simplicity
Simplicity Assumes
Assumes all
all customers
customers Combines
Combines lifecycle
lifecycle and
and Segments
Segments are
are not
not Provides
Provides insights
insights for
for Requires
Requires insight
insight into
into
follow
follow one
one curve
curve segmentation
segmentation methods
methods perfectly homogeneous
perfectly homogeneous AER decisions
AER decisions future migration
future migration
Ease
Ease of
of use
use Matches strategic
Matches strategic Puts continuous
Puts continuous change
change Supports aa customer-
Supports customer- Requires detailed
Requires detailed
Averages
Averages all
all customers
customers marketing
marketing thinking
thinking into
into discrete
discrete stages
stages centric
centric culture
culture financial
financial data
data
Ignores
Ignores causes
causes of
of Identifies
Identifies temporally
temporally Captures
Captures dynamics
dynamics and
and
customer dynamics
customer dynamics homogeneous groups
homogeneous groups heterogeneity
heterogeneity
© Palmatier 11
Lifecycle Perspective: “Ok” First
Approximation
 Assumes “all” customers, markets, products, industries move thru a
sequential set of “stages” as they mature
 Applies a standard set of marketing tactics at each stage
 Pros:
 Easy to apply
 Makes common sense
 Cons:
 Misses many unique trigger points and migration paths (ignores
temporal heterogeneity)
 Inaccurate and/or ineffective for many firms
© Palmatier 12
Different Lifecycle Approaches
 Customer lifecycle attempts to capture how individuals typically change

as they age and reach common age-related milestones
 Product lifecycle proposes that various products go through four typical

stages in relation to their acceptance by society: introduction, growth,
maturity, and decline
 Industry lifecycle comprises of five stages:

1. Early establishment of its range and boundaries
2. An innovation stage to set a “dominant design”
3. The shakeout stage, marked by economies of scale, such as that

smaller players get forced out
4. Maturity, when firms focus on market share and cash flows
5. The decline stage, when sales decay for the industry as a whole
© Palmatier 13
Typical Customer Product Lifecycle
Introduction Growth Maturity Decline

Sales
Descriptions
of the Stages
• Product just launched on the • Product gains acceptance in • Product is widely accepted, • Destructive competition
market, often perceived as the market, and sales and growth begins to slow, and changing consumer
risky by customers. expand quickly. because fewer new users needs and desires lead to
are available. product decline.
• Most relevant features are still • Users are more comfortable
unknown by customers and with the product and know • Market becomes • Firms’ sales and profits
sellers. which features they want. competitive, and some firms decline.
drop out.
• High prices. • More focus on retaining • Firms with higher cost and
customers and generating • Intense price competition those without a unique
• Seller focuses on finding new repeat sales. reduces profits. advantage exit the market.
customers and promoting
product trials. • Customers become • Some sellers focus on niche • Market often consolidates
increasingly price sensitive. segments to avoid with fewer suppliers.
competitive pressures.
© Palmatier 14
Customer Dynamic Segmentation Approach
 Evaluates existing customer’s behaviors/needs in each AER stage to understand

temporal differences
 Customers are “temporally” similar in each stage (assumption)
 Matches marketing action domains (i.e., acquisition is often a self-contained
marketing domain)
 Dynamic-based segmentation is sometimes called the Acquisition–Expansion–

Retention (AER) model, because it captures customers entering the firm’s
portfolio and expanding over time, even as other customers slowly leave
 Acquisition stage begins with first contact, typically before the first purchase occurs,
when prospects and early customers have similar needs
 Expansion stage has firms that are trying to upsell or cross-sell to expand their sales and
engagement with existing customers
 Retention stage deals with customers who migrate not because of a mismatch in the
core offering or a life event but because they have a basic propensity to switch, in pursuit
of “greener pastures”
© Palmatier 15
Customer Dynamic Segmentation Approach
(AER Model)
Acquis ition Stage Expans ion Stage Retention Stage
Prospective A1 E1 R1
Customers
A2
E2 R2
Lost
Custome rs
© Palmatier 16
Example: AER Strategies Emerge from a
Dynamic Segmentation in B2B Market
 Uses Hidden Markov Models (HMM)
 Simultaneously clusters and links clusters

 Give probabilities of moving among segments
 # clusters are data driven versus AER
 Can evaluate what strategies trigger or drive migration
 Example of 346 B2B customers over 6 years
 Migrations even occur in a mostly stable B2B customer

portfolio
© Palmatier (See Data Analytic Technique 3.1 for more details of HMM) 17
DAT 3.1 Hidden Markov Model (HMM) Analysis
Description When to Use It

Hidden Markov models (HMM) can uncover stages or • To understand the dynamics (or stages) stages of a customer’s relationship with a
“states” of customer behaviors, as well as how those states business.
evolve. Because each state describes the common • To dynamically segmentation the customer base.
behaviors exhibited by some group of customers at some • To predict when a customer might change stages, which may imply more or less
point in their relationship with a firm, HMM is a form of value for the firm.
dynamic segmentation. • To determine when to proactively seek to build customer relationships.
How It Works
• A customer’s relationship with a firm exists in one of several possible unobserved (or hidden) stage, each with finite probability. Customer behavior
varies depending on the stage, such that a “stronger” stage customer likely buys more than one in a “weak” stage. In HMM, customers also have a finite
probability of transitioning from any one stage to another, partially as a function of marketing efforts. For example, advertising might cause customers to
shift from a weaker to a stronger stage.
• Customer behaviors (e.g., purchases) and firm actions (e.g., marketing) serve as inputs to the HMM, which estimates five outputs: (1) the number of
feasible states (or dynamic stages) in the data; (2) initial probability that a customer is in each state; (3) transition probabilities, or the probability that
customers move from one state to another; (4) the conditional probability of a behavior, given the customers’ hidden state; and (5) the effect of marketing
in moving customers across stages.
Example
To dynamically segment alumni donation behavior and investigate which of its marketing activities prompt donors to give money, ABC University
conducted a HMM analysis that identified three hidden states: dormant (corresponds with no donation), occasional (corresponds with infrequent
donation), and active (corresponds with frequent donation). With low marketing effort, dormant customers remain dormant in the next period with a
90% probability (red text); active customers have a 33% chance of becoming occasional in the next period (green text). With high marketing effort
though, the dormant customers become occasional donors with a 57% probability (red text), and active customers exhibit only a 25% chance of
becoming occasional (green text), both of which are good for ABC.
Dormant Occasional Active Dormant Occasional Active
Dormant 0.90 0.10 0.00 Dormant 0.40 0.57 0.03
Occasional 0.08 0.55 0.37 Occasional 0.03 0.50 0.47
Active 0.02 0.33 0.65 Active 0.00 0.25 0.75
Transitions: Low Marketing Effort Transitions: High Marketing Effort

© Palmatier 18
Hidden Markov Model Example:
Relationship States and Migration Paths
Strong
Relationships
Communal State
(61%)
Endowment
Migration 62% 16% 21%
Transitional State
(29%)
Exploration Weak
Migration 35% 7% Neglect Relationships
Migration
Transactional
State (50%)
Recovery
38% 13%
Migration Betrayal
Migration
Damaged State
(57%) Poor
Relationships
© Palmatier 19
Insights for B2B Hidden Markov Model
Example
 States in HMM describe different types of behavior that the same (or different)
consumers might exhibit at different points of time; transitions among states
capture the notion that consumers can switch from one state to another at any
point in time
 In the transactional state, the relationships indicate low levels of customer
trust, commitment, dependence, and relational norms
 If customers follow a positive migration path and move to the transitional
state, they do so only briefly
 In the communal state, the levels of trust, commitment, dependence, and
relational norms are higher than in any other state, and the relationship
produces good cooperation and profit
 The damaged state produces low levels of trust and commitment and very low
relational norms and cooperation, though customer dependence tends to stay
high
© Palmatier (See Data Analytic Technique 3.1 for more details) 20

Customer Lifetime Value (CLV) is a Key
Analysis Tool for Making AER Decisions
 How do you know best customers to acquire/expand/retain?
 In many banking initiatives only 1 in 3 “customers” remain after incentive
ends
 Are all customers worth acquiring or retaining?
 CLV approach: evaluates a firm’s profit as the sum of each customer’s
lifetime discounted cash flows
 Approach captures “true” contribution of each customer at any stage by
accounting for:
 Customer heterogeneity and dynamic effects (individual level, uses
transition expectations, and discounts future profits)
 Tradeoffs among AER strategies (e.g., how acquisition may affect
retention)
© Palmatier 21
CLV Approach (Australia and New Zealand
CMO Survey)
 Survey conducted on 255 CMOs and marketing directors in Australia and
New Zealand
 Those who “always measure the lifetime value of each customer”

achieved a 16% average increase in their annual marketing budget as
compared to 0% for those who do not measure it.
 75% of the marketers are engaged in some level of CLV effort within the
organization
© Palmatier 22
CLV Accounts for Varying Profits Across
Customers
 Beyond 80/20 rule: firms earn 150% of their profits from 30% of their
customers
 CLV captures these difference in your existing customers so you can
acquire, expand, and retain the “best customers”
Number of
Customers
Modestly Modestly
Unprofitable Profitable
Heavy Highly
Losses Profitable
Breakeven
Range of Customer Probability
© Palmatier The Right Customers: Acquisition, Retention, and Development (HBR Press) 23
CLV Accounts for the Time Varying Profits of
Your Customers
 On average, annual earnings typically increase over a customer's life due to
cross/up-selling
 But, some customers are more costly to acquire or retain (lowering prices, high
service levels)
© Palmatier The Right Customers: Acquisition, Retention, and Development (HBR Press) 24
Customer Lifetime Value (CLV) Analysis
 Need cash flow (sales - costs) for individual customers or group of

customers
 Calculate CLV of each customer: CFi ,t

CLVi  t 0
T
(1  d ) t
 Where
 CFi,t = net cash flow generated by the customer i at time t
 T = time horizon for estimating the CLV

 d = discount rate
 CLV is the “value” added, by an individual customer, to the company
 CLV approach is a form of customer-centric accounting where firm’s

value is the sum of all its customers’ CLV
© Palmatier 25
Simplified Customer Lifetime Value Analysis
 Several simplifications make CLV calculations even more straightforward
 Assuming that T  infinity and that the contribution margin and marketing costs
(weak) do not vary over time
 Assuming that the contribution margin and marketing costs do not vary over
time, the CLV in dollars for the ith customer reduces to just five inputs:
1. Mi = margin for ith customer in $ (sales $ and margin as %)
2. Ci = annual marketing cost for ith customer in $
3. ri = retention rate for ith customer as a %
4. d = discount rate as a %
5. Ai = acquisition cost for ith customer in $
© Palmatier 26
DAT 3.3 Customer Lifetime Value (CLV) Analysis

This method quantifies the future discounted profitability • To identify which customers are worth acquiring and retaining.
of a customer. It breaks down firm- or product-level • To determine where to target marketing programs to maximize the firm’s return on
profitability to the customer level, enabling a customer- marketing investments.
centric approach. • To understand the “true” value of a customer to a firm, including both revenues and
costs.
How it Works
Customer lifetime value is the dollar value of a customer relationship, according to both its present value and the projected future cash flows from the
relationship. The calculation process consists of three steps: (1) estimating the remaining customer lifetime, or number of years over which a customer is
likely to maintain a relationship with the firm, normally according to retention rates; (2) forecasting net profits from the customer over the predicted
lifetime, and (3) calculating the net present value of the future amounts. Because CLV ranks customers on the basis of profitability, it can target marketing
campaigns toward the most high value customers. The CLV formula is given as follows.
where:

= Customer Lifetime Value
Mi = margin for ith customer in $
i Ci = annual marketing cost for ith customer in $
ri = retention rate for ith customer as a %
d = discount rate as a %
Ai = acquisition cost for ith customer in $

Both current and potential customers can be segmented according to expected long-term profits or CLV. The graph below plots the CLV distribution of firm,
which consists of inactive customers (low to negative CLV), active customers (positive CLV), and highly active customers (very high CLV) shows that the right
portion of the graph below highlight a firm’s most active customers). Firms can use such a graph to identify and target the most profitable customers for
marketing retention campaigns.
Customers
Inactive Customers Active Customers Highly Active

# of
Customers
CLV
Example
A manager of a cable company wants to determine if it is strategic to acquire the Brett family, by estimating their household-level CLV. The manager
estimates that it will cost the company $65 (A) to get the Bretts’ to switch, and the Bretts’ will generate $100 profit each year (M), with a $10 annual
marketing cost to retain them (C). The estimated retention rate (r) is 65%, and the current discount rate is 5%.(d) . From the formula, the CLV for the
Brett’s is $235, which suggests the Brett’s on net, are profitable to the cable company.
© Palmatier 27
Example: RBC (Canada)
 Royal Bank of Canada (RBC)
 Identified medical students as high CLV customers
 Implemented a program to satisfy their needs early during the

progression of their careers: products such as credit cards, help with
student loans, and loans to set up new practices.
 In the first year, RBC’s market share in this segment increased from 2%
to 18% and average sales were four times higher than average
customers.. These customers were also very loyal.
© Palmatier 28
Some Generalizations on AER Strategies
from CLV Analysis
 AER strategy that maximizes CLV maximizes neither the acquisition rate
nor retention rate
 Investments in customer acquisition and retention have diminishing

marginal returns
 Under spending in acquisition and retention is more detrimental and

results in smaller CLV than overspending
 A suboptimal allocation of retention expenditures will have a larger

detrimental impact on long-term customer profitability than suboptimal
acquisition expenditures
© Palmatier (Kumar 2005) 29

Customer Referral Value (CRV)
 What is the lifetime value of a customer bringing you

another customer?
 Highest CLV customers do not always generate the highest
CRV (weakness of CLV)
 “Advocates” real value is higher than a CLV would predict so
you need to protect these customers (3x more in one study)
 Identify advocates: protect, enable, expand
 Referral programs
 How to build advocates (Apple, BMW, not Wal-Mart)
© Palmatier (Kumar, Peterson, and Leone 2007) 30

RFM Analysis is “Poor Man’s” CLV
 Direct marketers have been using a simplified version of the CLV for
decades, targeting customers to receive expensive catalog mailings. They
use three readily available customer behaviors:
 Recency or time elapsed since last purchase
 Frequency of purchases in last period
 Monetary purchases in last period
 These RFM (recency, frequency, and monetary) variables put customers

in rank-ordered groups, based on their value in the past year (not by
modeling but by rank-order sorting)
 Using the profits generated from a test mailing to a few customers from
each group, direct marketers then mail the catalog only to the groups
with an acceptable return on investment
© Palmatier 31
RFM Code Construction Where Higher
Numbers are Better
R
5 F
35 M
4 335
34
334
3 33 333
332
32
2 331
31
Twenty-five
1 sorts
Five
Database Sorts
One Sort
© Palmatier 32
Test of a Expansion Strategy Using RFM
Analysis for Mailing
Catalog mailing is
above breakeven
for customers with
these RFM codes
Breakeven Analysis
RFM Cell
© Palmatier 33
Lost Customer Analysis Informs AER
Strategies
 A firm contacts customers that have migrated away, to identify the cause for this change, then
works backward to fix the problem and ensure other customers don’t leave for the same reason
 Takes a significant number of lost customers before a firm recognizes that it isn’t just “normal”
customer churn but rather an indication of an underlying problem
 Three-step process, which provides insights into both strengths and weaknesses:
1. Firms set regular intervals for contacting lost customers to identify the cause of their transition, where
they went, and potential recovery strategies
2. If the lost customer is not in the firm’s main target segment, firms could:
a. Change their acquisition criteria
b. Evaluate an expansion strategy to address a new subsegment of customers
3. If the lost customer is in the firm’s target market, firms should:
a. Fix the problem
b. Implement retention strategies to build brand and relational loyalty
 A choice model can benefit the lost customer analysis, and can inform analyses across all AER
stages, because it predicts the likelihood of observed customer choices/responses, using data
about that customer’s characteristics and past behaviors, as well as the firm’s marketing
interventions
© Palmatier 34
What are Choice Models?
 Analysis approach that attempts to determine the impact of

different factors (price, promotion) on consumer’s individual
choices (joining, cross buying, leaving)
 Most popular individual-level response model
 Uses past behavioral data
 No need to survey or get customer input (infers weights from past
customer's behaviors)
 Determines probability of choices and elasticities of marketing variables
 While regression analysis…

 Is not an individual model and uses continuous outcomes
 Gives weights of inputs, but not probabilities or elasticities
 Does not use “logit model,” which is better predictor of how people act by
capturing diminishing effects (inputs have less effect as you do it more)

Choice (Logit) Models Integrate Important
Characteristics of Consumer Behavior
High
Marginal Impact
of a Marketing
Action
Low
0.0 0.5 1.0
Probability of Choosing an Alternative
Assumes that consumers make rational choices based on their individual

utility with a diminishing sensitivity for marketing effort
Thus, marketing has the highest effect on people who are “sitting on the
fence” (i.e., probability of .5 of choosing an alternative)

Choice Models are Excellent for
Determining “Best” AER Strategies
 After determining AER positioning for each stage and ranking
personas on CLV, then you need to develop effective AER marketing
strategies
 Use database of past marketing actions and demographics linked to
actual customer responses (choices) in a stage as input to choice
model
 Choice model will provide:
 Elasticity for every input variable on outcome (e.g., how does age, kids, credit,
and direct mail impact choice)
 Elasticity = % change in output / % change in input
 Probabilities of customer’s choice (probability of upselling, retaining, and can
run on lists for acquisition targeting)
 Latent class choice models: “clusters” and runs choice model at

the same time (segments on elasticity to IVs, same things work for
segment)
© Palmatier 37
Example of Choice Model on MBA Choice
Intensity of
Observations / Choice Choice Income level contact with Distance to Coworkers in
data (0/1) EMBA (internet, campus the program
mailing, call, visit)
INPUTS 1
2
1
0
3
6
7
4
1
7
7
3
3 0 6 4 7 7
4 1 7 7 1 7
5 1 2 7 1 7
6 0 5 6 6 3
7 0 3 1 6 3
 Inputs (no survey needed, infers importance of criteria

from behavior)
 Family income level
 Intensity of contact with EMBA office (internet, mail, call, visit)
 Distance to campus from home
 Coworkers in the program
© Palmatier 38
Customer Choice Determines Coefficient
Estimates, Probabilities, and Elasticities
Coefficient Estimates
Elasticities
Variables / Coefficient Coefficient Standard
t-statistic Elasticities of Income
estimates estimates deviation level
Response Dummy
Response 0.245253 -0.38359
Income level 1.700397 1.172524 1.450202
Dummy 0 0
Intensity of contact with
EMBA (internet, 23.18698 50.94818 0.455109
mailing, call, visit)
Distance to campus -1.0191 0.508133 -2.00548 Elasticities of Intensity
of contact with EMBA
Coworkers in the Response Dummy
2.092535 1.125706 1.858866 (internet, mailing, call,
program visit)
Const-1 -151.835 307.1951 -0.49426
Response 5.474283 -8.5622
Baseline n/a n/a
Dummy 0 0
Probabilities
Elasticities of Distance
Response Dummy
to campus
Response Response -0.25866 0.404571
Respondents / Choice Dummy Predicted Predicted Observed Observed
probabilit Dummy 0 0
probabilities probability Response Dummy Response Dummy
y
1 1.000 0.000 1 0 1 0
Elasticities of
6 0.017 0.983 0 1 0 1
Coworkers in the Response Dummy
12 0.159 0.841 0 1 0 1 program
32 0.476 0.524 0 1 1 0 Response 0.549165 -0.85894
Dummy 0 0
© Palmatier 39
DAT 3.2 Choice Model Analysis

A choice model is a mathematical model that predicts how • To determine a customer’s most likely choice when faced with many product
the likelihood of an observed customer choice or response, alternatives.
is influenced by a firm’s marketing interventions, and/or • To determine the most important factors that influence customer choice likelihood.
customer characteristics. • To segment and target customers according to the similarities in their choice drivers.
• To simulate the potential market share for various products on the basis of customer
choice.
How it Works
• In a choice model setting, every individual is assumed to derive an unobserved product-specific utility from several product options. The individual is
assumed to pick the product option that provides the maximum utility. The dependent variable in a choice model is binary: every individual chooses (or
does not choose) a product option.
• Every product option’s attractiveness is assumed to stem from a finite set of attributes (e.g., brand name, price, advertising). The independent variables in a
choice model are the measure of the strength of attributes of each of the product option, e.g., product option 1 may have a low price, while product option 2
may have a higher price.
• The model uses the two inputs (dependent variable, independent variables) to estimate several outputs. First, it provides the weights (or coefficients) that
each attribute would have had to cause customers to pick a certain product. This provides the most important factors that influence customer choice
likelihood.
• Second, it is used in a predictive sense. For example, when we only observe product attributes, we can use the attributes and the weighs of the model to
predict the choices that are likely to be made by a new set of customers. This in turn can help a firm segment and target customers based on choice
likelihood.
• Third, the model can be used to simulate the market share of a product category, by adding up the product choices made by all customers faced with all
products. This can help manages plan their marketing efforts.
Example
A retailer is planning to introduce a store brand of bleach (Store Brand “C”) in their bleach category, which predominantly has two national brands
(Brand “A” and Brand “B”). The manager responsible for the store brand obtains transaction data from all the retail stores on the sales, price and
promotional efforts by Brand A and Brand B. With a choice model, the manager learns the weights and elasticities associated with price and promotional
efforts respectively. A 1% increase in the price of Brand A decreases the sales of Brand A by 2.7%, while it increases the sales of Brand B by 1.6%. A 1%
increase in the price of Brand B decreases the sales of Brand B by 3.7%, while it increases the sales of Brand A by 1.2%. A 1% increase in promotional
intensity (a 10% price cut for 2 weeks) by Brands A and B increases their respective sales by 8% and 6% respectively. The model fits the data very well,
and hence the retail manager feel confident about the results. Also, the manager learns that frequent price promotions, and lower price do help increase
market share significantly. Hence, the retail manager decides to introduce the store brand (Brand C) as a low price, generic version of bleach (price 20%
below Brands A and B), with promotions held 20% more frequently than Brands A and B. The goal of the store brand introduction is to steal market
share from Brands A and B, especially in a category where price seems to have a large effect on sales (as learnt from a choice model).
© Palmatier 40
Agenda
 Introduction

 Choice Models

 Takeaways
 Case
© Palmatier 41
Marketing Principle #2: All Customers
Change Managing Customer Dynamics
Inputs (CRM data) Managing Customer Dynamics Outputs (AER)

Your Customers Segmentation of
• Individual customers’ sales, Customers
margins, costs Approaches & Processes • Customer personas
• Behaviors/needs over Lifecycle approach • Needs and CLV of personas
time/events Dynamic segmentation approach • Why and how they migrate
Acquisition, expansion, retention (AER)
model AER Positioning
Past Marketing Programs
Lost customer approach
• Source of customers Statements
• Past programs targeted at • How best to position the firm in
specific customers Analyses each persona/AER stage
Customer lifetime value (CLV)
Hidden Markov model (HMM)
Lost Customers Choice models AER Strategies
Factor, cluster, discriminant analyses
• Cause of defection • What marketing strategies work
• Characteristics of lost customers best for each persona/AER stage
© Palmatier 42
Inputs to the Customer Dynamics
Framework
1. The firm’s existing customer portfolio – ideally a firm’s CRM system
provides detailed customer-level data for the dynamic
segmentation analysis
2. Data linking past customer responses with specific marketing

programs and the programs’ cost
3. The qualitative and quantitative information gleaned from the lost

customer analysis, which reveals the causes of customer defection,
where they go, and potentially effective recovery strategies
© Palmatier 43
Outputs of the Customer Dynamics
Framework
1. A description of the firm’s customer personas and expected migrations
to understand how they change, including:
 Critical life event triggers
 The products and services they buy at different points in their

lifecycle migration
 When they stop buying and why
 How they feel at different stages in their lifecycle
 The CLV of customers in each persona
2. AER Positioning statements – how to best position the firm in each

persona/AER stage
3. AER strategies – what marketing strategies work best for each

persona/AER stage
© Palmatier 44
Process for Managing Customer Dynamics
To convert CRM, marketing program, and lost customer input

data into dynamic segmentation and AER positioning
statements and strategies, managers should follow a series of
steps:
1. Dynamic segmentation
2. Migration Paths and Triggers
3. Customer Lifetime Value of Segments and Migrations
4. AER positioning statements
5. AER strategies
© Palmatier 45
Agenda
 Introduction

 Choice Models

 Takeaways
 Case
© Palmatier 46
Dynamic Segmentation: Hotel Example
Acquis ition Stage Expans ion Stage Retention Stage
Prospe ctive Le arne rs Satisfie d Loyalists

Custome rs Custome rs
Path A
Path B Path C
One Time rs
Upgrade d Bore d
Custome rs Custome rs
Lost
Custome rs
Path D
Steps to Dynamic Segmentation Migration Path Triggers

1. Segment customers in each AER stage and name Path A: The main trigger point appears to be positive interactions
the related personas with the manager or key staff (20 percent of time).
2. Find the migration paths, triggers, and CLVs of Path B: The main trigger is being offered upgraded services on first
each persona visit (20 percent of the time).
3. Determine the AER positioning statement and Path C: The main trigger is poor customer experience due to Internet
strategies (who, what, why, and how) for each speed or insufficient work space (30 percent of the time).
persona to maximize sales and profits, based on Path D: The main trigger is either low perceived value or poor
the CLV of these personas interactions with hotel staff (30 percent of the time).
© Palmatier 47
Markstrat Simulation: Making Decisions
When Dealing with Customer Dynamics
Managing Developed Markets (Sonites) as Customer Segments Change
Segment Descriptions Growing Changing

High customer
•• customer Shoppers
High
High income
income level
level Earners needs
High
High Earners
Earners •• Demand
Demand performance
performance and
and convenience
convenience segments
•• Purchase
Purchase expensive
expensive products
products
•• Personal
Personal and
and professional
professional usage
usage
Professionals
Professionals •• Look
Look for
for high
high quality,
quality, high-performance
high-performance products
products
•• Can
Can afford
afford expensive
expensive products
products
•• Cautious
Cautious in
in the
the way
way they
they spend
spend their
their money
money
Savers
Savers •• Demand
Demand cheap,
cheap, average
average convenience
convenience products
products Competitive
•• Future
Future growth
growth rate
rate could
could exceed
exceed forecasts
forecasts Pricing
Professionals
product
•• pressures Savers Professionals
Good
Good product
product knowledge
knowledge through
through comparison
comparison launches
Shoppers •• Demand
Demand high
high quality–price
quality–price ratio
ratio
•• Quite
Quite price-sensitive
price-sensitive
Managing Developing Markets (Vodites) as Prototypical Customer Segments Emerge
Followers
segment
Sales
Early
adopters segment
Innovators segment
© Palmatier 48
Time
Agenda
 Introduction


 Choice Models
 Takeaways
 Case
© Palmatier 49
Takeaways
 The second underlying challenge that firms face when making marketing
decisions is that all customers change. This principle can be either an
opportunity or a threat, depending on how well the firm understands
and manages it.
 Customer dynamics arise from five sources: Individual customers change

due to life events and move through typical lifecycles as they age.
Customer learning effects occur as customers gain knowledge about a
product category. Learning and experience effects also operate at a
societal level. Finally, each customer is situated in an environmental
context that is constantly changing, filled with outside entities trying to
change the customer’s perceptions and behaviors. Each source works
simultaneously and cumulatively to create customer dynamics.
© Palmatier 50
Takeaways
 Due to rapid technological and communication developments, the speed

at which customers change and their expectations about firms’ response
times have increased.
 There are three approaches to managing customer dynamics: lifecycle,

customer dynamic segmentation, and customer lifetime value
approaches.
 The lifecycle approach predicts that customers, products, and industries

go through similar lifecycles that can be used to inform marketing
decisions at different stages. This approach can be problematic though,
because it assumes an average rate of change.
© Palmatier 51
Takeaways
 The customer dynamic segmentation approach, with an AER model,

predicts that acquisition occurs when customers are just beginning to
interact with the firm (customer onboarding). Expansion is when the
firm tries to cross-sell or upsell customers and increase engagement, and
retention involves keeping customers who might otherwise tend to
migrate to competitors.
 Hidden Markov models (HMM) can uncover states, reflecting how a large set of
customer behaviors changes over time. A state is similar to a consumer
segment, describing common behaviors by a group of consumers at some point
in their relationship with the firm. Thus, HMM enables dynamic segmentation.
 As a powerful diagnostic tool, lost customer analysis can be integrated into a
customer dynamic segmentation approach. It often features a mathematical
choice model that predicts the likelihood of an observed customer choice or
response (e.g., joining, cross-buying, leaving), according to data gathered from
the firm’s marketing interventions and customer characteristics.
© Palmatier 52
Takeaways
 Customer lifetime value (CLV) seeks to capture the true contribution of

each customer, according to the migration path this customer is
predicted to follow throughout the relationship with the firm. This
approach beneficially provides guidance for making trade-offs and
resource allocation decisions among different AEP stages. It also can
change a firm’s culture, such that the focus is on profits as the sum of
each customer’s lifetime value, rather than the sum of a product line’s
profits. The firm then becomes more focused on customers, enabling
firms to detect and respond to market changes.
 The framework for managing customer dynamics uses three inputs:

CRM, marketing programs, and lost customer data. It produces three
outputs: dynamic segmentation and AER positioning statements and
strategies.
© Palmatier 53
Agenda
 Introduction

 Choice Models

 Takeaways
 Case
© Palmatier 54
Analytics Driven Case: Preempting and
Preventing Customer Churn at TKL
 TKL is a leading US-based distributor of electrical component products
 Three industry segments: construction, industrial, and original equipment

manufacturers (OEMs)
 Heavy fragmentation in industry, customers evolve as industry matures (learning

effects)
 Problem: market share and annual sales down, increasing customer churn rates,
drop in ratings of warranty, sales support, and delivery speed
 Need to manage customer dynamics (What product attributes are desired? How to
segment the market? Which customers to acquire and expand?)
 Data:
 Acquisition model: 1000 acquired and 1000 non-acquired customers
 Expansion model: 1000 retained and 1000 non-retained customers
 Drivers of acquisition/retention: price, warranty, delivery time, sales support, industry
group, firm size, centralized buying center
© Palmatier 55
Analytics Driven Case: Preempting and
Preventing Customer Churn at TKL
 Results of acquisition model:
 Negative impact: increase in prices, sector: OEM’s
 Positive impact: increase in days of warranty, increase in sales support, sector:
construction and industrial
 No impact: decrease in days to deliver warranty
 Targeting and Positioning for Competitive Advantage

 Segmenting on Acquisition Probability: probability of acquisition higher for
larger sized firms in the construction and industrial sectors  market lowered
price, high sales support and high days of warranty to these customers
 Segmenting on Expansion Probability: probability of expansion was higher for
firms in the construction and OEMs sectors, larger firms, and firms with a
centralized buying center  market sales support and speed of delivery
© Palmatier 56
Readings
 Dealing with customer dynamics using AER modeling and strategies

(regression, CLV, and Bayesian)
 Getting the Most Out of All Your Customers (good overview of
tradeoffs between acquisition and retention uses regression)
 Customer Lifetime Value (explains CLV approach and how to use for
it for acquisition and retention of cohorts of customers)
 Know What to Sell, When, and to Whom (example of integrated
modeling techniques to simultaneously handle customer heterogeneity
and dynamics uses Bayesian models)
 Marketing Strategy: Chapter 3
57

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Marketing Strategy: Marketing Principle #2 All Customers Change Managing Customer Dynamics

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Marketing Strategy

 Approaches for Managing Customer Dynamics

 Framework for Managing Customer Dynamics

 Managing Customer Dynamics Example

 Customer's needs vary not only due to inherent differences in people

 Thus, we need to adapt our “static” segmentation of all customers based on

 Everyone take a few minutes to describe your or your parents

 Car now _______________

 Discrete life events

Product market level

 Customers change; failure to understand and address these dynamics

Marketing principle #2: all customers change and an effective

 Buick: failure to manage customer dynamics

 Acura: success in managing customer dynamics

 Approaches for Managing Customer Dynamics

 Framework for Managing Customer Dynamics

 Managing Customer Dynamics Example

Slow Speed of Response Fast

All Customers Size of Segment Managed Niche Segment

Lifecycle Approach Dynamic Customer Segmentation Customer Lifetime Value

Pros Cons Pros Cons Pros Cons

 Applies a standard set of marketing tactics at each stage

 Makes common sense

 Customer lifecycle attempts to capture how individuals typically change

 Product lifecycle proposes that various products go through four typical

 Industry lifecycle comprises of five stages:

2. An innovation stage to set a “dominant design”

3. The shakeout stage, marked by economies of scale, such as that

Introduction Growth Maturity Decline

 Evaluates existing customer’s behaviors/needs in each AER stage to understand

 Dynamic-based segmentation is sometimes called the Acquisition–Expansion–

Acquis ition Stage Expans ion Stage Retention Stage

 Simultaneously clusters and links clusters

 Example of 346 B2B customers over 6 years

 Migrations even occur in a mostly stable B2B customer

Description When to Use It

Dormant Occasional Active Dormant Occasional Active

Dormant 0.90 0.10 0.00 Dormant 0.40 0.57 0.03

Occasional 0.08 0.55 0.37 Occasional 0.03 0.50 0.47

Active 0.02 0.33 0.65 Active 0.00 0.25 0.75

Transitions: Low Marketing Effort Transitions: High Marketing Effort

© Palmatier (See Data Analytic Technique 3.1 for more details) 20

 Those who “always measure the lifetime value of each customer”

Range of Customer Probability

 Need cash flow (sales - costs) for individual customers or group of

 Calculate CLV of each customer: CFi ,t

 T = time horizon for estimating the CLV

 CLV is the “value” added, by an individual customer, to the company

 CLV approach is a form of customer-centric accounting where firm’s

 Several simplifications make CLV calculations even more straightforward

Description When to Use It

Inactive Customers Active Customers Highly Active

 Royal Bank of Canada (RBC)

 Identified medical students as high CLV customers

 Implemented a program to satisfy their needs early during the

 Investments in customer acquisition and retention have diminishing

 Under spending in acquisition and retention is more detrimental and

 A suboptimal allocation of retention expenditures will have a larger

© Palmatier (Kumar 2005) 29

 What is the lifetime value of a customer bringing you

© Palmatier (Kumar, Peterson, and Leone 2007) 30

 These RFM (recency, frequency, and monetary) variables put customers

 Analysis approach that attempts to determine the impact of