Economics of Customer

Relationship Management

Quantitative Benefits of CRM Using

Revenue Enhancement Metrics
Acquisition/prospect increase
27-45 percent
Expense per convert decrease
30-60
percent
Renewal rate increase
5-15 percent
Cross-sell/up-sell increase
3-25 percent
Share of wallet increase
3-25 percent
Churn decrease
30-80 percent
Campaign cycle time decrease
50-70
percent
Campaign conversion increase
20-50 percent
Win-back increase
25-33 percent

The Market Share Fallacy

Increasing market share should not be a companys

goal. Rather, increasing share of the right kinds of
customers should be the goal.

Retail Banks Have Realized the Following

Benefits from CRM Benefits
Increase in average products sold per customer
over one year from 4.6 to 6.2
3-5 percent decrease in administrative costs
200 percent return on technology investment
through cost reduction over one year
83 percent decrease in average customer info
retrieval time
15 percent increase in product revenue in one year

A Customer Focus Can Aid Retention

Annual Defection Rates

Newspaper subscriptions
Long distance telephone
Clothing catalogues
Internet service providers

Griffen and Lowenstein 2001

66 percent
30 percent
25 percent
22 percent

Which Companies Benefit Most from

CRM?
Companies serving large numbers of customers
through complex and frequent interactions:

Communications companies
Retail banks
Insurance companies
Healthcare organizations
Utilities

Companies with a steep skew

Companies in lost for good markets

Introduction to Customer Based

Marketing Metrics

Traditional Marketing Metrics

Customer based Marketing Metrics

Marketing Metrics
Marketing Metrics

Traditional

Market Share

Sales Growth

Primary
Customer-based

Customer
Acquisition

Popular
Customer-based

Customer
Activity

Strategic
Customer-based

Traditional and Customer Based

Marketing Metrics
Traditional Marketing Metrics

Market share
Sales Growth

Popular Customer Based metrics

Size of Wallet
Share of Wallet

Primary Customer Based metrics

Acquisition rate
Acquisition cost
Retention rate
Survival rate
P (Active)
Lifetime Duration
Win-back rate

Strategic Customer Based metrics

Past Customer Value
RFM value
Customer Lifetime Value
Customer Equity

Traditional Marketing Metrics

Market share

Sales Growth

Market Share (MS)

Share of a firms sales relative to the sales of all firms

across all customers in the given market

Measured in percentage

Calculated either on a monetary or volumetric basis

J

Market Share (%) of a firm (j) in a category = 100 S j S j

j 1

Where j = firm, S = sales, Sj = sum of sales across all firms in the market

Adequate indicator of marketing performance?

Sales Growth

Compares increase or decrease in sales volume or sales

value in a given period to sales volume or value in the previous period

Measured in percentage
Indicates degree of improvement in sales performance between two or more time
periods
Sales growth in period t (%) =

100 S jt S jt 1

where: j = firm, Sjt = change in sales in period t from period t-1, Sjt-1 = sales in
period t-1

Adequate indicator of marketing performance?

Primary Customer Based Metrics

Customer Acquisition Measurements
Acquisition rate
Acquisition cost

Customer Activity Measurements

Average interpurchase time (AIT)
Retention rate
Defection rate
Survival rate
P (Active)
Lifetime Duration
Win-back rate

Acquisition Rate

Acquisition defined as first purchase or purchasing in the first predefined

period

Acquisition rate (%) = 100*Number of prospects acquired / Number of

prospects targeted

Denotes average probability of acquiring a customer from a population

Always calculated for a group of customers

Typically computed on a campaign-by-campaign basis

Adequate indicator of marketing performance?

Acquisition Cost

Measured in monetary terms

Acquisition cost (Rs) = Acquisition spending (Rs) / Number of prospects

acquired

Precise values for companies targeting prospects through direct mail

Evaluation:

Difficult to monitor on a customer by customer basis

Minicase: American Airlines

Leading scheduled air carrier running both passenger and

cargo services

Uses Database Marketing for efficient customer acquisition

First to implement a frequent flyer program (AAdvantage)

Purpose:
To induce current members to spend more of their flight dollars with
American Airlines
To efficiently target new prospects and convert patrons of competing
airlines

Strategy: Cooperation with the credit card company American Express

To identify attractive customers who are not American Airlines flyers
Provide attractive offers to these prospects for inducing them to try
American Airlines

IMC Builds Brands

Customer Activity Measurement

Objectives
When customer is a customer? Marketing interventions
Active living relationship.
Non-purchase interaction contributes to relationship.

Average Inter-purchase Time (AIT)

Average Inter-purchase Time of a customer

= 1 / Number of purchase incidences from the first purchase
till the current time period

Measured in time periods

Information from sales records

Important for industries where customers buy on a frequent basis

Information source
Sales records

Evaluation:
Easy to calculate, useful for industries where customers make frequent purchases
Firm intervention might be warranted anytime customers fall considerably below their AIT

Retention and Defection

Retention rate (%) = 100* Number of customers in cohort buying in (t)| buying
in (t-1) / Number of customers in cohort buying in (t-1)

Avg. retention rate (%) = [1 (1/Avg. lifetime duration)]

Avg. Defection rate (%) = 1 Avg. Retention rate

Avg. retention rate (%) = 1 Avg. defection rate

Avg. lifetime duration = [1/ (1- Avg. retention ratet)

Retention and Defection-Example

If the average customer lifetime duration of a group of customers is 4 years.

Average retention rate is

 The effect for a cohort of customers over time out of 100

customers who start in year 1, about 32 are left at the end of year 4

Customers starting at the beginning of year 1: 100

Customers remaining at the end of year 1:

75

(0.75*100)

Customers remaining at the end of year 2:

56.25

(0.75*75)

Customers remaining at the end of year 3:

42.18

(0.75*56.25)

Customers remaining at the end of year 4:

31.64

(0.75*42.18)

Assuming constant retention rates, the number of retained

customers at the end of year

The defection rate is 1-0.75 = 0.25 or 25%

Variation in Defection rate with respect to

Customer Tenure
# of customers defecting

30
25
20
15
10
5
0
1

9 10 11 12 13 14 15 16 17 18 19

Customer tenure (periods)

Plotting entire series of customers that defect each period, shows variation (or
heterogeneity) around the average lifetime duration of 4 years.

Change in Customer Lifetime Duration

with Retention Rate
Avergae Customer Lifetime
(periods)

20
16
12
8
4
0
50% 55% 60%

65% 70% 75% 80%

85% 90% 95%

Retention rate

Note: increasing the marginal retention rate is likely to be increasingly expensive

CRM at Work: Amazon

One of the leaders in implementing customer relationship management

programs on the web

Helped drive both customer acquisition and retention

In 1999 Amazon acquired 11 million new customers, nearly tripling its

number of customers from 1998

Greatest success in customer retention: Repeat customers during the year

accounted for 71% of all sales

Success attributed to attempt to learn about customers and their needs and
then using this information to offer value-added features to them

How is retention different from loyalty?

Is retention only about buying?
Retention measured on a period by period basis.
Loyalty has theoretical meaning.
Loyalty has an emotional and psychological dimension.
Retention may be simply due to inertia and convenience.

Survival Rate

Measured for cohorts of customers

Provides a summary measure of how many customers survived between the

start of the formation of a cohort and any point in time afterwards

Survival ratet (%) = 100*Retention ratet * Survival ratet-1

Number of Survivors for period 1 = Survival Rate for Period 1 * number of

customers at the beginning

Survival Rate Computation-Example

Number of Customers starting at the beginning of year 1: 1,000

Period 1:
Period 2:
Period 3:
Period 4:

Retention rate
0.55
0.62
0.68
0.73

Survival rate
0.55
0.341
0.231
0.169

Survivors
550
341
231
169

Number of Survivors for period 1 = 0.55 * 1000 = 550

Survival rate for period 2 = Retention rate of period 2 * Survival Rate of
Period 1. Therefore, Survival rate for period 2 = 0.62 * 0.55 = 0.341
(=34.1%)

Projecting Retention Rates

To forecast non-linear retention rates,
Rrt = Rrc * (1-exp(-rt))
where:

Rrt is predicted retention rate for a given future period,

Rrc is the retention rate ceiling
r is the coefficient of retention

r = (1/t) * (ln(Rrc) ln(Rrc Rrt ))

Actual Retention Pattern of a

Direct Marketing Firm
1.Period
since
acquisition

2.Actual
retention rate

3.Predicted
retention rate

4.Defection
rate%

5.Survival
Rate

6.Expected
Number of
active
customers

7.Number of
Active
periods

1
2
3
4
5
6
7
8
9
10
11
12
13

32.0%
49.1%
63.2%
69.0%
72.6%
76.7%
77.9%
78.5%
79.0%
80.0%
79.7%
79.8%
79.9%

68.0%
50.9%
36.8%
31.0%
27.4%
23.3%
22.1%
21.5%
21.0%
20.0%
20.3%
20.2%
20.1%

32.0%
15.7%
9.9%
6.9%
5.0%
3.8%
3.0%
2.3%
1.8%
1.5%
1.2%
0.9%
0.7%

2400
1178
745
514
373
286
223
175
138
111
88
70
56

2400
2357
2234
2056
1865
1717
1560
1400
1244
1106
969
844
730

14

79.9%

20.1%

0.6%

45

628

15

80.0%

20.0%

0.5%

36

538

Cohort of 7500 customers at the outset, maximum retention rate is 0.80 and the
coefficient of retention r is 0.5; after period 10, the company retains approximately 80% of
customer base

Customer Lifetime Duration

T

Average Lifetime duration =

Customers retained
t 1

* Number of periods / N

Where: N = cohort size, t= time period

Differentiate between complete and incomplete information on customer

Complete information - customers first and last purchases are assumed to
be known
Incomplete information- either the time of first purchase, or the time of the
last purchase, or both are unknown

Customer Lifetime Duration (contd.)

Customer relationships
Contractual Lifetime duration (lost-for-good )is time from the start of the
relationship until the end of the relationship (e.g.: mobile phone
contract)

Noncontractual (always-a-share): ) Whether customer is active at a

given point in time (e.g.: department store purchase)

Customer Lifetime Duration when the

Information is Incomplete
Buyer 1

Buyer 2

Buyer 3

Buyer 4

Observation window
Buyer 1: complete information

Buyer 2 : left-censored
Buyer 3: right-censored
Buyer 4: left-and-right-censored

Estimation of P(Active)-Example

Customer 1

Customer 2

Observation period

Month 1

Month 8

Month 12

Month 18

An x indicates that a purchase was made by a customer in that month

To compute the P(Active) of each of the two customers in the 12th month of activity
For Customer 1: T = (8/12) = 0.6667 and n = 4
P(Active)1= (0.6667)4 = 0.197
And for Customer 2: T = (8/12) = 0.6667 and n = 2
P(Active)2= (0.6667)2 = 0.444

P (Active)
Probability of a customer being active in time t
P(Active) = (T)n
Where, n is the number of purchases in the observation period.
T is the time the last purchase expressed as a fraction of the observation
period..
N is the time elapsed between acquisition and the period for which
P(Active) needs to be determined.

Non-contractual case

Any drawback of using P(Active) to predict

customers future activity?
It assumes that when a customer terminates a relationship, he/she
does not come back to the firm.
This approach called lost-for-good is questionable because it
systematically underestimates CLV .
To overcome this, researchers use always-a-share approach,
which takes into account the possibility of a customer returning to
the supplier after a temporary dormancy in a relationship.
In this case, predicting the frequency of a customers previous
purchase is a better way of projecting future customer activity.

Customer Based Value Metrics

Customer
based
value
metrics

Popular

Size
Of
Wallet

Share of
Category
Reqt.

Share of
Wallet

Strategic

Transition
Matrix

RFM

Past
Customer
Value

LTV
Metrics

Customer
Equity

Size-of-Wallet
J

Size-of-wallet ($) of customer in a category = Sj

j 1
Where: Sj = sales to the focal customer by the firm j
J

j = firm, = summation of value of sales made by all the J firms that

j 1

sell a category of products to the focal customer

Information source:
Primary market research

Evaluation:
Critical measure for customer-centric organizations based on the assumption
that a large wallet size indicates more revenues and profits

Example:
A consumer might spend an average of $400 every month on groceries
across the supermarkets she shops at. Her size-of-wallet is $400

Share-of-Wallet (SW)
Individual Share-of-Wallet
J

Individual Share-of-Wallet of firm to customer (%) = Sj / Sj

j 1

Where: S = sales to the focal customer, j = firm,

= summation of
j 1

value of sales made by all

the J firms that sell a category of products to a buyer

Information source:
Numerator: From internal records
Denominator: From primary market research (surveys), administered to individual customers,
often collected for a representative sample and then extrapolated to the entire buyer base

Evaluation:
Important measure of customer loyalty; however, SW is unable to provide a clear indication of
future revenues and profits that can be expected from a customer
If a consumer spends Rs 3000/- on groceries monthly, and Rs 1000/- of her purchases are with Big
Bazaar, then BBs share of wallet of that consumer is 30%

Segmenting Customers Along

Share of Wallet and Size of Wallet

High

Maintain and guard

Hold on

Share-of-wallet

Target for
additional selling

Do nothing
Low

Small

Size-of-wallet

Large

The matrix shows that the recommended strategies for different segments differ
substantively. The firm makes optimal resource allocation decisions only by
segmenting customers along the two dimensions simultaneously

Share of Wallet and Market Share (MS)

Difference between share-of-wallet and market share:

MS is calculated across buyers and non-buyers whereas SW is calculated only

among buyers

MS is measured on a percent basis and can be computed based on unit volume, $

volume or equivalent unit volumes (grams, ounces)

Example:

BINGO has 5,000 customers with an average expense at BINGO of $150 per
month (=share-of-wallet * size of wallet)

The total grocery sales in BINGOs trade area are $5,000,000 per month

BINGOs market share is (5,000 * $150) / $5,000,000 = 15%

Strategic Customer Based Value Metrics

RFM
Past Customer Value
LTV Metrics
Customer Equity

RFM
Recency, Frequency and Monetary Value-applied on historical data
Recency -how long it has been since a customer last placed an order
with the company
Frequency-how often a customer orders from the company in a
certain defined period
Monetary value- the amount that a customer spends on an average
transaction

Tracks customer behavior over time in a state-space

Only on historical data , not on prospect data.

Computation of RFM
Method 1: Sorting customer data based on RFM, grouping and
analyzing results

RFM Method 1

Example:

Customer base: 400,000 customers

Sample size: 40,000 customers

Firms marketing mailer campaign: $150 discount coupon

Response rate: 808 customers (2.02%)

Recency coding: Analysis

Test group of 40,000 customers is sorted in a descending order based on the
criterion of most recent purchase date.

The earliest purchasers are listed on the top and the oldest are listed at the bottom.
The sorted data is divided into five equal groups (20% in each group)
The top most group is assigned a recency code of 1 and the next group
a code of 2 and so on, until the bottom most group is assigned a code of 5

Analysis of customer response data shows that the mailer campaign got the highest
response from customers grouped in recency code 1 followed by code 2 etc

Response and Recency

Customer Response %

Recency Vs. Response

5.00%

4.50%

4.00%
2.80%

3.00%

Response %
2.00%

1.50%
1.05%

1.00%

0.25%

0.00%
1

Recency Code (1 - 5)

Graph depicts the distribution of percentage of those customers who responded fell
within the recency code grouping of 1 through 5
Highest response rate (4.5%) for the campaign was from customers in the test
group who fell in the highest recency quintile (recency code =1)

Response and Frequency

Frequency Vs. Response

Response Rate %

3.00%
2.50%

2.45%

2.22%

2.08%

2.00%

1.67%

1.68%

1.50%

Response %

1.00%
0.50%
0.00%
1

Frequency Code 1-5

Graph depicts the distribution of what % of those customers who responded fell
within the frequency code grouping of 1 through 5
The highest response rate (2.45%) for the campaign was from customers in the
test group who fell in the highest frequency quintile (frequency code =1)

Response and Monetary Value

Monetary Value Vs. Response

Response Rate %

2.50%

2.35%
2.05%

2.00%

1.95%

1.90%

1.85%

1.50%
Response %
1.00%
0.50%
0.00%
1

Monetary Value Code (1-5)

Customer data is sorted, grouped and coded with a 1 to 5 value

The highest response rate (2.35%) for the campaign was from those customers in the
test group who fell in the highest monetary value quintile (monetary value code =1).

Limitations

RFM method 1 independently links customer response data with R, F and M

values and then groups customers, belonging to specific RFM codes

May not produce equal number of customers under each RFM cell since

individual metrics R, F, and M are likely to be somewhat correlated

For example, a person spending more (high M) is also likely, on average,
to buy more frequently (high F)

For practical purposes, it is desirable to have exactly the same number of

individuals in each RFM cell

RFM Cell Sorting

Example:

List of 40,000 test group customers is first sorted for Recency and grouped into 5
equal groups of 8000 each

The 8000 customers in each group is then sorted based on Frequency and divided

into five equal groups of 1600 each- at the end of this stage, there will be RF codes
starting from 11 through 55 with each group having 1600 customers

In the last stage, each of the RF groups is further sorted based on monetary value
and divided into five equal groups of 320 customers each
- RFM codes starting from 111 through 555 each having 320 customers

Considering each RFM code as a cell, there will be 125 cells ( 5 recency divisions *
5 frequency divisions * 5 monetary value divisions = 125 RFM Codes)

RFM Cell Sorting (contd.)

F

11
R
1

M
131

12

132

13

133

14

134

15

135

41
3
4

42
43
44

Customer
Database

45

441
442
443
444
445

Sorted Once

Sorted five times

per R quintile

Sorted twenty five

times per R quintile

Helps target valuable customers with high chances of purchasing

Lifetime Value metrics

(Net Present Value models)
Multi-period evaluation of a customers value to the firm
Recurring
Revenues
Recurring
costs

Contribution
margin

Lifetime of a
customer

Lifetime Profit
LTV

Discount
rate

Acquisition
cost

Calculation of Lifetime Value: Simple Definition

1
LTV CM t

t 1
T

where LTV = lifetime value of an individual customer in $, CM = contribution margin,

= interest rate, t = time unit, = summation of contribution margins across time
periods

LTV is a measure of a single customers worth to the firm

Used for pedagogical and conceptual purposes

Information source:
CM and T from managerial judgment or from actual purchase data.
The interest rate, a function of a firms cost of capital, can be obtained from financial

accounting
Evaluation:
Typically based on past customer behavior and may have limited diagnostic value for
future decision-making

Customer Equity

Sum of the lifetime value of all the customers of a firm

I

Customer Equity,

CE
i 1

1
CM

it
1
t 1
T

Indicator of how much the firm is worth at a particular point in time as a

result of the firms customer management efforts

Can be seen as a link to the shareholder value of a firm

Customer Equity Share, CESj = CEj / CE k,

k

where, CE = customer equity , j = focal brand, k = all brands

Customer Equity Calculation: Example

1
Year
from
Acquisition

2
Sales per
Customer

3.
Manufacturer
Margin

4.
Manufac
-turer
Gross
Margin

5.
Mktg
and
Servicin
g Costs

6.
Actual
Retention
Rate

7.
Surviva
l
Rate

8.
Expected
Number
of
Active
Customer

9
Profit per
Customer
per period
per Manufacturer

10.
Discounted
Profit per
Customer
per Period
to
Manufacturer

11.
Total
Disctd.
Profits per
Period to
the
Manufact
u-rer

120

0.3

36

20

0.4

0.4

400

16

16

6400

120

0.3

36

20

0.63

0.25

250

16

14

3500

120

0.3

36

20

0.75

0.187

187

16

12

2244

120

0.3

36

20

0.82

0.153

153

16

11

1683

120

0.3

36

20

0.85

0.131

131

16

1179

Total
customer
equity

15006

Summary

Firms use different surrogate measures of customer value to prioritize their customers
and to differentially invest in them

Firms can use information about size of wallet and share of wallet together for optimal
allocation of resources

Transition matrix provides the probability that a customer will purchase a particular

brand if what brand has been purchased the last time is known

The higher the computed RFM score, the more profitable the customer is expected to
be, in the future

Firms employ different customer selection strategies to target the right customers

Lift analysis, decile analysis and cumulative lift analysis are various techniques firms
use to evaluate alternative selection strategies

Logistic Regression is superior to Past Customer Value and RFM techniques

Summary

In the absence of individual customer data, companies used to rely on

traditional marketing metrics like market share and sales growth

Acquisition measurement metrics measure the customer level success of

marketing efforts to acquire new customers

Customer activity metrics track customer activities after the acquisition stage

Lifetime duration is a very important metric in the calculation of the customer

lifetime value and is different in contractual and non-contractual situations