CUSTOMER PROFITABILITY

MARKETING METRICS
PRESENTERS

 Mubeen Ahmed 11056

 Sikendar Razak 10984
 Ahsan Ahmed 11039
 Bilal Tasneem 11045
 Sikendar Javed 11098

Course Instructor:
MR. NAVEED ILYAS
 KEY
CONCEPTS
• Customers, Recency & Retention
• Customer Profit
• Customer Lifetime Value
• Prospect Value Vs Customer
Value
• Acquisition Vs Retention
Spending
CUSTOMERS, RECENCY & RETENTION

Customers
 A person or business that buys from the firm.

Situations
 Contractual
 Non-Contractual
Purpose: To monitor firm performance in attracting
& retaining customers

• The firm must be able to

count its customers first.

• Counting customers will be

different in contractual vs
non-contractual situations.
 Construction: Counting Customers

• Contractual Situations

Vodafone was able to report 2.6 million

direct customers at the end of the
December quarter.
Complications (Contractual Situations)

• Handling of contracts with

two or more individuals.

• Treatment of customers with

multiple contracts with a
single firm.
 Construction: Counting Customers

Non-Contractual Situations with Non-

Identifiable Customers

• Firms can only count

visits or transactions.
 Construction: Counting Customers

Non-Contractual Situations with Identifiable

Customers

• Such as direct mail, retailers, warehose clubs, purchase

of rental cars that require registration.
• Complication – customer purchase activity is sporadic.
For example, Catalog Customers.

“Count how many customers have bought within a

certain period of time”
 RECENCY

• The length of time since a customer’s last

purchase.
• For example

o eBay reported 60.5M active users in first quarter of

2005.
o Active users were number of users who bid, bought,
or listed an item within previous 12-month period.
o Active (12-month) users increased from 45.1M to
60.5M
 RETENTION RATE

• It is the ratio of the number of

customers retained to the number at
risk.
• Retention applies to contractual
situations in which customers are
either retained or not.

• For example:
o Magazine subscriptions
o Checking account with a bank
o Renters pay rent until they move out
 CUSTOMER LOYALTY
“Customer Satisfaction and Customer
Loyalty are the best predictors of
CUSTOMER RETENTION”
CUSTOMER PROFITS
AND PROFITABILITY
 CUSTOMER PROFITS

“A profit that firm makes from serving a

customer or customer group over a specified
period of time”.
• Helps in finding out the relationship of
customers with the firm.
• Not all the customers are profitable.
– Identify the most profitable and growing customers.
– Discard or fire low profitable or non profitable customers.
 Identify Profitability Of Individual Customers

• Usually companies calculate their

performance in aggregate.
– “We made profit of $5.23 per customer”
– “Is mahinay 25000 ki kamai hui” etc..
• This conventional method disguises the fact that not
all the customers are equal.
• What each customer contributes, its what that
should be found.
 CUSTOMER PROFITABILITY

“The difference between revenues earned

from and costs associated with the customer

relationship during a specified period”.

 CUSTOMER TIERS….

• TOP TIER CUSTOMERS – REWARD

– Most Valuable Customers.
– The ones you want to retain.
– Should receive more attention than others.
– Loosing them is not an option!!!!
– Look to reward them in ways other than simply lowering your
price.
– The customers might not be price-sensitive but surely are
value seeking.
 CUSTOMER TIERS….

• SECOND TIER CUSTOMERS – GROW

– Customers with middle to low profits associated.
– They might be targeted for growth.
– Might be developed to Top tier customers.
– Figure out on metrics which customers have the most growth
potential.
 CUSTOMER TIERS….

• THIRD TIER CUSTOMERS – FIRE!!

– Customers due to which company loses money on servicing
them.
– If they cannot be promoted to higher tiers, loose them.
– Consider charging them more for the services.
– If they are recognized beforehand, its best not to acquire
these customers.
 To Calculate Individual Customer Profitability

• Create a Database that can analyze individual

customer profitability.

• By doing this you can,

– Defend your best customers.
– Poach consumers from competitors.
 To Calculate Individual Customer Profitability

• This is an easy task for small scale companies.

• It is a challenge for large scale companies to find
individual customers profits.
To Calculate Individual Customer Profitability

• In order to make the task easier, analysis is

done on groups rather than individuals.
Top Tier Customers

Second Tier Customers

Third Tier Customers

 CUMULATIVE PROFITABILITY
• Same information is presented in cumulative
form.
• The figure shows a “Whale Curve”.
DATA SOURCES, COMPLICATIONS and CAUTIONS

• Assigning Revenues and costs:

– COGS assigned to each customer.
– Activity based costing (ABC) system.
– Some categories of cost are impossible to assign.
 DATA SOURCES, COMPLICATIONS and CAUTIONS

• Considerations and Complications:

– Things change over time.
– Profitable customers might not
be profitable in the coming future
and vice versa.
– Don’t rely on “Whale Curve” only.
– Continue a relationship if you can forecast it to convert
to a profitable one.
– Consider legal environment in which company
operates. i.e. antidiscrimination laws etc.
DATA SOURCES, COMPLICATIONS and CAUTIONS

• Considerations:
– Sometimes its seems profitable to stop non-
profitable customers but it can become a bad
choice. For e.g. Delivery service to remote areas
– Make certain that negative profits will go away!!
– Make sure you cover the fixed costs…
– Its very hard to attract back a
terminated customer.
Customer Lifetime Value
 Customer Lifetime Value

• Customer lifetime value is the dollar value of a

customer relationship based on the present value of
the projected future cash flows from the customer
relationship.
• When margins and retention rates are constant, the
following formula can be used to calculate the lifetime
value of a customer relationship
Purpose: To access the values of each
customer..

• Customer profit (CP) is the difference between the

revenues and the costs associated with the customer
relationship during a specified period.
• CP measures the past and CLV looks forward.
• CP is a matter of carefully reporting and summarizing the
results of past activity, whereas quantifying CLV involves
forecasting future activity.
 Customer Lifetime Value
• The present value of the future cash flows attributed
to the customer relationship.
• The concept of CLV is nothing more than the concept
of present value applied to cash flows attributed to the
customer relationship
• CLV will represent the single lump sum value today of
the customer relationship.
• It is an upper limit on what the firm would be willing
to pay to acquire the customer relationship as well as an
upper limit on the amount the firm would be willing to
pay to avoid losing the customer relationship.
 COHORT AND INCUBATE

•Collect data on a cohort of customers all acquired at about

the same time.
•carefully reconstruct their cash flows over some finite
number of periods.
•Discount the cash flows for each customer back to the
time of acquisition to calculate that customer's sample CLV
•Average all of the sample CLVs together to produce an
estimate of the CLV of each newly acquired customer.
 COHORT AND INCUBATE

Equivalently,

• The present value of the total cash flows from the

cohort and divide by the number of customers to get the
average CLV for the cohort.
• If the value of customer relationships is stable across
time, the average CLV of the cohort sample is an
appropriate estimator of the CLV of newly
acquired customers.
 EXAMPLE
Berger, Weinberg, and Hanna(2003)
All the customers acquired by a cruise-ship line in 1993.
•The 6,094 customers in the cohort of 1993 were tracked (incubated) for five
years.
•The total net present value was $27,916,614 included revenues from the
cruises taken (the 6,094 customers took 8,660 cruises over the five-year
horizon), variable cost of the cruises, and promotional costs.
•The total present value of the cohort per-customer

$27,916,614/6,094
$4,581 per customer

The cohort and incubate approach works well when customer relationships
are
stationary—changing slowly over time. When the value of relationships
changes
slowly, we can use the value of incubated past relationships as predictive of
the value of new relationships.
 CLV Model
1) constant margin (contribution after deducting
variable costs including retention spending) per
period
2) constant retention probability per period
3) discount rate

Furthermore, the model assumes that in the event that

the customer is not retained, they are lost for good.

The one other assumption of the model is that the firm

uses an infinite horizon when it calculates the present
value of future cash flows.
 Customer Lifetime Value
Customer Lifetime Value:
The CLV formula8 multiplies the per-period cash margin
(hereafter we will just use the term “margin”) by a factor
that represents the present
value of the expected length of the customer relationship:

When retention equals 0, the customer will never be

retained, and the multiplicative factor is zero.

When retention equals 1, the customer is always retained,

and the firm receives the margin in perpetuity.
 EXAMPLE
An Internet Service Provider (ISP) charges $19.95 per month.
Variable costs are about $1.50 per account per month. With
marketing spending of $6 per year, their attrition is only 0.5%
per month. At a monthly discount rate of 1%, what is the CLV of
a customer?
 DATA SOURCES, COMPLICATIONS and CAUTIONS

• The retention rate (and by extension the attrition rate) is a driver

of customer value. Very small changes can make a major difference
to the lifetime value calculated. Accuracy in this parameter is vital to
meaningful results.
• The retention rate is assumed to be constant across the life of the
customer relationship. For products and services that go through a
trial, conversion, and loyalty progression, retention rates will
increase over the lifetime of the relationship.
• The discount rate is also a sensitive driver of the lifetime value
calculation—as with retention, seemingly small changes can make
major differences to customer lifetime Value.
• The contribution is assumed to be constant across time. If margin
is expected to increase over the lifetime of the customer
relationship, the simple model will not apply.
 Customer Lifetime Value (CLV) with Initial Margin
The first cash flow accounted for in the model is the margin
received at the end of one period with probability equal to the
retention rate.
Other models also include an initial margin received at the
beginning of the period. Then the new CLV will equal the old CLV
plus the initial margin.
If the initial margin is equal to all subsequent margins

OR

The second formula looks just like the original formula with 1 + Discount Rate taking
the place of the retention rate in the numerator of the multiplicative factor.
Remember:
New CLV formula and the original CLV formula apply to the same situations
and differ only in the treatment of an initial margin
PROSPECTIVE LIFETIME VALUE VS
CUSTOMER VALUE
PROSPECTIVE LIFETIME VALUE VS CUSTOMER VALUE

Prospective Lifetime Value

 It is the expected value of the

prospect i.e. the value expected
from the prospect minus the cost
of prospecting.

 The firm should proceed with the

planned acquisition spending
only if the Prospect Lifetime
Value is positive.
Purpose: To account for the lifetime value of a newly acquired customer
when making prospecting decisions.

 A prospect is someone whom the firm will spend money on

in an attempt to acquire him or her as a customer.

 The acquisition spending must be

compared not just to the contribution from
the immediate sales it generates but also
to the future cash flows expected from the
newly acquired customer relationship.
 Construction

 The Expected prospect lifetime value (PLV) is the

value expected from each prospect minus the cost
of Prospecting.

 The Value expected from each prospect is the

acquisition rate (the expected fraction of prospects
who will make a purchase and become customers).

Prospect Lifetime Value ($) = Acquisition Rate (%) * [Initial Margin ($) +
CLV($)] - Acquisition Spending($)
 Construction

If PLV is positive, the Acquisition spending is

wise investment. If PLV is negative the
acquisition spending should not be made.

 The PLV number will usually be very small.

Although CLV is sometimes in the hundreds
of dollars, PLV can come out to be only a
few pennies.

PLV applies to prospects, not customers.

A large number of small but positive value

prospects can add to a considerable
amount of value for a firm.
 Example
A service company plans to spend $60,000 on an advertisement reaching 75,000
readers. If the service company expects the advertisement to convince 1.2% of the
readers to take advantage of a special introductory offer (priced so low that the firm
makes only $10 margin on this initial purchase) and the CLV of the acquired
customers is $100, is the advertisement economically attractive?

Solution
Here Acquisition Spending is $0.80 per prospect, the expected acquisition rate is 0.012,
and the initial margin is $10. The expected PLV of each of the 75,000 prospects is

 
PLV = 0.012 * ($10 + $100) - $0.80
PLV = $ 0.52
The total expected value of the prospecting effort will be:

75,000 * $0.52 = $39,000

The proposed acquisition spending is economically attractive.

 Example….Contd
• If we are uncertain about the 0.012 acquisition rate, we might
ask what the acquisition rate from the prospecting campaign
must be in order for it to be economically successful. We can
get that number using Excel’s goal seek function to find the
acquisition rate that sets PLV to zero. Or we can use a little
algebra and substitute $0 in for PLV and solve for the break-
even acquisition rate:
Break-Even Acquisition Rate = Acquisition Spending($) / [Initial Margin($) + CLV($)]

= $.80 / [ $10+$100 ]

Break-Even Acquisition Rate = 0.007273

The acquisition rate must exceed 0.7273% in order for the campaign
to be successful.
Data Sources, Complications & Cautions
 In addition to the CLV of the newly acquired customers, the firm needs to know the
planned amount of acquisition spending (expressed on a per-prospect basis), the
expected success rate (the fraction of prospects expected to become customers),
and the average margin the firm will receive from the initial purchases of the newly
acquired customers.

 The initial margin number is needed because CLV accounts for only the future cash
flows from the relationship. The initial cash flow is not included in CLV and must be
accounted for separately. Note also that the initial margin must account for any first-
period retention spending.

 Perhaps the biggest challenge in calculating PLV is estimating CLV. The other terms
(acquisition spending, acquisition rate, and initial margin) all refer to flows or
outcomes in the near future, whereas CLV requires longer-term projections.

 Another caution is that the decision to spend money on customer acquisition

whenever PLV is positive rests on an assumption that the customers acquired would
not have been acquired had the firm not spent the money.
Data Sources, Complications & Cautions

 The firm must be careful to search for the most

economical way to acquire new customers. If there
are alternative prospecting approaches, the firm
must be careful not to simply go with the first one
that gives a positive projected PLV. Given a limited
number of prospects, the approach that gives the
highest expected PLV should be used.

 Finally, we want to warn you that there are other

ways to do the calculations necessary to judge the
economic viability of a given prospecting effort.
Although these other approaches are equivalent
to the one presented here, they differ with respect
to what gets included in “CLV.” Some will include
the initial margin as part of “CLV.”
 Acquisition
VS
Retention Spending
 Acquisition Vs Retention Spending
Purpose: To Determine the Firm’s Cost of Acquisition
and Retention

 Before optimizing mix of

acquisition and retention
spending, firms must first
assess the status quo to
answer following questions:
o How much it cost to acquire new
customers?
o How much it Cost to retain it’s
existing customers?
 Average Acquisition Cost

“This represents average cost

to acquire a customer”

Average Acquisition Cost = Acquisition Spending ( $ )

Number of Customers Acquired

Purpose:
o To track the cost of acquiring new customers.
o To compare that cost to the value of newly acquired
customers.
 Average Retention Cost

“This represents average cost to

retain an existing customer”

Average Retention Cost = Retention Spending ($)

No. of Customers Retained

Purpose:
o To monitor retention spending on a
per customer basis.
 Complications and Cautions

• Acquisition costs are period based.

• Retention cost is only calculated for
customers that existed at the start of
spending period. Any customers
acquired during this period are not
calculated.
• Some customers will be retained even
if the firm spend nothing on the
retention. So retention cost can be
misleading sometimes.
• Firms should focus on spending that
improve both acquisition and
retention.