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How much are your customers worth?> Valuing customers as assets

June 20, 2008

Questions that need to be answered to value customers.

  • How customers are assets. Customers are typically the primary source of earnings for a company. If you can estimate the value of current and future customers, then you can determine the true value of your firm.

  • How to calculate the value of your customers simply. If you know the profit generated from a customer, as well as your average retention/defection rate, you can use a very simple equation to estimate the lifetime value of that customer.

  • How customer value can drive your marketing strategies. Effective customer-based marketing strategies take into consideration the value that a firm provides to a customer, and the value of a customer to the firm.

  • How your organization must change. Shifting to a customer-based mind-set in your business means that old product-based practices and processes must be jettisoned.

Customers Are Assets

Customers are the lifeblood of any organization. Without customers, a firm has no revenues, no profits, and therefore, no market value. Contrary to the commonly held view, creating shareholder wealth in the short run is not the main purpose of an organization. Long-run shareholder wealth is the reward for creating customer value.

The approach to linking customer and firm value is based on a simple premise — that customers are typically the primary source of earnings for a company. we can estimate the value of current and future customers, then we have a proxy for a large part of the value of a firm. If, for example, the average value of a customer to a firm is $100, and the firm has 30 million customers, then the value of its current customer base is $3 billion. If we factor in the firm’s future customer acquisition rate and estimate the present value of future customers at $1 billion, then the value of its current and future customers is $4 billion. This estimate provides a good proxy for the value of the firm.

This approach differs from the traditional finance approach in two key aspects. First, unlike traditional finance, this approach builds from the bottom up by assessing the value of a customer. Secondly, it treats marketing expenditures differently than traditional approaches. If you believe that customers are indeed assets that generate profits over the long run, then marketing expenditures to acquire and retain these customers should be treated as investments, not expenses.

The Value of a Customer

The fundamental building block of the approach in this summary is the customer lifetime value (CLV), which is the present value of all current and future profits generated from a customer over the life of his or her business with a firm. This concept incorporates several aspects — the importance of not only current but also future profits, the time value of money such that $100 of profits today are worth more than $100 of profits tomorrow, and the possibility that customers may not do business with a firm forever.

To estimate CLV, two pieces of information are required: customers’ profit patterns and their defection rate. The profit pattern is the profits (margin) generated from a customer over his or her tenure with the firm. The defection rate plots the pattern of the number of customers who stop doing business with a firm over a period of time.

Creating Metrics That Matter

Firms have historically faced enormous challenges in implementing the concept of customer lifetime value as a core business metric. This gap between theory and practice is a result of three major factors:

  • Data requirements. Consider what data are needed to estimate the lifetime value of a customer. First, in order to know a customer’s tenure with a company, one needs to track each customer or customer cohort (a group of customers acquired simultaneously). Second, for each customer or cohort, one needs to know its profit pattern over time, which requires projections of future profits. Third, one needs to know customer retention and defection rates over time.

    The need for detailed customer data such as these has encouraged many companies to invest millions of dollars in creating customer relationship management (CRM) systems. While some companies have used these databases with spectacular results, most have failed.

  • Complexity. In the zeal to create enormous databases, companies have lost sight of the big picture. Metrics that matter to top management must be clear, simple, forward-looking, and they must capture the big picture. CRM systems, in contrast, have become very complex and largely the domain of a firm’s information technology arm, yet they have difficulty answering the simple question of what a typical customer is worth to the firm.

    What is needed is a simple, easily understood metric that captures the spirit of customer lifetime value. Simplicity is key — simple methods are more likely to be used than their complex counterparts. For most decision-making purposes, it is enough to know the approximate value of the customer. Plus, when venturing into using new metrics, it is best to start with simple methods and see how they affect decisions. Additional precision and sophistication can and will follow, if necessary.

  • Illusion of precision. Even with the most detailed and sophisticated data and modeling, estimating CLV requires a host of assumptions and subjective decisions that make it far less precise than many would like to believe.

A Simple Approach

For typical situations, the lifetime value of a customer is simply 1 to 4.5 times the annual dollar margin (profit) that is generated from the customer. To arrive at this simplification, one must make three assumptions:

  1. Profit margins remain constant over the life of a customer.

  2. Retention rate for customers stays constant over time.

  3. Customer lifetime value is estimated over an infinite horizon.

The customer lifetime value (CLV) simplifies to the following equation:

CLV= m(r/1+r-i)

where the following is true:

  • m = margin or profit from a customer per period

  • r = retention rate (expressed as a decimal or percentage, e.g., 0.8 or 80 percent)

  • i = discount rate (expressed as a decimal or percentage, e.g., 0.12 or 12 percent).

The factor to which the margin (m) is multiplied is the margin multiple. This multiple depends on the customer retention rate (r) and the company’s discount rate (i). The retention rate depends on product quality, price, customer service, and a host of related marketing activities. For most companies, retention rates are in the range of 60 percent to 90 percent.

If the assumptions inherent to the equation do not hold, the margin multiple changes, but not much. If margins grow over time, the multiple ranges from 1 to 6, instead of 1 to 4.5. A gradually increasing retention rate has only limited impact on the margin multiple. Finally, limiting the length of projection to five to seven years (a common practice) has essentially no impact on the multiple for low retention cases, but biases the multiple downward when retention rates are high.

Customer-Based Strategy

For years, managers have reiterated the need to focus on customers, provide them good value, and improve customer satisfaction. In fact, metrics such as customer satisfaction and market share have become so predominant that many companies not only track them but also structure employee rewards based on these measures.

This kind of customer focus misses one important component — the value of a customer to a company. Effective customer-based strategies take into consideration the two sides of customer value: the value that a firm provides to a customer, and the value of a customer to the firm. This approach recognizes that providing value to a customer requires marketing investment and that the firm must recover this investment. It combines the traditional marketing view, where the customer is king, with the finance view, where cash is king.

Traditional Marketing Strategy

The first component of this framework is the analysis of customers, company and competition (the three Cs) to understand customer needs, company capabilities, and competitive strengths and weaknesses. If a company can fulfill customer needs better than its competitors, it has a market opportunity.

The second component is to formulate the strategy for segmentation, targeting and positioning (STP). Customers are different in terms of their needs for products and services, so a firm has to decide which of these customer segments it should target. After selecting a target segment, the firm must decide on the value proposition or positioning of its products with respect to competitive offerings.

The final component of this framework is to design the four Ps — product, price, place, and promotion or communication programs.

Implicit in this structure is an emphasis on providing value to customers by satisfying their needs with little focus on cost. Metrics used to measure success in this framework, such as sales or customer satisfaction, drive decisions. Missing from the framework is the explicit recognition or measurement of return on marketing investment.

Value to the Firm Vs. Value to the Customer

Customer-based strategy recognizes that marketing investment in customers must be recovered over the long run. Specifically, this approach highlights the two sides of customer value — the value a firm provides to a customer (the investment), and the value of a customer to a firm (the return on this investment).

A firm provides value to a customer in terms of products and services, and a customer provides value to a firm in terms of a stream of profits over time. Investment in a customer today may provide benefits to the firm in the future. The firm must assess that potential return. Since not all customers are equally profitable, investment in customers should vary by their profit potential.

The Two Sides of Customer Value

With this in mind, the following are the four key scenarios and their different values to and of customers:

  • Star Customers get high value from the products and services of the firm, but they also provide high value in return, in the form of high margins, strong loyalty, and longer retention time. The relationship is balanced, equitable and mutually beneficial — a true “win-win.”

  • Lost Cause customers do not get much value from the products and services of the firm. Absent economies of scale — when many Lost Causes engage the firm — if the company cannot migrate these customers to higher levels of profitability, it should consider either reducing its investment in them, or even dropping them.

  • Vulnerable Customers provide high value to the firm but do not get much value out of the company’s services. These may be long-standing customers who, largely through inertia, remain loyal.

  • Free Riders are the mirror image of the Vulnerable Customers. These customers get a superior value from using the company’s products and services but are not very valuable to the firm. For whatever reason, these customers “exploit” the relationship with the company, appropriating the lion’s share of the value.

Successful customer-based strategies require a company to consider both its investment in customer relationships, as well as the return on that investment.

Drivers of Customer Profitability

Customer profitability is influenced by three factors:

  1. Customer Acquisition. In recent years, many companies, particularly the dot-coms, went on a binge to acquire customers in the belief that customer acquisition and rapid growth are critical to success. This belief was so strong, several companies had a mandate to acquire customers regardless of the acquisition cost. These costs can be substantial, and a surprising number of companies spent too much on customers who gave them too little in return.

  2. Customer Margin. While customer acquisition focuses on growing the number of customers, increasing customer margin focuses on growing the profit from each existing customer. In the context of retailing, this means increasing same-store sales rather than opening new stores. Growth can be achieved through a variety of methods, such as up-selling and cross-selling related products.

  3. Customer Retention. In their zeal to grow, many companies focus almost exclusively on entering new markets, introducing new products, and acquiring new customers. However, these companies often have a “leaky bucket” — as they add new customers, old ones defect from the firm. On average, 20 percent of a company’s customers defect every year. This means that, roughly speaking, the average company loses the equivalent of its entire customer base in about five years.

Studies show that the cost of acquisition is generally much higher than the cost of retaining existing customers. Therefore, it seems obvious then, that a firm should focus on retaining its existing customers. Unfortunately, many companies don’t even know their customer retention or defection rates.

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