Study Unit 1 Customer Value: RFM and CLV · 2015. 10. 27. · Study Unit 1 Customer Value: RFM and...

Study Unit 1

Customer Value: RFM and CLV

ANL 309 | Business Analytics Applications

© 2014 SIM University. All rights reserved.

Introduction

• Concept of customer value• Recency-Frequency-Monetary Value (RFM) y q y y ( )

approach to calculate customer value• Customer Lifetime Value (CLV) approach to

calculate customer value• Calculating CLV• Differentiation between the RFM and CLV

approachesapproaches


Customer Value

• Customer Value (or customer profitability): Making a company’s• Customer Value (or customer profitability): Making a company s relationship with its customers profitable

Th d t di f t l th t bl t• The understanding of customer value that enables a company to organise different parts of its infrastructure to support different segments of customers, in a cost-effective way.

• Customer value is difficult to define and calculate


Approaches to Estimate Customer Value

There are currently a number of approaches to estimate customer value.

• Recency-Frequency-Monetary Value (RFM) ApproachRecency Frequency Monetary Value (RFM) Approach

• Customer Value Lifetime (CLV) Approach


Recency-Frequency-Monetary Value (RFM)

The RFM approach utilises three aspects to estimate customer value:

R (R) h l i t l t l d• Recency (R) measures how long since a customer last placed an order with company.

Frequency (F) measures how often a customer orders from the• Frequency (F) measures how often a customer orders from the company within a specified period.

• Monetary value (M) measures the amount a customer spends on• Monetary value (M) measures the amount a customer spends on the average.


BA Models for Former Customers

• Sort customer data for customer database using RFM criteria, group them into equal quintiles, and analyse the resulting data

• Calculate relative weights for RFM using regression techniques, use those weights to calculate the total effects of RFM.


RFM: An Example

A business wants to send a marketing mailer campaign to its customers.

It has a customer base of 400,000 and it has selected a sample of 10%=40,000 for the purpose of test marketing.


Recency Coding

• A company sends campaign mailers to 40,000 customers in the testA company sends campaign mailers to 40,000 customers in the test group. Assume that 20% of 40,000=808 customers responded.

• It then sorts the test group of 40 000 in decreasing order of “most• It then sorts the test group of 40,000 in decreasing order of most recent purchase date”.

It divides the result into five equal groups or quintiles (20% in each• It divides the result into five equal groups or quintiles (20% in each group).

f• And finally assigns a recency code to each quintile: the top most group has a recency code of 1 and so on, up to 5.


Recency Coding


Frequency and Monetary Value Coding

• Both are similar in procedure to recency coding.Both are similar in procedure to recency coding.

• In the case of frequency coding, the data are sorted based on frequency such as the average number of purchases made by afrequency , such as the average number of purchases made by a customer per month.

In the case of monetary value sorting is based on the monetary• In the case of monetary value, sorting is based on the monetary value, such as the average money value of purchase made per month.


Frequency Coding


Monetary Value Coding


Limitations of RFM

• RFM may not produce an equal number of customers under each RFM cell because the individual metrics “R”, “F” and “M” may be correlated. For instance, a customer with a high “M” is also likely to have a high “F”.

• Backward looking as it applies to the historical customer dataBackward looking as it applies to the historical customer data available. Hence, its use is limited to established customers.


Same Number of Individuals in Each RFM


Customer Lifetime Value (CLV)

• The Customer Lifetime Value (CLV): To estimate the customer value of prospective or established customers

• The Customer Lifetime Value (CLV): The expected present value of a prospect or customer over a specified period of time


Components of CLV Estimation

Generally, estimation of CLV involves the following components:

• DurationDuration

• Time Interval

• Profits=Total Revenue-total Cost

• Discount Rate


Calculating CLV

The simplest and most common definition of CLV: The sum of the discounted profits over the duration of the customer lifetime (T) with the firm


Discount Rate

The discount rate depends on the market interest rate “r” and itThe discount rate depends on the market interest rate r and it is given by


Computing the CLV

Year Future Profit ($)($)

1 1000

2 2000000

3 3000

4 40004 4000

5 5000


a) Calculate the Discount Rate

The interest rate “r” is 5% or 0.05.

Discount rate for the first year=1/(1+0.05)=0.952Discount rate for the second year

And so on…


b) Calculate the Net Present Value for Each Year

The net present value at period “t” is the expected profit multiplied by the discount ratethe discount rate.

Net present value for year 1=$1,000*0.952=$952

Net present value for year 2=$2,000*0.907=$1 814=$1,814

And so on…


c) Calculate the Customer Lifetime Value of this Customer

CLV is the sum of the discounted profits or net present values over the duration of the customer lifetime “T” with the firm.

For this customer, T=5 years., y

Hence, CLV=952 + 1814 + 2592 + 3592 + 3920=12570=12570


Computing the CLV


Study Unit 1 Customer Value: RFM and CLV · 2015. 10. 27. · Study Unit 1 Customer Value: RFM and...

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