Towards an Application of Option Pricing Theory in the Valuation of Customer Relationships

Abstract

While customer retention is a critical factor to the success of most companies, proper management of customer defection requires rigorous customer valuation. We propose a financial options approach to achieve this. The model incorporates sequential purchase profitability and probability, and recognises that the probability of every purchase may be influenced by prior purchase experience. Our analysis suggests that, in situations where the decision to purchase is significantly influenced by prior decisions, changes in the probability of purchase may have greater impact on customer value than changes in the level of profitability. New insights into the trade-off between profitability and customer retention are highlighted.