Valuing the Real Option of Abandoning Unprofitable Customers when Calculating Customer Lifetime Value

Abstract

In recent years, several authors have developed models that focus on the allocation of scarce marketing resources based on customer lifetime value (CLV). These approaches use CLV to develop a rank order of customers and recommend devoting more resources to customers with higher ranks. However, it has been discussed in the literature that a simple net present value analysis may not reflect the value of the flexibility to make such decisions. Therefore, some authors recommend the use of a real-options analysis in certain situations. Building on this stream of research and using the case of the option to abandon unprofitable customers, this article proposes an approach that combines real-options analysis and CLV; this approach explicitly values the seller's flexibility to abandon unprofitable customers. Using a combination of examples, empirical analysis, and Monte Carlo simulations, the authors provide evidence that the divergence between CLV that includes and CLV that excludes option value can be substantial and may not be the same for all customers. Therefore, the authors conclude that a distribution of customers based on CLV can change when option value is included. Thus, using CLV as a basis for marketing decisions but not including the value of the option to make such decisions a priori when calculating CLV can lead to an overall biased result.