APPLICATION OF THE RFM METHOD IN THE CUSTOMER RELATIONSHIP MANAGEMENT

Balan Auhor: Carmen Balan Institution: Academy of Economic Studies of Bucharest, Faculty of Marketing, Department of Marketing, Address: Piata Romana no. 6, Sector 1, Bucharest, Romania, Phone: 021 319 19 80; 021 319 19 00 / ext. 469, 237, E-mail: cbalan@ase.ro The paper focuses on customer relationship management (CRM) underlining its analytical contribution to the substantiation of effective marketing strategies and programs. More specifically, the objective of the paper consists in the presentation of the RFM method, one of the most widely used tools in analytical CRM, in order to segment the customer portfolio of the company and identify the best targets for a particular offer or campaign. The acronym RFM corresponds to the following terms: recency, frequency and monetary value. Two alternative ways to apply the RFM method are analyzed. The former is based on sorting customer data in equal quintiles and analyzing the resulting data. The latter is centered on the calculation of relative weights for the recency, frequency and monetary value on the basis of the regression technique. The method is based on data that are available internally, being acquired by companies on continuous basis about their customers. The databases represent a real gold nugget for the companies that are interested to improve their performance by generating value for both customers and shareholders. Key words: customer relationship management, recency, frequency, monetary value, segmentation At present, CRM is one of the acronyms that are widely used by business and marketing managers, as well as by IT specialists. In essence, the abbreviation corresponds to the terms customer relationship management. Most market players who are or would like to enter the first league have designed CRM strategies and have invested in dedicated software solutions, in order to increase customer retention, boost organizational profitability and acquire sustainable competitive advantage.

1. CRM: a modern strategic and analytical perspective

The CRM definitions abound in the marketing and management literature. According to their background and specialization, various experts support different approaches. Some perspectives focus on the IT side, others on the marketing side, while an ever increasing number of managers concentrate on CRM as a business strategy. The CRM continuum spans from a narrow and tactical definition centered on technology to a broad and strategy-oriented definition concentrated on shareholder value [1]. According to the renowned research agency Gartner, CRM is an IT enabled business strategy, the outcomes of which optimize profitability, revenue and customer satisfaction by organizing around customer segments, fostering customer-satisfying behaviors and implementing customer-centric processes. [2] Building strong and long-term relationships with customers is one of the most important value disciplines for the organizations. Treacy and Wiersema, have identified the following three value disciplines: operational excellence, product leadership and customer intimacy. [3] The company promoting a customer intimacy perspective develops its strategies based on the knowledge about individual customers, their behavior and preferences. From a CRM standpoint, the company attention shifts from the profit on transaction to the customer lifetime value. The implementation of the CRM objectives and strategies implies a thorough knowledge about customers. Consequently, organizations have built the analytical CRM, a bottom-up perspective which focuses on the intelligent mining of customer data for strategic and tactical purposes. Organizations may turn into value information available in their own databases and in external sources. Every company has data about purchasing and payment history of customers, credit score, response to direct marketing campaigns, customer loyalty and services required by customers. At the same time, it may outsource valuable data on geodemographics and lifestyle. On the basis of the analytical CRM, organizations may answer fundamental questions such as: Which customers should be targeted with this offer?; Which is the likelihood of each customer to purchase/repurchase a specific product?; Which is the relative priority of the customers waiting in the line and what level of service should they be offered?. Analytical CRM is able to increase the capability of the company to provide customized solutions adapted to the specific needs and expectations of each customer and to increase customer satisfaction. At the same time, analytical CRM is able to increase the effectiveness of the cross-selling, up-selling and retention programs.

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2. The RFM method

The RFM acronym stands for recency, frequency and monetary value. Its goal consists in identifying and targeting the most attractive customers for a specific marketing project. This method is applied by CRM experts in order to select the segment of customers that will better respond to a particular marketing campaign. The application of the method implies data about the past behavior of customers. The RFM method may be implemented for the customers existing in the portfolio of the company, not in the case of prospects. It helps the marketers predict the reaction of customers to an offer made by the company, based on dynamic data about their purchase history. Consequently, RFM method has as result a behavioral segmentation of customers and the selection of those customers that will respond more favorably to the marketing proposition. The main idea on which the method relies is that past behavior is a better predictor of future behavior than customer declarations relative to their purchasing intentions and attitudes. [4] The likelihood of response to a specific marketing campaign is more reliably estimated by data on historical behavior than by the reasoning and plans stated by customers. The term recency refers to the time interval from the date when the customer either an individual or an organization has placed an order with the company. The frequency describes how often the customer has ordered within a specific period. The monetary value quantifies the amount of money that a customer has spent on an average transaction. Two alternative ways to apply the RFM method are presented hereinafter.

3. RFM: the approach based on quintiles

According to this approach, the application of the method requires customer grouping into equal quintiles based on data about the RFM criteria. The main steps of the application process are the following: (a) recency coding; (b) frequency coding; (c) monetary value coding; (d) customer sorting based on RFM codes; (e) calculation of the breakeven value for each customer; (f) computation of the breakeven index for each customer; (g) selection of the most attractive customers. A hypothetical example will be considered, in order to present the sequence of steps to be followed. The example refers to a company that owns a database of 600,000 customers. The organization decides to select a sample of 60,000 customers that is representative for the entire customer base. The purpose is to quantify the response of the customers to a specific direct marketing campaign. The assumption is that marketers have initiated the project in order to entice actual customers of the company to buy a newly launched durable good. In this respect the campaign will consist in mailing a coupon equivalent to a 70 Euro amount. The addressees are the customers from the selected sample. The response rate for the mailing campaign reaches a hypothetical level of 3%. More precisely, only 1,800 customers have responded. From this point onward, marketers will make a thorough analysis based on RFM data, with the objective to determine if there is any correlation between the response of customers to the mailing campaign and their past purchasing behavior. First, the sample of 60,000 customers is sorted in descending order of their most recent purchase date. Subsequently, the sample is divided into five quintiles that are coded from 1 to 5. The figure 1 is associated with the first quintile that consists of all the customers that have bought most recently the products of the company. The figure 5 corresponds to the last quintile consisting in customers that have made the least recent purchases. Similarly, figure 2 is associated with the second quintile, figure 3 with the third quintile and 4 with the fourth, according to the descending date of their purchase (or ascending length of the time interval from their last purchase). The average response rate is computed for each quintile defined according to the recency of the purchases. The average of the response rates corresponding to the five quintiles is equal to the average response rate of the sample (3%). Following the same sequence of steps, the sample is divided into quintiles based on the other two variables of the method, i.e. purchase frequency and monetary value. The coding procedure is relatively similar. The hypothetical response rates of each quintile are presented in the table 1. The sample of 60,000 customers is divided in five quintiles of 12,000 persons each, according to the purchase recency. Each recency quintile is divided into five quintiles of 2,400 persons each, according to the frequency variable. Similarly, each frequency quintile is divided into five quintiles of 480 persons each, based on the monetary value. Consequently, marketers have generated 125 sets of codes (5 recency divisions * 5 frequency divisions * 5 monetary value divisions = 125 RFM sets of codes).

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Table 1 The hypothetical distribution of response rates by quintiles Recency Quintile Q1 Q2 Q3 Q4 Q5 Average Response rate (%) 5.2 4.6 3.1 1.3 0.8 3.0 Frequency Quintile Q1 Q2 Q3 Q4 Q5 Average Response rate (%) 4.1 3.8 3.2 2.0 1.9 3.0 Monetary value Quintile Q1 Q2 Q3 Q4 Q5 Average Response rate (%) 3.8 3.4 3.2 2.4 2.2 3.0

After the coding of each quintile, marketers are able to associate a set of codes with each customer in accordance with their specific recency, frequency and monetary value. For instance, a customer may be associated the figure 1 according to purchase recency, 2 in terms of frequency and 5 in terms of monetary value. In fact, the customers of a specific purchase recency quintile may belong to one of the quintiles 1 to 5 in terms of purchase frequency and to one of the quintiles 1 to 5 in terms of monetary value. The next step consists in the calculation of the breakeven value (BE). It is calculated using the formula presented bellow:

BE =

UCP 100 UNP

(1)

where UCP is the unit cost price and UNP is the unit net profit. Assuming that the cost of the mail sent to each customer is one Euro and the net profit is 50 Euros, the breakeven value is 2%, respectively (1Euro/50 Euros)*100. The value BE = 1 shows that the marketing campaign did not generate any profits and it only broke even. A value higher than one (BE > 1) reflects positive results achieved by the campaign. The breakeven value may be calculated for each customer and compared to the response rate achieved in the mailing campaign. The attractiveness of each customer account is reflected by the breakeven index. The indicator is computed using the following formula:

BEI =

RR BE 100 BE

(2)

where RR is the response rate to the marketing campaign (percentage of customers that have responded positively to the marketing campaign), BE is the breakeven value. For example, if the response rate is 3% and the breakeven is 2%, the value of the breakeven index is [(3% 2.0%)/2.0%] * 100 = 50. The values BEI > 0 indicate that profits have been generated by transactions. The value BE = 0 corresponds to a break even situation. The values BE < 0 indicate that transactions ended with losses, not with profits. Marketers should target only the customers with a positive breakeven value index. The customers with negative values of the BEI should not be considered for that specific marketing campaign because they do not generate any profit. The company must target only the profitable customers. It will gain more by focusing on the best customers than by mailing to all the customers in the database. A hypothetical situation is presented in the table bellow.

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Table 2 Comparative analysis of the potential profits Indicators Average response rate Number of responses Average net profit/sale Net revenue Number of mails sent Cost per mail Total mailing cost Profits M.U. % Test 3 1,800 50 90,000 60,000 1 60,000 30,000 Full customer base 3 18,000 50 900,000 600,000 1 600,000 300,000 Target segment based on RFM 20 7,600 50 380,000 38,000 1 38,000 342,000

The data from the above table shows that a campaign targeting the most attractive customers leads to higher profits than a campaign directed to the full customer base.

4. RFM: the approach based on relative weights

Another alternative way to apply the RFM method is centered on the assignment of weights to the three variables, according to their importance. The first approach consisted in the sequential sorting of the customers existing in the database, based on their RFM values. The second perspective relies on weights calculated by using the regression analysis. The weights are determined with a test sample and considered to calculate the score specific to each customer in the database. The highest the score, the more profitable is the customer for the company. For each customer, the score is calculated as follows: S = Pr*Wr + Pf*Wf + Pm*Wm (3)

where S is the RFM score corresponding to a specific customer, Pr is the number of points associated to the customer according to the purchase recency, Wr is the weight of the recency variable, Pf is the number of points associated to the customer according to the purchase frequency, Wf is the weight of the frequency variable, Pm is the number of points associated to the customer according to the monetary value of the purchases made by in a specific period, Wm is the weight of the monetary value variable. For each purchase of each customer, the recency score is computed based on a specific rule. A possible example is the following: 20 points are allocated if the purchase was made 3 months ago or less than 3 months ago, 10 points if the purchase was made in the interval (3,6] months ago, 5 points for (6, 9] months ago, 3 points for (9, 12] months ago and 1 point for more than 12 months ago. Similarly, the frequency score for each purchase may be calculated multiplying the number of purchases within the last 24 months by 4 points, but no more than maximum 20 points to each purchase. The score for the monetary value is calculated as one tenth (10%) of the purchase value, up to a maximum of 20 points per purchase. The regression will be used to identify the weights of the three variables (R, F, M). An example of possible weights is the following: 5 for recency, 3 for frequency and 2 for monetary value. The next table presents a hypothetical case of three customers.

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Table 3 RFM score calculation Total score per customer 209 A B C C C 2 1 1 2 3 7 13 2 4 6 2 1 3 3 3 80 50 60 70 120 5 1 20 10 10 8 4 12 12 12 8 5 6 7 12 65 27 148 100 110 358 27 Frequency (number of purchases in the last 24 months) Monetary value score 10 Frequency score Customer Monetary value (Euros) Total weighted score per purchase 144 Recency (months) Purchase Recency score 20

100

According to the total score corresponding to each customer, the most attractive account is C (358 points), followed by A (209 points). Customer B (27 points) will not be considered as target for the marketing campaign due to the very low RFM score. The RFM method is a very useful tool for marketers in the process of customer target selection. Both alternative ways of application may be considered by companies. With the support of IT solutions, the RFM may be used on continuous basis for the assessment of customer attractiveness. The monitoring and evaluation of the recency, frequency and monetary value of the purchases facilitate the efficient segmentation and targeting of the customers existing in the portfolio of the company and the design of the most effective strategies in customer relationship management.

BIBLIOGRAPHY
1. 2. 3. 4. Payne A.F.T., Frow P. A Strategic Framework for Customer Relationship Management, in Journal of Marketing, October, 2005. Peelen, E. Customer Relationship Management, Pearson Education Limited, Prentice Hall, 2005, p. 4. Treacy M., Wiersema F. The Discipline of Market Leaders, Harper Collins, New York, 1996. Spiller L., Baier M. Contemporary Direct Marketing, Pearson Education, Upper Saddle River, New Jersey, 2005.

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