MGT 356 Simulation

Example 11.11 Long-term Value of a Customer

(CustomerLoyalty)

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 Example 11.11
The Long-Term Value of a Customer

 Objective: To use simulation to find the NPV of a customer

and to see how this varies with the retention rate.
 CCAmerica is a credit card company that does its best to
gain customers and keep their business in a highly
competitive industry.
 After the first year, the profit from a customer is typically
positive and continues to increase.
 For nth year a customer is with the company, the profit
from that customer is normally distributed with:
mean = shown in the Excel file, Customer Loyalty.xlsx
standard deviation = 10% of the |mean|

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 Example 11.11 Background (cont)
 At the end of the year,
Prob(customer leaves the company) = 0.25 (= churn rate)
Prob(customer stays) = 0.75 (= retention rate)
 Goal: Estimate NPV of the net profit from a customer who
just signed up.
 Assumption:
 Discount rate = 15%
 Cash flow occurs in the middle of the year.
 Also, sensitivity analysis of NPV with varying retention rate.
 Solution: Keep simulating profits for the customer until the
customer churns. We simulate 30 years worth of potential
profits.
 CustomerLoyalty
 Inputs:
 Parameters – retention rate (varied), discount rate, mean profit each
year, standard deviation each year
 Random variable
 Customer life time (# of years customer stays)
For each year, P(customer stays) = retention rate
 Profit each year
 Assumed to have a normal distribution with mean = given in the table,
standard deviation = 10% abs(mean)
 @RISK formula: =RiskNormal(mean,stdev)
 Excel formula: =NORM.INV(rand(),mean,stdev)

 Output:
 NPV (Net Present Value) of a customer
 Length of customer lifetime
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 Timing of Churn

 Stay at end of year?

 Yes if stay
 No if quit
 First Year
If RN < 0.75, then customer stays
=IF(RAND()< 0.75, “Yes”, “No”)
 Subsequent Years
If customer quit before this year, enter “No”


 Else, if RN < 0.75, then customer stays this year

=IF(Stay?(t-1)=“No”, “No”, IF(RAND()<0.75, ”Yes”, “No”))

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 Actual and Discounted Profits

 Actual Profit
 If customer is around, generate profit from a normal distribution
=IF(Stay?(t-1) = “No”, 0, RISKNORMAL(Mean, StDev))
 Discounted Profit
 Actual profit / (1+discount rate)^(year-0.5)
(Cash flow occurring middle of year – more realistic than end of
year)
 Try varying the retention rate:
Use =RiskSimTable with values: 0.75, 0.80, …, 0.95

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 NPV Calculation
 Since the cash flows occur in the future, we need to discount
them (compute their present values).
 Recall
CFt
Present Value of a Cash Flow =
(1  r )t
where
CFt  cash flow t years from now
r  discount rate

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 NPV Calculation: Example
 Suppose cash flows are:
-40 at end of year 1 40 66 72
NPV   
66 at end of year 2
1 2
(1.15) (1.15) (1.15)3
72 at end of year 3.  34.78  49.91  47.34
 62.46
 If they occur in the
middle of the resp years:
40 66 72
NPV  0.5
 1.5

(1.15) (1.15) (1.15) 2.5
 37.30  53.52  50.77
 66.99
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 Outputs & Simulation

 NPV
Sum the discounted values (E11:E40)
 Lifetime Length (Years loyal)
=1 + number of years customer stays at end of year
= 1 + COUNTIF(E11:E40,”Yes”)
 Designate both of the above as @RISK output cells.
 Set the number of iterations to 1000 and the number of
simulations to 5 and run @RISK.
 Because Excel’s RAND() function used, the results will vary.

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Histogram of NPV with 85% Retention Rate

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 Summary of Output

Name Sim# Min Mean Max % Increase

NPV 1 ($46.26) $102.66 $559.65
NPV 2 ($46.73) $131.23 $553.81 28%
NPV 3 ($45.53) $182.56 $579.32 39%
NPV 4 ($52.40) $259.09 $589.79 42%
NPV 5 ($46.73) $366.69 $598.49 42%
Years loyal 1 1 4 25
Years loyal 2 1 5 31 20%
Years loyal 3 1 7 31 36%
Years loyal 4 1 10 31 49%
Years loyal 5 1 16 31 62%
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Value of Customer vs Retention Rate

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 Incentive to Stay

 How about offering an incentive for the customer to stay?

 Suppose CCAmerica is considering offering a $50 gift
certificate for a customer willing to sign a 3-year contract,
i.e., the customer will stay with the company for at least 3
years. Is this a good idea?
 Do not allow customer to switch at the end of 1st year and
2nd year. Run simulation.

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Summary of Output with 3-year Contract
Name Sim# Min Mean Max
NPV 1 $43.91 $180.89 $551.64
NPV 2 $47.98 $212.01 $586.23
NPV 3 $43.91 $251.80 $565.87
NPV 4 $47.98 $312.09 $589.88
NPV 5 $47.98 $404.99 $597.09
Years loyal 1 3 6 31
Years loyal 2 3 7 31
Years loyal 3 3 8 31
Years loyal 4 3 12 31
Years loyal 5 3 17 31
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