Customers are really the key assets. There are two significant implications: assets have value, which need to be measured; and assets require investment in care and maintenance to maximise their value to the business. The first is about measuring the value of a customer or customer segment; the second is about customer relationship management (CRM) or how to manage the relationship with the customer over the relationship lifetime in order to maximise the value of the customer to the firm.

MEASURING THE VALUE OF A CUSTOMER?

Most companies have management accounting systems that measure profit by product line rather than by customers, and most organisational structures reflect this product-based thinking. Banks, for example, have mortgage departments that are completely separate from other departments, so customers who move house find their bank statements continue to be sent to their old address. Sometimes this can lead to quite serious problems in customer management, such as the bank whose personal loans department ran a mailshot offering £2000 loans to customers, some of whom were hopelessly overdrawn on their current accounts.

The profitability of a customer can be estimated by looking at the mix of products that this customer holds. However, this kind of exercise gives rise to three problems. Firstly, it can be hard to compile the information, which may be held on a number of different product databases. Persuading these different legacy systems to talk to one another in order to obtain a complete picture of the customer can be complicated, expensive and time-consuming. Second, customer profitability calculations may not be very helpful in the development of CRM strategies. The current (or, more accurately, the historic) profitability of a customer may be no guide to his or her future profitability. Third, marketing people sometimes argue that they still want to do business with certain unprofitable customers. In other words, there may be reasons other than the profitability of a particular customer for wanting to do business with them.

These three issues in valuing customers – difficulties in calculating customer profitability, current versus future profitability, and understanding the non-financial benefits of customer relationships – are explored in more detail below.

DIFFICULTIES IN CALCULATING CUSTOMER PROFITABILITY

Obtaining the information to calculate customer profitability can be difficult. The first problem is getting different departments to agree to share information. Sometimes, departmental managers can be protective of their customer relationships and customer information. This can be a particular problem where product departments might compete with one another for the same slice of a customer’s spend, or where product departments have had bad experiences with cross-selling attempts by their Marketing Department.

Even where managers are prepared to share information, systems incompatibilities may make it difficult to centralise the data. The ultimate goal is to create a single data warehouse which is built so that customer records can be mined for previously unrecognised patterns of profile or behaviour. Before this can be done, however, the data has to be cleaned and duplicate records eliminated. For example, a single customer might be recorded as "Ms Smith" in one database, "Ms Jane Smith" in a second, and "J Smith" in a third.

As well as the technical difficulties that may arise when trying to obtain a single picture of the customer there are accounting issues that have to be dealt with. To calculate the profitability of the customer, an organisation with a product-based accounting system needs to know three things: the income from the customer; the cost of the products that the customer buys, and the indirect costs – principally sales, marketing and administration (SAG) costs – involved in servicing that customer.

When calculating customer profitability, SAG costs are commonly spread across the customer base proportionate to revenue or unit volumes purchased. The problem with this approach is that customers vary greatly in their purchasing behaviour. Some customers buy in a very efficient way – perhaps they buy ‘off the peg’ or they make up their minds quickly, taking up less sales time, or they collect their goods rather than having them delivered, or place regular orders that are easy to schedule. Others want customised products, frequent sales visits, specialised documentation etc. These are all things that push up the cost of looking after such customers. If there are differences in customer buying behaviour, allocating SAG costs proportionately to volume or revenues will tend to understate the profitability of the customers who are easier to sell to and overstate the profitability of customers who need more marketing and administrative support. This would not be a serious problem if SAG costs were a relatively small proportion of total expenses. However, SAG costs can be a large element of total costs, as an extract from Xerox’s Report and Accounts demonstrates. A study of the 500 largest listed companies in the US across a wide range of industries found that SAG was, overall, the fastest-growing element of total costs, growing up to four times faster than product costs.

Selling, Admin and General costs at Xerox

Total revenue (sales and service) 19,449

Cost of Sale 5,724

Cost of Service and Rentals 4,140

Selling, Admin and General 5,320

All other costs and expenses 3,502

Even when the problems of calculating customer profitability have been overcome, the numbers that are arrived at may not be very useful for developing customer strategies. Specifically, customer profitability can vary from period to period, sometimes quite dramatically.

Not 80/20 but 225/20

US heating wire manufacturer Kanthal analysed its customer base and developed its own version of the famous 80/20 rule, which says that 80% of profits come from 20% of customers. In Kanthal’s case, 225% of profits came from 20% of customers. 70% of customers were break-even; the remaining 10% of customers generated minus 125% of profits.

Source: Harvard Business Review

CURRENT VERSUS FUTURE PROFITABILITY

It is not unusual for an analysis of customer profitability to uncover unprofitable customers. Sometimes quite a significant proportion of an organisation’s customers turn out to be unprofitable. A study at First Manhattan, for example, showed that 20% of the bank’s households bring in about 60% of its revenues and more than 100% of its pretax income. This means that 80% of First Manhattan’s customers were unprofitable in that period. Other studies of banking have suggested that between 60% and an amazing 90% of customers are unprofitable, a finding that has been repeated in other industries. The problem is to determine what the appropriate marketing strategy for unprofitable customers should be. Some unprofitable customers are new customers who will become profitable as the relationship develops and sales increase and / or costs reduce. Others are customers who, for some short-term reason, were unprofitable in the period being measured but are likely to return to profitability soon. Yet another type in this group will never become profitable, at least without a change in their buying behaviour. The marketing strategies for these three types are very different.

In the first case, the focus should be on retention; ensuring that the customer stays with the company long enough for the account to become profitable. In the second case, the best strategy might be to renegotiate terms or, if the account is valuable enough in the long term, to do nothing and accept the short-term unprofitability in the interests of longer-term shareholder value creation. In the third case, an organisation should consider making changes to the service levels it offers to customers like these or even ceasing to do business with them at all.

The fundamental point here is that decisions about managing the customer relationship cannot be taken on the basis of past, or even of current, profitability information alone. It is the expected future value of the customer that is relevant for the development of CRM strategies. Fortunately, data warehouses support new data analysis tools such as predictive modelling, which can help with the estimation of future customer revenues and costs. These are then discounted to arrive at a Net Present Value (NPV) of the customer. The NPV can then be used in developing appropriate customer management strategies.

Data mining can also help organisations identify customers that may leave. Certain patterns of customer behaviour indicate that the customer is likely to defect. Indicators include a reducing average purchase amount, falling average account balance, and progressively slower settlement of bills. The more value potential those customers have, the more important that the CRM programme includes retention strategies. One Dutch insurance company implemented a CRM system to flag up likely customer defectors on its data warehouse and then pass this information to a special team tasked with contacting customers and identifying dissatisfaction. The insurer suceeeded in cutting customer defections by 25%.

Although customer NPV gives better results for CRM strategy development than single period or historic profitability, there is still the problem of what rate is used to discount future customer profits. In many organisations, a single discount rate is applied across all customers. What this universal discount rate does not do is to reflect the riskiness of that customer. Just as some customers are more difficult and costly to serve than others, some customers are more risky. Some of the risks that organisations experience with their customers are: the risk of default (bad debt); the risk of defection (the customer leaves); volatility (customer revenues and profitability fluctuate unpredictably); and terrorism (unhappy customers try to damage the reputation of the organisation, e.g. by setting up a hostile website).

To create shareholder value, organisations must invest in projects or relationships that more than compensate for the risks involved. Increasingly, organisations are using measures based around value to evaluate business performance. Similarly, evaluating customers in terms of the value they create is likely to lead to more effective relationship marketing strategies. The value that customers create comes partly from their economic relationship with the organisation over the relationship lifetime and partly from other, non-financial, benefits that the organisation obtains from the relationship.

NON-FINANCIAL BENEFITS OF CUSTOMER RELATIONSHIP

Relatively few organisations are able to calculate the current profitability of their customers, let alone the future value and appropriate risk-adjusted discount rate. Those that do sometimes find that there is one more piece that is needed to complete the picture of how valuable a customer is to the organisation. This additional part is the non-financial benefits of doing business with certain customers; the relationship benefits. There are at least four relationship benefits that can create value for an organisation: reference, referral, learning and innovation.

Non-financial benefits of relationships:

CRM strategies should include strategies to manage relationship benefits as well as financial benefits. Some of the more familiar activities that organisations undertake to obtain relationship benefits include case studies / guest speakers (reference); member-get-member schemes (referral); joint training sessions (learning); beta testing (innovation). Some customers are even willing to advertise on behalf of their suppliers, something Martha Sanchez of the restaurant Casa Sanchez exploited in an unusual way:

No such thing as a free lunch?

Casa Sanchez is a Mexican-style restaurant located in San Francisco. The owners were keen to advertise but could not afford to pay for expensive conventional advertising in magazines, newspapers or on advertising billboards. So the restaurant owners offered free lunches for life to any customers who would have the restaurant’s logo – a Corn Man wearing a Mexican sombrero – tattooed onto their bodies.

About 50 customers have taken Casa Sanchez up on this offer and are walking around on the streets of San Francisco sporting the logo on their biceps, thighs, or even their buttocks.

Source: Financial Times, 21.7.00

MEASURING AND MANAGING CUSTOMER RELATIONSHIPS

Some relationship benefits create very significant value for organisations. This means that it may pay an organisation to retain an unprofitable customer in order to obtain the relationship benefits from that customer.

THE MANAGERIAL IMPLICATIONS FOR ORGANISATIONS ARE:

Relationships benefits are difficult – although not impossible – to quantify. The overall conclusion is that customers with high economic and high relationship value are key customers and deserve the red carpet treatment. Customers with high economic value but low relationship value, and customers with low economic value but high relationship value, probably create value for the organisation. However, customers with neither economic or relationship value may in fact destroy value and the firm’s continuing relationship with such customers deserves careful scrutiny.