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, the authors point out that 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 discussed in Managing Customers as Investments is based on a simple premise � that customers are typically the primary source of earnings for a company. The authors write that if 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. The authors write that this estimate provides a good proxy for the value of the firm.
The authors explain that 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, the authors write, 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 described in Managing Customers as Investments 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, the authors write that 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
The authors explain that 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, a firm needs to track each customer or customer cohort (a group of customers acquired simultaneously). Second, for each customer or cohort, a firm needs to know its profit pattern over time, which requires projections of future profits. Third, a firm needs to know customer retention and defection rates over time.
- Complexity. Metrics that matter to top management must be clear, simple, forward-looking, and they must capture the big picture.
- Illusion of precision. Estimating CLV requires a host of assumptions and subjective decisions that make it far less precise than many would like to believe.