Wednesday, June 25, 2008

Using Real option Approach in Calculating Customer Lifetime Value

The Flaw in Customer Lifetime Value.
By: Schoder, Detlef,
Harvard Business Review,
Dec 2007, Vol. 85, Issue 12

Companies have been using real options for a long time to optimize their investment portfolios. It's time they applied them in the valuation and management of their investment in customers, too. Here's a five-step process for bringing real-options analysis into the NPV calculation:

Estimate the future purchasing behavior (that is, the probability of purchase and dollar amount expected to be spent) for a set of customers, using the common RFM (recency, frequency, and monetary value) approach. This determines expected revenues.

Calculate costs generated per customer per period.

Use those two inputs to estimate the profit contribution for each customer over the time horizon under consideration, for example ten periods.

For each period, determine whether the expected future profit contribution for that customer might be negative.

Finally, calculate the CLV that includes the option value (the value of abandoning that customer). What would be saved by dropping him at any given period?

The difference in CLV using the real-options approach versus the traditional approach was, in some cases, as much as 20%. More important, some negative CLVs actually turned positive when the value of the real options was considered.

See Michael Haenlein, Andreas M. Kaplan, and Detlef Schoder's "Valuing the Real Option of Abandoning Unprofitable Customers When Calculating Customer Lifetime Value" in the Journal of Marketing, July 2006.)

Detlef Schoder ( is a professor and chairs the Department of Information Systems and Information Management at the University of Cologne in Germany.

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