Question

Homework 4, Ch. 5: Calculating Customer Lifetime Value

Introduction

Customer lifetime value (CLV) is a good way of demonstrating the financial return on marketing activities, particularly as the return is often generated over several years. The basic calculation for CLV is:

CLV =     ((annual revenue - annual costs) X years a customer) less initial acquisition costs

Part A: Your first task is to calculate the CLV for two retailers (with an example provided to assist you). Which of the two retailers have the more valuable customers?

Part B: Redo the calculations, but this time do NOT take into account `years a customer'.

That is, assume that they are only customers for one year only.

In this case, which of the two retailers have the more profitable customers now? Therefore, how important is it for firms to try and enhance customer loyalty (that is, years a customer)?

Activity/Task

(PART A) AVERAGE CUSTOMER	Example (See below)	Retailer A	Retailer B
Annual Revenue	$500	$3,000	$1,100
Annual Costs	$100	$1,000	$100
Annual Profit	$400	?	?
Years a Customer	5 yrs	5 yrs	3 yrs
Profit X Years	$2,000	?	?
Acquisition Cost	$500	$2,000	$500
CLV	$1,500	?	?

(PART B)	Example (See below)	Retailer A	Retailer B
Annual Revenue	$500	$3,000	$1,100
Annual Costs	$100	$1,000	$100
Annual Profit	$400	?	?
Years a Customer	Looks at 1 yr only	Looks at 1 yr only	Looks at 1 yr only
Profit X Years	$400
Acquisition Cost	$500	$2,000	$500
CLV	- $100 (Loss)

Discussion Questions

Comparing your calculations in Part A and Part B, if firms just look at a customer's immediate return (that is, one year's income), will that lead to poor decision making?
Referring to Part A, would the retailers benefit more from: Trying to acquire customers more efficiently (that is, a better use of their promotional mix) OR Trying to extend customer loyalty (that is, hold customers for an extra year)?
Given your response above, using a rough estimate, what proportion (%) of these retailers' promotional budget should be allocated to enhancing customer loyalty?

Answer 1

(PART A) AVERAGE CUSTOMER	Example (See below)	Retailer A	Retailer B
Annual Revenue	$500	$3,000	$1,100
Annual Costs	$100	$1,000	$100
Annual Profit	$400	$2,000	$1,000
Years a Customer	5 yrs	5 yrs	3 yrs
Profit X Years	$2,000	$10,000	$3,000
Acquisition Cost	$500	$2,000	$500
CLV	$1,500	$8,000	$2,500

(PART B)	Example (See below)	Retailer A	Retailer B
Annual Revenue	$500	$3,000	$1,100
Annual Costs	$100	$1,000	$100
Annual Profit	$400	$2,000	$1,000
Years a Customer	Looks at 1 yr only	Looks at 1 yr only	Looks at 1 yr only
Profit X Years	$400	$2,000	$1,000
Acquisition Cost	$500	$2,000	$500
CLV	- $100 (Loss)	$0	$500

Discussion Questions

Comparing your calculations in Part A and Part B, if firms just look at a customer's immediate return (that is, one year's income), will that lead to poor decision making?	Yes, if the retailers were to look at the immediate return (one-year income), the Retailer A will decide to dispose its customers as it is not making any profit. This is a poor decision making. Because the retailer losses $8,000 of profit during the life time of its customer. This is higher than the $2,500 Retailer B would have earned during the life time of its customer. Thus, this example shows the significance of customer life time valuation in decision making.
Referring to Part A, would the retailers benefit more from: Trying to acquire customers more efficiently (that is, a better use of their promotional mix) OR Trying to extend customer loyalty (that is, hold customers for an extra year)?	The retailers would benefit more from customer loyalty. Looking at the above table we can understand that even if a retailer is able to acquire customer efficiently, if the customer lasts only for one year, retailer will make a loss. But if the retailer extends an impressive customer loyalty programme, the customer will stick on for more years earning the retailer more profit. Hence it can be concluded that customer loyalty programmes will earn the retailers more profit.
Given your response above, using a rough estimate, what proportion (%) of these retailers' promotional budget should be allocated to enhancing customer loyalty?	In the previous question we understood the importance of customer loyalty. So on a rough estimate at least 50% of the promotional budget should be allocated to enhancing customer loyalty.