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Amos Brocco
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CRM SEMINAR SS- 2004
CUSTOMER EQUITY
Managing the customer as an asset and cornerstones of customer equity
Report based on Customer Equity (R. C. Blattberg et al. 2001, Harvard School Press), Managing the Customer as an Asset ­ Cornerstones of Customer Equity, Blattberg et al. 2001, p. 3­32
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Summary
I.Introduction...................................................................................3
II.Customer Equity motivations..................................................3
Benefits of customer equity (Why should I... ? )........................................................3
New technologies (Why can I... ?).............................................................................5
Changes in the marketing (Why must I...?)................................................................6
Customer value measurement.....................................................................................7
To summarize.............................................................................................................8
III.Customer Equity in practice....................................................9
Managing the customer life cycle...............................................................................9
Stage 1 : Prospects........................................................................................9
Stage 2 : First­Time buyers..........................................................................9
Stage 3 : Early Repeat Buyers....................................................................10
Stage 4 : Core customers............................................................................10
Stage 5 : Core defectors..............................................................................10
Exploiting the power of databases............................................................................11
Quantifying customer value.....................................................................................12
Optimizing acquisition, retention and add­on selling...............................................13
To summarize...........................................................................................................13
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I. Introduction
In the last twenty years managerial trends have tended to focus on either cost
management or revenue growth; marketing strategies have put their attention on
the so called brand equity, which means that the goal is to maximize brand'
s total
revenues and get the maximum return of investment (ROI). This strategy
approach works well in a stable market, but in today's
economic environments,
where everything has to be considered has “ uncertain” , there is a need to
concentrate on the customer in order to build up a solid customer base. Today the product life cycle is shorter, the customer has more choice, and new
communication and information technologies such as Internet have provided the
customer a way to compare products and choose for the best offer, and ERP
(Enterprise Resource Planning) do not guarantee a real competitive advantage.
Following this trend, products become commodities, the real competitive
advantage for the business is in the customer relationship management, and the
key for profits is customer fidelty. The actual or future (potential) value of
the customer is called customer equity; customer equity management tries to
evaluate the customer value in terms of past, present or potential buy, but it is
more than just a method for calculating the asset value of customer relationship:
it's
a total, dynamic and integrative marketing system that use financial valutation
techniques and customer's profile to optimize the different stages of customer's
life cycle (acquisition, retention, add­on selling) and maximizes the value to the
company of the customer relationship throught its life cycle. Clearly it requires
integrative business strategies to simultaneously manage product and customers
throughout the customer life cycle and to reframe brand and product strategies
depending on thieir effects on customer equity. Additionally it permits to better
allocate business resouces and efforts. II.Customer Equity motivations
After having briefly introduced customer equity, let's
have a look at the reasons
why companies should move to a customer equity approach. We will first present
the main benefits of such marketing system, then provide the some fundamental
reasons for companies to move to a customer equity approach.
Benefits of customer equity (Why should I... ? )
Changing the management strategy is an important choice for every organization;
before talking about “h ow” exactly the customery equity model works, we will
here introduce the main benefits for business that use this marketing system, first
by showing the main differences between customer equity management and
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“ marketing” a s most companies practice it. To switch from a “ classical” marketing strategy to a customer equity­based
approach, authors emphasize six basic changes:
1. Move from a product­centric to a customer­centric strategy, tactics and
execution.
2. Manage customer life cycle. The marketing mix varies by stage in the
customer life cycle.
3. Manage customer portfolio across the acquisition, retention and add­on
selling stages.
4. Manage marketing using the appropriate customer equity measures, as
the marketing output of the firm become quantifiable. Costs are
balanced against financial returns.
5. Use customer equity flow statements to communicate changes in the
asset value of customers.
6. Organize around customer acquisition, retention and add­on selling
Returns
Acquisition Retention
Add­on selling
Customer
Life Cycle
Spending
Figure 1 – The Customer Equity model
Figure 1 shows how the customer equity model works: by expoiting the actual
or future value of the customer through the acquisition, retention and add­on
selling stages of its life cycle. Managing the customer as an assets provides many
new possibilities such as the ability to:
• Compute the asset value of customers, in order to make informed
decisions regarding investment in acquisition, retention and add­on
selling.
• Adjust marketing investment levels as customer relationships move
through their dynamic life cycles
• Maximize the profitability of processes and structures around
acquisition, retention and add­on selling over the customer life cycle.
• Address the “ whole customer”, who buys and uses a broad range of
services and products
• Utilize customer interactions to reinforce relationships and acquire new
customers
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Customer equity is, at present, a critical point in firm's su
ccess for three reasons: – it allows marketers to make better decisions, – thanks to new technologies they can now efficiently obtain and
process customer information – they will be able to better respond to market changes thanks to a
better evaluation and understanding of each customer. Nevertheless, yet most firms do not act as if they consider customers as assets,
instead they still maximize product line or transaction profitability; this strategy
often increase near­term profits but forfeit longer­term ones. Companies have to
understand that viewing customers as assets significantly differ from treating
brand equity as the primary marketing asset.
Marketing Activity
Brand Equity Approach' Goals
Customer Equity Approach'
Goals
Product and service
quality
Create a strong customer
preference
Create high customer retention
rates
Advertising
Create brand image and position
Create customer affinity
Promotions
Deplete brand equity
Create repeat buying and enhance
lifetime value
Product development
Use brand name to create flankers Acquire products to sell to the
and related products
installed customer base
Segmentation
Customer characteristics and
benefit segmentation
Behavioral segmentation based on
customer database
Channels of distribution
Multistage distribution system
Direct distribution to customer
Customer service
Enhance brand image
Create customer affinity
Table 1 – Brand Equity vs Customer Equity
Looking at Table 1, it should be clear that compamies that take a customer asset
approach operate differently from their brand equity­based counterparts: for
example, where brand­oriented companies focus on product quality and customer
service to build the brand'
s perceived value, customer equity­oriented ones use
this element as retention tool.
New technologies (Why can I... ?)
We said that the customer equity management requires to profile customers,
which means to store information about clients and their behavior, for example by
mantaining a database of their purchases. Thanks to the availability of affordable
information technology, low­cost communications (for example Internet),
sophisticated statistical modeling and flexible fulfillment, adopting a customer
equity marketing system is now possible. Computing power as greatly increased
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in the last years, and today also small companies can manage large databases at a
very low cost. On the other hand, new communication technologies, such as
Internet, have also provided a low cost information media from and to customers:
firms have now access to customers at costs that early direct marketers could only
dream about. Changes in the marketing (Why must I...?)
In the introduction we already said that, due to changes in the world of marketing,
a new approach was necessary. There are five forces that drive this change, and
companies understanding them have a significantly advantage:
– Information­based targeted marketing is becoming more efficient and
effective than blanketed mass marketing. – Mass marketing strategies that achieve targeted profits by counting on
more­profitable customers to subsidize less­profitable ones will fail as
the more attractive customers are stolen away by competitors'
targeted
acquisition efforts.
– Customer can now easily look for alternatives because of a near
transparent market.
– Firms that use acquired information about customer purchases behavior
achieve better acquisition, retention and cross­selling rates.
– Companies can no longer depend on orderly vertical channel system to
control customers' buyi
ng behaviors.
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Trends
Disruptions
Efficient
Databases
Unit­of­One
Production
Increased affordability of target marketing
1­to­1 Internet communication
Behavior data explosion
Death of cross­
subsidies
Channel Proliferation
“ Best in class” marketplaces
Near­Perfect
online information
Frictionless markets (easy switching)
Flexible alliance networks
Data deluge (available data / information)
Warfare for customer loyalty
Disintermediation
From vertical chain to infinite choice
Figure 2 – Trends & Disruptive changes
Figure 2 shows the main disruptive changes to the world of marketing and the
underlying trends driving these disruptions. It should be clear now that, due to
these changes, customer equity management is becoming a necessity and a
requirement for business success.
Customer value measurement
Managing customer as assets requires measuring, managing and maximizing their
value. Measurement has to be considered as the core of customer equity. One
problem that raises when migrating to customer equity is that marketing is
essentially based on marketing research, which is far to be an exact source of data.
Customer equity will provide an exact way to measure customer value, so
decision are no longer opinion based but fact based. We will provide a way to
determine this value in the next section. For now, let's
introduce a few important
concepts related to customer measurement:
•
Customer loyalty: it's the choice of repeated buy of a product or a
service driven by a good satisfaction from previous buy/consume
experiences (fidelty) and good value perception that create a
collaborative relationship between buyer and marketers.
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•
Customer retention rate: it's
an indicator of the fidelty rate of buyers,
calculated on the number of customers at the beginning of a period
(normally a year), that are still there at the end of the same period.
•
Lifetime value: it'
s the value of customers relative to their fidelty in
time.
To summarize
We have seen why a change to a customer equity­based model is a key point to
profits, and that actual technologies along with new communication methods have
made such a way of marketing feasible and successful. In the next section we will
analyze in detail how customer equity management works and what it depends on.
It'
s up to the company to develop customer equity as marketing system, depending
on the existing approach.
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III.Customer Equity in practice
Customer equity management depends on four cornerstones to maximize the
value of the customer as a financial asset:
•
Managing the customer life cycle
•
Exploiting the power of databases
•
Quantifying customer value precisely
•
Optimizing the mix of customer acquisition, retention and add­on
selling
In this section we will discuss these cornerstones, as they provide the structure
needed by a company to select, cultivate and reape customer value. If one of them
is missing, the marketing system will weaken; obviously a company may
implement these practices in stages, but, for long­term success, it must adopt all
four.
Managing the customer life cycle
The relationship between customer and the firm evolves over time; customer
relationship management usually recognizes five stages in the customer life cycle
and emphatizes on differencies between them.
Stage 1 : Prospects
Prospect represent potential value, as they are not yet customers. There are
several questions regarding prospect that should be answered: should the
company offer better prices to prospect than prices offered to existing
customers? How much effort should a company invest at this stage?
An important point is that the company should not to create overly high
expectations on prospects, because a mininum disappointment in early
purchases could end up with the customer loss, meaning that, despite the
company gets high acquisition rates it could get low retention rates.
Usually a potential customer decides for the first purchase when his
expectations about a product or service exceed his product­quality cutoff.
This threshold is determined by previous experiences as well as
information provided by the company. At this stage, the price could be an
important factor that to determine the product cutoff. Stage 2 : First - Time buyers
After one purchase, prospects become first­time buyers. This category of
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buyers usually has the lowest retention rate, and customer at this stage are
still evaluating the company. If the product meets expectation and remains
above the product­quality cutoff the customer will continue to purchase; at
this stage the fidelity of the customer is low, meaning that also a single
product failure could end up with the loss of the customer. For industries
characterized by shorter purchase cycles, converting first­time buyers into
repeat buyers and core customers is very important.
Stage 3 : Early Repeat Buyers
Customers in this stage have made at least one repeat purchase, which
indicate their satisfaction with the product, however, although their
confidence with the firm has increased from the previous stage, they'r
e still
evaluating the relationship, meaning that a failure (such as poor service) in
one purchase is dangerous. Nevertheless, the retention rate at this stage is
higher than for first­time buyers.
Stage 4 : Core customers
As customers begin to repeat­purchase regularly they enter in the core
customer stage. Purchased products meet customer required specifications
and value, and unless major problems, the customer rarely reevaluates the
product. Because of the numerous positive experiences, occasional product
failures will not automatically cause defection. This stage has the highest
retention rate and the highest sales per customer rate. It's
important that
such class of customer is not de­emphatized by firm because of its high
retention rate. Management does not see these customer as problems and
there is a risk of paying less attention to them.
Stage 5 : Core defectors
Core customers switching supplier or brand become core defectors. There
are several factor that cause switching: new competing products, a
customer service problem,... Switching cause are essentially of two types:
internal or external events. While internal events are controllable and firm
has the possibility to influence customer decision, external events are not
(thus retention efforts are someway useless). By recognizing the
underlying problem it is possible to reactivate a defector.
Customer life cycle has been studied either by research on new product
acceptance or by RFM analysis (Recency, Frequency and Monetary). A research
on new­product acceptance models, published in the 1970s, showed that during
the first few purchases, the customer had a lower probability of repeat buying than
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aftrer four or five purchases. These research introduced the term depth of repeat to
indicate the number of repeated purchases by a customer, and show that the
retention rate increases along with the number of purchases.
On the other hand, the Recency, Frequency and Monetary analysis, by looking at
the buying behavior, tries to categorize customers into cells, each associated with
a specific targeting strategy. This categorization is represented by a RFM matrix,
as in example proposed in Table 2, but it's
up to the retailer to determine it's
RFM
matrix depending on the product/service he's o
ffering.
Frequency
Monetary
Recency in months (time since last purchase)
0­6
1
< $50
1
> $50
2
< $50 2
> $50
3
< $50
3
> $50
4
< $100
4
> $100
5+
< $150
5+
> $150
7­12
13­18
19­24
25+
First­Time
Customers
Low Targeting Value
Early Repeat
Customers
Non­Core Defectors
Core
(High­Value)
Customers
Core Defectors
Table 2 – Sample RFM Matrix
Now that we know how to segment customers through the concept of life cycle,
there is yet to answer a fundamental question: how does the customer life cycle
relate to marketing strategies? Determining the customer life cycle allow to select
different marketing strategies for each category of customers. The firm's
marketing strategy is then a mix of the different strategies of each life cycle
segment. Additionally the firm can analyze customer flows between these
categories in order to track down problems in acquisition, retention and add­on
selling, and to plan future marketing investments.
Exploiting the power of databases
Database are the core software technology in today's
asset management; it follows
that, to manage customer as an asset, we need customer databases. Storing
customer profile also helps reducing advertising or promotion costs through
targeted and individualized mailings and information. The use of databases for
targeting and analysis is powerful because it allows a third­degree to first­degree
segmentation shift, which means the creation of individually tailored offerings
based on customer characteristics and behavior. By using observation instead of
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inference, database analysis provide a more powerful way of predict future buying
behavior, so it is possible to “ mass customize” every element of the marketing
mix for markets of one.
In the past, databases were used as a tactical tool to acquire new customers and
one­on­one marketing pushed database marketing a step further, by capturing
interactions between firm and customer at each point in time and analyzing this
data to search for common patterns.
Unfortunately, database marketing also has some limitations, most of them are
related to the (sometimes) extreme complexity and resources needed to set up a
good database system. Data quality influences analysis, and personal privacy
could represent a big limitation in tracking customer behaviour. Up to now,
database marketing has found application in the acquisition step, but, in order to
maximize customer equity, it is necessary to expand the use of databases beyond.
Companies that integrate databases into their relationship and customer valuation
efforts as part of a broader customer equity approach will be able to balance
acquisition programs with targeted, effective retention efforts, so that they'
ll get a
good acquisition rate but also a good retention rate.
Quantifying customer value
To manage customer as an asset we have to provide a way to evaluate his
financial value. There are various examples of metrics and accounting measures;
here, to compute customer equity (CE) for a give segment 'i'
at time 't'
, we provide
a mathematical equation, which relates customer equity with various factors:
I
∞
k
i=0
k=1
j=1
CE t =∑ [ N i , t i , t S i , t −c i ,t −N i , t Bi , a , t ∑ N i ,t i , t  ∏ i , tk S i , tk −ci , tk −B i ,r , tk −Bi , AO , tk 
where
CE t = the customer equity value for customers acquired at time t
N i , t = the number of potential customers at time t for segment i
i , t = the acquisition probability at time t for segment i
i , t = the retention probability at itme t for a customer for segment i
Bi , a ,t = the marketing cost per prospect (N) for acquiring customers at time t for segment i
Bi , r , t = the marketing in time period t for retained customers for segment i
Bi , AO , t = the marketing costs in time period t for add­on selling for segment i
d= the discount rate
S i ,t = sales of the product/services offered by the firm at time t for segment i
I = the number of segments
i= the segment designation
t 0= the initial time period
In other words, the customer equity equals:
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1 k
]
1d
•
the profit from first­time customers (i.e. the number of prospect
contacted mutiplied by the acquisition probability and the margin)
•
minus the cost of acquiring customers (which is the number of
prospects multiplied by the acquisition cost per prospect)
•
plus expected profits from future sales to these newly acquired
customers (which is the retention rate in each future period multiplied
by the profit obtained from customers in that period and then divided by
the discount rate, which transforms future profits a currency value,
summed across all future periods)
•
summed across all customer segments and cohorts.
The firm'
s total customer equity equals the sum of acquisition, retention and add­
on selling returns over time; the company has to identify the strategic balance that
maximizes this sum. The key point here is that there exist an exact way to
calculate customer value! Beyond customer evaluation, there are statistical models
that can be used to link marketing mix variables such as pricing and promotion to
key parameters of the equation, to determine the relationship between acquisition
price and acquisition response rate and optimize it.
Optimizing acquisition, retention and add - on selling
As we said before, customer equity management is built around three core
strategies: acquisition, retention and add­on selling; every marketing activity
affects one of them, or a combination of them. Customer equity management has
changed the way of combining these, not new, elements in order to exploit the
relationship between them. It is important not to concentrate on only one strategy,
but instead optimize the whole. For example it is not a good move to focus only
on customer retention, althrough the cost of retaining a customer may be lower
that acquiring a new one. It'
s clear that there is no universal prescription: every
firm has to analyze its situation (acquisition, retention and add­on selling equity
values) in order to determine its best strategy. So, for example, retention
marketing is incomplete, because it does not focus on individual requirements, it's
static and does not change as customers move through their life cycle.
To summarize
We have seen that in customer equity management we have to discriminate
various customer classes (prospects, first­time buyers,...) in order to build up
winning marketing strategies. Evaluating the customer value at some point in time
is a key factor to manage customer as an asset: we have seen that it is now
possible to exactly calculate its value and then elaborate statistical models for
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marketing strategies. Firms has to maximize customer value by optimizing
parameters involved.
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