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A Review of the Customer Lifetime Value As a Customer Profitabilitu Measure IC, 2011 – 7(2): 261-279 - Online ISSN: 1697-9818 - Print ISSN: 2014-3214 http://dx.doi.org/10.3926/ic.2011.v7n2.p261-279 A review of the customer lifetime value as a customer profitability measure in the context of customer relationship management Raphael Damm, Carlos Rodríguez Monroy Universidad Politécnica de Madrid (Spain) [email protected], [email protected] Received December, 2010 Accepted June, 2011 Abstract Purpose: A number of customer metrics allow estimating customer profitability with methods such as the Customer Lifetime Value (CLV). However, investments in customer relationships carry the potential risk to destroy value and reduce profitability when based on incorrect estimates of customer profitability. Therefore, estimating future customer value correctly is essential to allocate marketing expenditures in the most effective way. In this article recent literature about the CLV is reviewed in order to assess its ability as a customer profitability measure. Besides the financial perspective of the CLV, non-financial perspectives such as customer advocacy, (customer or open) innovation and learning have been identified to have an impact on customer profitability. How to properly estimate a customer’s value taking all relevant value creating factors, financial as well as non-financial, into account is the underlying research question. Design/methodology/approach: This research is based on the review of a number of theoretical and empirical articles published between 1990 and 2010. The aggregation of measures, key-drivers and risks of each key- perspective of the customer relationship contributes to the development of a more systematic understanding of the value creation process and provides answers to the research question. Indirect effects of the CLV as a source of - 261 - Intangible Capital - http://dx.doi.org/10.3926/ic.2011.v7n2.p261-279 value have received increasing attention in previous research but are not sufficiently accounted for by mainstream methods for valuing customers (Ryals, 2008). Therefore, the attempt to structure available knowledge on indirect effects of the CLV in its contextual setting is made. Findings: This research is concluded providing evidence that one- dimensional calculations of the CLV deliver an incomplete picture of the customer relationship and estimate customer profitability incorrectly. This supports the idea of a multidimensional CLV approach that accounts for interrelated key-perspectives and results in superior resource allocation. Originality/value: Seeing customers in a comprehensive way helps to better understand their needs and potential contributions, so that long-term overall profitability can be advanced through the consideration of indirect effects. Indirect effects are usually not reflected in common accounting methods but might result in benefits for the firm. In this research, evidence is provided for the importance of indirect effects offered by customers. This makes the consideration of all relevant dimensions in the value creation process fundamental in order to allocate marketing resources in the most effective way. Keywords: customer lifetime value, customer profitability, non-financial values, customer relationship management Jel Codes: M31 1. Introduction The ever-present need to justify investments in marketing activities, calls for marketing measures that can be linked to future customer value and firm performance (Peterson et al., 2009). The CLV approach captures customer metrics in order to quantify the potential monetary value of customers over their lifetime. This allows better estimating customers’ financial values, focusing on profitability, grouping customers and analyzing the returns on investments made into customers. The purpose of the CLV is to increases marketing’s accountability within the firm, help managers and retailers to identify the drivers of future customer and firm value and build linkages between marketing strategy and financial outcomes - 262 - Intangible Capital - http://dx.doi.org/10.3926/ic.2011.v7n2.p261-279 (Peterson et al., 2009). However, applying the CLV also leads to a number of questions. 1. Does the valuation take all relevant value creating factors into account so that the CLV is properly estimated? 2. Does the CLV properly account for risks inherent in customer relationships such as customer defection or negative customer advocacy? 3. Do forecasting difficulties limit the practical use and acceptance of the CLV? The CLV takes direct customer spending into account but does not incorporate indirect revenues from additional sales through Word of Mouth (WOM) or the likes. In addition, neither savings that result from customer triggered process optimizations are subject of the CLV, nor are reductions of uncertainties resulting from reliable customer relationships reflected by the CLV. That raises the question if customer profitability will be estimated correctly when neither customer advocacy, the innovation potential nor the learning potential are accounted for. Moreover, will marketing expenses be utilized in the most adequate, that is, profitable way if long-term overall customer profitability is estimated incorrectly not accounting for important value creating potentials? Relationships might be seen as emotional selling propositions due to the fact that satisfied customers return to trusted companies (Urban, 2005). The Customer Relationship Management (CRM) aims at establishing long-term relationships with customers in order to gain insights into what matters most to customers. Insights into specific customer needs enable companies to better target and satisfy them and provide knowledge for potential product developments. Measuring and comparing the costs to acquire and to maintain customers are prerequisites in order to be able to decide focusing on customer retention or on customer acquisition. Although it is commonly accepted that it is important to measure what is to be managed there are important aspects that are unobservable but nevertheless need to be managed. As the CLV is estimated over a number of transactions, that are likely to occur throughout the customer lifetime, it cannot be seen in an isolated way but rather in the long–term relationship context that CRM suggests. The CLV can therefore be seen as a tool that allows the calculation of potential customer value only if a (long- term) relationship exists. The contextual settings, such as long-term relationship, customer satisfaction, customer learning and others that are suggested by the CRM approach are crucial, as CLV estimates will only be calculated correctly if contextual - 263 - Intangible Capital - http://dx.doi.org/10.3926/ic.2011.v7n2.p261-279 settings support the compliance of customer metrics. Expected lifetime, retention rate and others are CLV determining elements that are strongly influenced by the contextual settings. Hence, an overview of the CRM approach is necessary to understand the contextual settings that are required for the calculation of the CLV. 2. A brief review of the customer relationship management concept The CRM approach reflects the shift from functional traditional marketing, focused on products and customer acquisition, towards comprehensive marketing that puts the relationship with the customer first. The essence of CRM is to change organizations from a products-centric to customer-centric philosophy (Kim et al., 2003). Developments in technology have enabled companies to see customer relationships more holistically provoking this change from transactional to relationship marketing (Alt et al., 2005). Although technologies play a crucial role in CRM enabling the aggregation of customer data and the recognition of patterns, they are not subject of this research and will not be discussed here. The central idea behind engaging customers in long-term relationships is to increase company and customer value by systematical management of existing customers. Kim et al. (2003) summarize the following potential benefits of CRM: • Increased customer retention and loyalty • Higher customer profitability • Creation value for the customer • Customization of products and services • Lower process, higher quality products and services The tangible effects of companies’ commitment to retaining customers were first published by Dawkins and Reichheld (1990) who claim that higher retention rate leads to higher net present value of customers (Ahmad & Buttle, 2002). The selection and acquisition of customers based on the purely financial CLV become critical to the long-term customer profitability. The CLV as the measure for customer profitability possesses a fundamental role as it serves within the customer analysis as a deciding feature. The correctness of the CLV in terms of long-term overall customer profitability consequently turns out to be essential for the most efficient employment of marketing expenditures. - 264 - Intangible Capital - http://dx.doi.org/10.3926/ic.2011.v7n2.p261-279 The review of literature on the CRM approach has revealed the existence of varying definitions (Reinartz et al., 2004; Payne & Frow, 2005; Richards & Jones, 2008) and an imperfect conceptualization of the CRM concept (Magro & Goy, 2008). The aim of a conceptualization is to provide a general definition and categories, so that areas can be classified and grouped accordingly. A formalized ontology building process is suggested by Pinto and Martins (2004). They state specification, conceptualization, formalization, implementation and maintenance
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