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Amos Brocco < [email protected] > 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 1 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 2 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 3 “ 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 4 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 5 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. 6 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. 7 • 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. 8 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 9 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 10 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 11 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 , tk S i , tk −ci , tk −B i ,r , tk −Bi , AO , tk 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: 12 1 k ] 1d • 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 13 marketing strategies. Firms has to maximize customer value by optimizing parameters involved. 14