The Tuscan Lifestyles catalog markets cookware, tableware, linens, and decorative home accessories all in a style reflective of the Tuscany region in Italy. The catalog has been in business for about 10 years and has gradually increased its customer base. Like other catalogs, and retail businesses in general, Tuscan Lifestyles seeks cost-effective ways to find and retain a loyal customer base. Many of the items in the catalog are exclusive and the limited data that Tuscan Lifestyles has indicates high levels of customer satisfaction. Nevertheless, like many other specialty catalog or retail businesses, Tuscan Lifestyles has many customers who make just one or two purchases in their life as a Tuscan Lifestyles customer. Given the nature of their products and their business, it is difficult for Tuscan Lifestyles to know whether or not a customer will return to make additional purchases. A customer may purchase a set of hand-painted dessert plates and make no additional purchase for several years, but then order a full set of table linens. Another customer may make an initial purchase, followed in quick succession by two additional purchases and then never be heard from again. While Tuscan Lifestyles can track the past purchasing history of their customers, there is no way to know when a customer stops being a customer. In contrast to businesses such as banks, telephone service or insurance, customers dont notify Tuscan Lifestyles when they stop being a customer. Instead, they just silently attrite. Joan Beckman was recently hired as the marketing director for Tuscan Lifestyles. In a market environment increasingly cluttered with catalogs, one of her first priorities is to begin to use their database of customer information. She is certain that the accumulated history on their customers can be used to increase the effectiveness and efficiency of future marketing expenditures.

Finding New Customers Since it is not uncommon for a catalog to lose half or even more of its customers from one year to the next, Tuscan Lifestyles is continually prospecting for new customers. Prospects are consumers who fit the profile (i.e. are in target market), but who have not yet made a purchase. Generally speaking, Tuscan Lifestyles prospects are typically middle-class females, aged 30 45, in suburban neighborhoods, with above-average education and a cosmopolitan outlook. To identify prospects, Tuscan Lifestyles purchases lists from various list brokers. List brokers sell or, more commonly, rent lists containing names, addresses and, often, additional information about consumers or households. Two types of lists are response lists and compiled lists. A response list is made up of people who've responded to direct mail from catalogs, card decks, internet sites, magazines, trade shows and professional journals. For example, it is possible to buy lists of people who have previously purchased CDs and DVDs through the mail or of people who have entered sweepstakes. A compiled list is a list of people who share a particular attribute. Compiled mailing and telemarketing lists are made up of names and addresses derived from telephone books, directories, public records, etc. They have not necessarily responded to any offers and are often used to reach an entire market (for example, all the architects in a specific county). For example, it is possible to buy lists of people who are female, of people who are dentists, or of people who live in Wyoming. Response lists tend to be more expensive and are thought to be more valuable by many direct marketers. Catalog companies often acquire prospect names from lists of other mail order businesses since these people are known to have made mail order purchases. Lists are usually rented on a one-time basis. Tuscan Lifestyles regularly rent lists of consumers who have traveled to Italy, who subscribe to certain home decorating, travel, and cooking magazines, or who have made catalog purchases in similar categories. The cost (per name) for a prospect mailing varies depending on the nature of the list and the number of names in total. For Tuscan Lifestyles the average cost per prospect name is $0.10. These prospects are sent a catalog. The cost of sending a typical catalog is about $0.95 including printing and postage. Adding in the 10 cents per prospect name brings the cost to send a catalog to a prospect to $1.05. The industry average for response rates from prospect lists ranges from less than 1.0% to approximately 2.0% depending on the source of the list. 1 Tuscan Lifestyles has realized an above-average response rate averaging 2.3% meaning that, on average, every 1000 catalogs sent to prospects will yield 23 new customers who place an order. Valuing Customers It is well known that some customers are more valuable than others. Over time, some customers purchase more often and make larger purchases than others. Other customers may purchase once and never again, despite repeated catalog mailings. The difficult part is determining how to distinguish the more profitable customers from the less profitable customers as early as possible in the customers lifecycle. Unfortunately, when a customer walks into a store or places an order, there is no easy way to know just how profitable (or unprofitable) that customer may ultimately turn out to be. While businesses have long considered customers to be assets, the advent of detailed databases with individual customer level data has made it possible to value customers in much the same way that other assets have been valued. Like assets such as machines, bonds, or stocks, customers are acquired at some cost. Over time, customers generate both revenues as well as the costs to retain them and/or develop them into better customers. The value of a new customer is the (discounted) stream of net cash flows minus the costs to acquire, develop and retain the customer. The difficult part is being able to predict the future revenue and cost streams for any given customer or group of customers. Businesses often study the past purchase behavior of customers and use the findings to predict how a new customer is likely to behave. For example, a bank may sort through their customer database to identify customers whose first contact with the bank was to open a student checking account. Then, using historical data from these customers, the bank can compute various statistics such as the average account balance over time; the average number of checks written, ATM transactions, and teller transactions; the average duration of the relationship with the bank; and the likelihood that other services such as a car loan or credit card are acquired from the bank. Combined with knowledge of the costs of providing these services, the bank can assess the average profitability or value for this customer group. As the bank accumulates information on specific customers, it is possible to refine customer value calculations using individual-level data. Whats a New Tuscan Lifestyles Customer Worth? Although a widely held maxim in direct marketing is that past behavior is a good predictor of future behavior, for a brand new customer there is little past behavior on which to build a forecast. However, Joan wonders whether a new Tuscan Lifestyles customers early behavior might be indicative of their future behavior. Specifically, she wonders whether the dollar value of a customers very first order is predictive of their ultimate value as a customer. To see whether her hunch was correct, Joan had an analyst in the IT department extract some key information from the customer database. Since Joan felt that 5 years was a reasonable time horizon for lifetime value calculations for the Tuscan Lifestyles business, the analyst began by identifying all customers who made their first purchase 6 years ago. In total there were 7953 new customers 6 years ago. The average dollar amount of the initial order was approximately $58. For each of these 7953 customers he tracked their purchase history for the next 5 years. Since customers made their initial purchases at different times in the calendar year, Year 1 for one customer may span March to March whereas Year 1 for a different customer may span September to September. The important thing is that Year 1 for any given customer begins immediately following their initial purchase. Years 2 through 5 reflect customers purchases in their second year as a customer, their third year as a customer, and so on. So for each of these 7953 customers, the analyst tracked their initial purchase plus purchases in the 5 years following the initial purchase. Once a prospect places an order, they are entered into Tuscan Lifestyles customer database. Tuscan Lifestyles mails 5 catalogs one per season plus one holiday catalog annually to all customers on its list. The cost of a mailing a catalog to a customer is approximately $0.95

(printing and postage included). Since it is hard to know when or if a customer will place another order, Tuscan Lifestyles has continued to mail catalogs to all its customers. That is, Tuscan Lifestyles has yet to drop any names from the customer list. Since the average initial purchase was $58, the analyst rounded down to $50 and used that to divide the 7953 new customers into two groups: those whose initial purchase was less than $50, and those whose initial purchase was $50 or more. Of the total, there were 4567 that made an initial purchase less than $50 and 3386 with an initial purchase of at least $50. Next, for each group he tracked the number of repeat purchases in each of their first 5 years as a customer of Tuscan Lifestyles. In any given year, there were some who did not make a repeat purchase and some who made one or more repeat purchases. Exhibits 1 and 2 summarize these results. In any given frequency table, the first row represents the total number of purchases made, the second row represents the number of customers who made the corresponding number of purchases. In interpreting these exhibits, note that # orders 5 years ago reflects orders placed during customers first year as a customer, # orders 4 years ago reflect orders placed during customers second year as a customer, and that # orders last year reflect orders placed during customers fifth year as a customer. Finally, for each of the two groups the analyst computed the average initial order size (in dollars) and the average repeat order size for years 1 through 5. This information is summarized in Exhibit 3. (Hint: All exhibits were produced in SPSS, hence the formats are comparable to others weve seen in this class.) Armed with this information, Joan wants to know the average lifetime value of a customer for each group. That is, what is the average lifetime value of a customer whose initial purchase is less than $50? And what is the average lifetime value of a customer whose initial purchase is $50 or greater? In making these calculations, Joan has instructed you to assume the COGS is about 58% of the revenue and to use a discount factor of 5% (2.5% interest x a risk factor of 2). Joan has turned this information over to you and scheduled a meeting to review your analysis and conclusions. In preparation for this meeting you should determine the average lifetime value of a customer for each of the two groups. In addition, Joan mentioned several other points that she would like your thoughts on:

ANSWER ALL OF THE FOLLOWING: 1. What is the LTV over five years for customers who initially spend less than $50? 2. What is the LTV over five years for customers who initially spend $50 or more? 3. Based on your findings, which group of customers has higher LTV? 4. Since when has the lower LTV group of customers become profitable? 5. Should you keep sending catalogs to the lower LTV group of customers? Why or why not?

Number of orders per year (not including initial purchase) for customers who first bought 6 years ago and whose initial order was less than $50 Exhibit 2 Number of orders per year (not including initial purchase) for customers who first bought 6 years ago and whose initial order was $50 or more Number of orders per year (not including initial purchase) for customers who first bought 6 years ago and whose initial order was less than $50 Exhibit 2 Number of orders per year (not including initial purchase) for customers who first bought 6 years ago and whose initial order was $50 or more