Valuing the Real Option of Abandoning Unprofitable Custorners When Calculating Customer Lifetime Value

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