Review: "Managing Customers As Investments"

    Customer equity (or lifetime value) calculations can get quite complex, complicated by the difficulty in finding some required data. But Sunil Gupta and Donald Lehmann simplify the task considerably by showing that “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 this customer.” Such much-needed simplification should go a long way toward focusing companies away from sales and market share growth toward profitability growth via retention branding.

    Gupta and Lehmann are the authors of Managing Customers as Investments: The Strategic Value of Customers in the Long Run. The book not only looks at the issue of calculating customer equity but also examines the greatest contributors to customer equity. More important, Managing Customers shows how focusing on customer value helps companies move away from the all-too-common current focus on products to greater customer-centricity. To improve readability, general discussion about principles and key formulas are backed up with detailed calculations in appendices.

    Customer equity calculations offer numerous advantages. They help financial analysts determine if a firm is under- or over-valued, especially for high-potential firms that are currently losing money. (It’s hard to calculate a P/E ration for companies with any “E.”) They can also determine whether companies are paying too much for acquisitions. AT&T effectively paid $4,200 to acquire each customer from MediaOne and TCI, a primary reason the acquisitions failed. Even more outrageously, Deutsche Telekom paid more than $21,000 per customer to buy VoiceStream.

    To calculate customer value, companies must capture three pieces of related data. First, they need to track the financial and other interactions with specific customers or customer cohorts (those who become customers at about the same time).  Next, companies must understand how profitability (margins) may vary over a customer lifetime. Generally, customers become more profitable over time. Finally, they must track defection rates. That’s harder than it sounds, especially for retail and other customers in non-contractual relationships.

    What is the best way to improve customer profitability – reduce customer acquisition costs, improve customer margins or increase retention? No contest, say the authors:

On average, a 1% improvement in acquisition cost improves customer value by only 0.1%. Improving margins by 1%, for example, by cross-selling, improves customer value by about 1%. This result is similar across firms and is consistent with the margin elasticity discussed in [an appendix]. Improving customer retention by 1% improves customer value by almost 5%. In addition, retention shows a virtuous cycle – the higher the current retention rate (e.g., Ameritrade’s 95% versus Amazon 70%), the higher the impact of improving retention.

    The case for retention is reinforced with tables showing varying levels of margin multiple (the greater the margin multiple, the greater the lifetime value). For example, the margin multiple for a company with a 60% retention rate and a discount rate of 10% is only 1.2, meaning that the lifetime value of a customer that generates profits of $100 annually is only $120. But increase the retention rate to 90% (with the same discount rate) and the multiple skyrockets to 4.5, translating into a lifetime value of $450. The effect on corporate profitability will be even greater, since the greater number of retained customers will collectively contribute even more to the bottom line.

    Gupta and Lehmann add important caveats about retention that also apply to those who seek to improve customer satisfaction. The financial argument for increasing retention does not factor in the costs of improvement.  Investments in customer retention also show diminishing return. Improving retention rates from 90% to 95% will cost exponentially more than, say, improving retention from 65% to 70%.

    Because customer equity is so vital to profitability, and even stock market value, Gupta and Lehmann logically suggest that companies start moving toward customer-based accounting and a customer-based organization. Fine in theory, extremely difficult in practice. Only a few financial service firms have even attempted to move toward customer-based accounting. The concept of customer-based organization was set back when the new CEO of HP, Mark Hurd, abandoned the customer-oriented sales organization initiated not long ago by his predecessor Carly Fiorina.

    Gupta and Lehmann are on much more solid ground with this advice to CEOs:

The CEO needs to develop metrics that reflect the value of customers and tie incentives to them. This means numbers such as customer satisfaction, churn, loyalty, same customer sales/revenue, new customer acquisitions, and acquisition, expansion, and retention costs need to be consistently and frequently assessed and displayed. Further, the CEO needs to pay attention to and publicly discuss these determinants of long-run profitability as much as or more than monthly revenue reports and fixed assets.  Put simply, these metrics need to be as important a part of the company’s scorecard as current period profit and stock price.

    There are some quibbles with the book. After stressing the importance of quantification and customer value, they slip into the usual non-measureable, product-centric babble about “awareness” and “brand equity.” Too much space in this thin volume is devoted to discrediting the calculations used to value dot-com firms, a point that has been widely made and is widely understood. Elements of a key formula are transposed in a summary. And they attach too much importance to “satisfaction,” even though Gallup and many other organizations have pointed out its measurement and other inadequacies as a management goal.

    Still, in an era when marketing is losing legitimacy within organizations because of a dated focus on “personality,” “position” or other immeasureable attributes, Managing Customers represents a metrics-based beacon back to a seat in executive suites.  By using the formulas and tools outlined in Managing Customers as Investments, executives can show the bottom-line financial benefits of marketing spending, and better calculate the difficult trade-offs involved in various acquisition branding tactics.

     Undoubtedly, a worthwhile read.