Class 3 Customer Lifetime Value

Author

Affiliation

Dr Wei Miao

UCL School of Management

1 Customer Life Cycle

Class objectives

• Understand the concept of customer-centric marketing and customer lifecycle

• Understand the concept of customer acquisition cost (CAC) and how to compute it with R

• Understand the concept of Customer Lifetime Value (CLV) and how to compute it with R

1.1 From Product-Centric to Customer-Centric Marketing

• In the past, companies focused on product-centric marketing, while ignoring the long-term relationship with customers.
  • Product-centric marketing: focus on the promotion of a specific product or service
• Customer-centric marketing is a strategy that places the individual customer at the center of marketing design and delivery.

1.2 Customer Life Cycle

• The customer life cycle is a term used to describe the progression of steps a customer goes through when considering, purchasing, using, and maintaining loyalty to a firm.
  • Acquisition: Persuade a prospect customer to purchase for the first time
  • Development: Increase the customer’s value by upselling higher-margin products or cross-selling complementary products and services
  • Retention: keep the customer loyal to the brand

Customer Life Cycle

2 Customer Acquisition Cost

2.1 Customer Acquisition Cost (CAC)

Definition

Customer Acquisition Cost (CAC) refers to the total expenses incurred by a business to acquire a new customer. This includes costs related to marketing, sales, and any other efforts made to attract and convert potential customers into actual buyers.

• Why should we care about CAC?
  • Acquiring new customers is not always beneficial if the costs of acquiring them exceed the revenue they generate.
  • For example, no company would want to spend £500 to acquire a new customer worth £300

2.2 How to Acquire New Customers

• Free sampling/trials

2.3 How to Acquire New Customers

• Referral Programs

2.4 Customer Acquisition Cost: Calculation

• When the marketing cost can be attributed to individual customers, the CAC can be calculated as the cost of making a marketing offer divided by the response rate of the customer.
  • CAC = (# of offers needed to acquire 1 customer) * (cost of making a marketing offer)
  • CAC = (cost of making 1 marketing offer) / (customer response rate)
• After we study machine learning later in this module, we will be able to predict response rate for each individual customer and compute individual-specific CAC.

2.5 Customer Acquisition Cost: An Example

A new Bubble Tea shop MeowMeow Bubble Tea in Canary Wharf is contemplating whether or not to attract new customers by sending ads leaflets to nearby residents.

The cost of sending a leaflet, which includes production and labor costs, is £0.5.

1. Sending out leaflets randomly to all nearby residents
   • expected response rate of 1%
2. Using names purchased from a marketing agency
   • each name costs £0.2
   • expected response rate of 4% by analyzing the buying behavior and demographics of current customers

Compute the CAC for each choice.

cost_per_random_offer <- 0.5
response_rate_random_offer <- 0.01
# Following the formula in the previous slide
CAC_random_offer <- cost_per_random_offer / response_rate_random_offer
CAC_random_offer

[1] 50

cost_per_targeted_offer <- 0.5 + 0.2 
response_rate_targeted_offer <- 0.04
CAC_targeted_offer <- cost_per_targeted_offer/response_rate_targeted_offer
CAC_targeted_offer

[1] 17.5

3 Customer Lifetime Value (CLV)

3.1 Customer Lifetime Value (CLV)

Definition

Customer lifetime value (CLV or LTV) is the total worth to a business of a customer over the whole period of their relationship.

• The underlying idea of CLV is essentially NPV, but at the customer level–Think of acquiring a new customer as an investment in an “asset” that can generate future cash flows.

• CLV is a key metric for customer-centric marketing. It helps companies to decide how much to spend on acquiring new customers and retaining existing customers.

3.2 CLV: Calculation

\[ \mathrm{CLV} = - CAC + \sum_{t=1}^{N} \frac{g_t * r^{(t-1)}}{(1+k)^{t}}, where \space g_t = M_t - c_t \]

• \(r\) is the average retention rate for one period; \(r^{(t-1)}\) is the cumulative retention rate in period \(t\)
• \(N\) is the number of periods over which the relationship is calculated
• \(M_{t}\) is the profit margin the customer generates from buying products and services in period \(t\)
• \(c_{t}\) is the expected cost of variable marketing costs or other expenses to the customer in period \(t\)
• \(g_t\) is the net profit the customer generates in period \(t\) (sometimes denoted as CF)
• \(k\) is the discount rate for discounting future cash flows. The discount factor \(d = 1/(1+k)\).

3.3 Retention Rate

• The churn rate, also known as the rate of attrition or rate of customer churn, is the rate (probability) at which customers stop doing business with the company. Sometimes we also use the term retention rate: retention rate = 1 - churn rate
  • The aggregate churn rate can be calculated as the number of customers lost during a certain time period divided by the number of customers at the beginning of that time period.
  • The individual churn rate: machine learning models to predict the churn rate of an individual customer (Week 5).
• Assumptions in the CLV formula
  • The retention rate is constant over time.
  • The first period retention rate is 100% (all customers stay with us after the first period).

3.4 Number of Years of Customer Relationship

• If we assume infinite customer economic life, we can simplify the formula into the following using the property of geometric sequence.

\[ C L V_{N} = \sum_{t=1}^{N} \frac{g r^{(t-1)}}{(1+k)^{t}} => C L V_{N}=\mathrm{g} \cdot \frac{1-\left(\frac{r}{1+k}\right)^{N}}{1+k-r} => C L V_{\infty}=\frac{g}{(1+k-r)} \]

• However, most of the time, we are more comfortable to assume finite customer economic life; we need to decide on a cutoff date for CLV calculation
  • Rule A: until the year when the \(g = M-c\) becomes negative
  • Rule B: industry’s average customer lifespan