Customer Valuation in the Financial Sector

Bachelorarbeit von Katharina Fee Kersten

Introduction:

It is not only the recent financial recession that alters the way organizations regard their strategy but also the continuously increasing intensity of competition caused by globalization and internationalization that forces them to search for novel strategies that will ensure they perform efficiently while remaining competitive. On the other hand, the adoption of available technologies in our everyday lifestyles has conceived a new, more sophisticated demand.

In the specific case of banks, Brakensiek et al. (2006) identify the major market factors that accelerated the evolution of the banking sector.

First of all, the banking sector is increasingly affected by technological advances. New technology lowers the market entry barriers for discount-, near- and non-banks, for example through the disappearing necessity of a branch network. Furthermore, the accessibility to information and the rising speed of information distribution through online media challenge the traditional branch of banks.

Secondly, Brakensiek et al. (2006) mention the shareholder value forcing the banks to intensify profitability. Besides increasing demand for success and performance, banks become more and more transparent as a result of reporting commitment. At the same time, customers become more price- and return- sensitive and new communication channels enable customers to compare and value the banks’ services.

All in all, this progression leads to an increasing pressure on banks to remain competitive, expand their supply and perform efficiently. Product features and resources no longer serve as strategy for long-term differentiation. The only possibility to meet that current challenge is to concentrate on the core business and profitability of each customer by using effective marketing instruments. Gupta et al. (2005) reason that the entire organization should be customer-centric. This awareness is at odds with the increasing complexity and expansiveness of acquiring, retaining and regaining a customer.

What becomes apparent: Not every customer is worth the same. Thus, customers should be treated unequally. The value of a customer depends on several factors. In general it is the amount a customer spends on a firm but also the money a firm must spend on the customer to make the customer spend money on the firm. In other words, it is the contribution made by each particular client to an organization. A customer can even harm a business. For instance, a firm may spend money on retaining a relationship but the customer does not purchase the appropriate amount to counterbalance the emerging costs. Therefore, the analysis and selection of profitable customers becomes the key factor of the success of any business.

In the literature, the customer value is not unitary defined. For example, the concepts differ depending on the time period, the level of aggregation, distinguishing between monetary and non- monetary value, object-related dimension, amount of selected assessment criteria or the variables used for calculating the value of a customer in a specific model.

However, in this case the customer value within the framework of Customer Relationship Management (CRM) is the value that is provided by a customer to the company. So this perspective is not from the customer’s point of view but the supply side.

In addition, not every customer provides the same value to every firm. To give an example, a very price sensitive customer is valuable to a discounter but less to a high price company with considerable service. As a result, a customer’s value also depends on the branch. As marketing serves as the driver for bonding customers, selecting the promising customers and allocating them to a specific segment that focuses on the profitable customer forms the basis of allocating marketing efforts efficiently and effectively. This fact is notably in this paper because it is attempt to find an applicable method to value a customer in the financial sector which constitutes a specific branch.

Marketing investments represent an eminent part of costs related to a customer. In that respect, it becomes increasingly important to make marketing accountable.

The rising challenge of banks to identify their valuable customers in their specific branch leads to the question:

Which approach to value a customer is most applicable to the financial sector?

To answer this question should note that many marketing metrics like brand awareness or attitudes do not show returns on marketing investments. Therefore, the importance to focus on quantitative methods rather than qualitative instruments used to measure marketing actions becomes apparent. On the basis of this critique, this paper will not regard qualitative instruments.

As a result of the recognition that the customer has currently become critical to the survival of a firm, an abundance of models has been created to calculate the value of a customer. These models vary in terms of variables and methodology used in specific models. Again, the literature does not provide consistency in systematization.

This paper is organized as follows: First, a selection of models will be discussed and evaluated in terms of the applicability to fulfill the requirements of providing an individual, monetary and potential customer value to the firm. The next section contains an explicit discussion of the most meaningful approach, namely the Customer Lifetime Value (CLV). A description of the various methods used to calculate the CLV will be presented depending on the setting and the customer’s behavior in terms of the customer lifecycle. It will be preceded by presenting the main characteristics of banks and discussing the applicability of specific models within the CLV to the financial sector. Finally, the conclusion of this paper will be discussed.

Table of Contents:

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Chapter 3, Customer Lifetime Value:

As arising from the last section, the CLV constitutes a sophisticated approach which fulfills all requirements discussed to calculate a proper economic worth of a customer and thus aiding a company in selecting profitable customers and allocating marketing activities efficiently. This section contains a detailed description of CLV concepts and an attempt to classify these models within the Customer Lifetime Value models. This will be based on regarding the current approaches of research for modeling Customer Lifetime Value in the literature.

Firms are interested in how much benefit a customer will generate over his or her tenure with the firm. In this respect, they form expectations regarding the lifetime value and future cash flow. Advances in information technology enable companies, to collect an enormous amount of customer data and therefore identify customer preferences. In the literature there are several definitions of the CLV but differences within these concepts are rather small.

In this paper, the CLV, is defined as ‘the present value of all future profits obtained from a customer over his or her life of relationship with the firm”, enabling a company to not only to select the profitable customers but also to allocate resources effectively and design customized marketing programs. Hoekstra and Huizingh use the term Customer Equity (CE) similarly to CLV whereas Schroeder defines the CE as the sum of all customers of the firm. Moreover, authors like Hoekstra and Huizingh use abbreviations like LTV for Lifetime Value instead of CLV. However, they all generally have the same meaning. The basic idea of Customer Lifetime Value is the observation of the customer relationship depending on the state in the customer lifecycle. To explain the customer lifecycle, Strauss refers to Dwyer et al.

The customer lifecycle is structured in five key phases. The first phase (awareness) contains a minimal turnover but high costs. The potential customer and supplier do not interact but the supplier tries to draw the customer’s attention. The second phase includes the first interaction (exploration) which leads to small turnover but still high costs. The expansion phase presents the next phase in the lifecycle model. It is the intensified relationship phase. Here turnover increases and costs decrease by experienced interactions. Fourth, the commitment phase constitutes the time where the customer becomes a loyal customer and costs decrease continuously while turnover rises. Dwyer in his concept adds an additional fifth phase which is called ‘dissolution”. Here, the long- term relationship terminates. This phase can occur rapidly and without mutual agreement.

Regarding the lifecycle, the importance to make assumptions to predict the CLV becomes apparent. To give a survey of the main factors that influence the CLV, Gupta et al. develop a conceptual framework that integrates the Customer Lifetime Value into the value chain.

The conceptual framework developed by Gupta et al., 2006 constitutes the firm’s behavior depending on the customer’s phase within the lifecycle. For instance, customer acquisition presents the starting point of a relationship where the company tries to get a customer’s attention and thus convince him or her to become a client of the firm. Customer expansion becomes important in an advanced phase where customers may be loyal and thus expand their purchase behavior. This may happen in the phase where the customer is already working and therefore earning money.

In the following, a distinction in the buyer-seller-relationship characteristics which vary in terms of methods used to calculate the CLV will be made. Thus, depending on the setting and the behavioral characteristics of its customers a large number of ways to estimate the CLV are suggested. This could be expressed by dealing with customers in a contractual or non-contractual setting or regarding a defecting customer as still being a part of the business or terminating forever. The customer’s purchase behavior can be seen as a stochastic process and thus include uncertainties in customer relationship. Different models to implement these stochastic processes will be presented. First, models used to calculate the CLV will be classified in terms of regarding a contractual or non- contractual setting. Secondly, it will be distinguished in ways to estimate CLV by its components. These contain customer acquisition, retention and margin as it is shown in the conceptual framework of Gupta et al. This classification may lead to some overlapping ways in calculation methods. However, it is advisable to classify methods in this way to find appropriate models for specific branches, in this paper the financial sector, which all have different characteristics.