How can you manage marketing so its business impact is apparent to the CEO? How can you put marketing at the center of the CFO's agenda? And how can you ensure that marketing is understood by all general management as a long- term investment, not a short-term expense?

Answers to these critical questions are offered in Managing Customers as Investments (Wharton School Publishing, 2005), a valuable new book by Columbia Business School marketing professors Sunil Gupta and Donald Lehmann. The book shows you how to integrate the marketing world where the customer is king, with the financial world where cash—discounted, of course—is king. If you want to learn how to increase the power and business impact of marketing in your organization, read it—no, study it!—now.

Many books tell you why you should put the customer at the center of the organization (see "2004: The Year of the Customer in Management Books"). This book shows you how, with frameworks, processes and metrics to manage marketing as the primary contributor of the firm's financial value.

The authors begin with the premise that customers are the primary source of cash flow, now and in the future, for all organizations. The management of customers has financial consequences not merely in the short term but also in the long term. Therefore, marketing must be managed as the investment in customers, just as other functions manage capital expenditures (e.g., buildings, factories, technology) as assets that produce a return on the investment in the long term.

To entice you to read the entire book, I will touch on the five key components prescribed by Gupta and Lehmann for managing marketing as investment in customers:

1. Customer Lifetime Value

2. Customer Value Portfolio

3. The Three Cs of Growth

4. Customer Value Management

5. Relationship of Customer Value to Firm Value

1. Customer Lifetime Value

The building block for managing customers as investments is customer lifetime value (CLV)—the present value of all current and future profits generated from the entire tenure of a relationship with a customer. You are probably familiar with this metric from previous MarketingProfs articles (for example, see "What Are Your Customers Really Worth"), so I won't spend time on the concept here.

While Gupta and Lehmann succeed in bridging the theory and practice of CLV, they warn us that implementation of the concept has its challenges.

First, you need to track each customer's profit and retention rate over time. Second, organizations have an inclination to make the analysis too complex; to be meaningful to top management, the measures must be clear and simple. Third, frequently you need to make subjective judgments about how to attribute revenues and costs to a customer group.

Costs of goods sold are easy to allocate to customers or customer groups, but costs of promotion or distribution are less clear. For example, how should a bank allocate costs of opening a new branch to online customers, knowing that most customers are initially acquired through branches?

Each of the other four components of managing customers use CLV as the core measure to assess the strategic value of customers and the results of decisions in the long run.

2. Customer Value Matrix for marketing strategy

"Customer value" is an all-too-common phrase in business, yet its full meaning is often misunderstood. There are two dimensions to customer value: the value that a firm provides to a customer and the value of a customer to the firm.

As Gupta and Lehmann teach, "the first part is the investment and the second part is the return on this investment." A firm invests in delivering value to a customer by creating and selling products and services; a customer provides value to a firm from purchases that produce a stream of profits (revenues minus costs) over time. Marketing must manage customer value on both dimensions.

All too often, however, marketing focuses only on the value the firm provides to a customer, without paying any attention to the value a customer provides to the firm. Accordingly, marketing asks:

  • What it will take to get customers to recognize the value of our products and services?

  • What benefits—economic, functional and emotional—will convince customers to buy our products and services?

  • What will make them satisfied enough to repurchase?

Thus, the focus of marketing is only on the investment (usually interpreted as an expense) in fulfilling customer needs and satisfying customers in order to generate revenue and build market share.

But this is only one side of customer value. Without taking into account the costs of meeting customer needs now and over time, marketing fails to recognize that increasing sales and market share must be evaluated as a return on an investment. In fact, increased sales and market share may actually result in losses—i.e., a reduction in customer value to the firm—if costs exceed revenues.

The real purpose of acquiring and retaining customers is to produce cash flow (profits). Therefore, in the end, it is not enough to just create value to customers; marketers must attract and keep customers at a cost of providing value that is below the value that satisfies customers. Only when customer value is managed on these two dimensions together can the firm realize a return on the investment and grow.

To guide the management of customer value, Gupta and Lehmann suggest marketers build a customer portfolio by categorizing all customers into one of four groups using a two-by-two matrix (see below). Each customer is rated as low or high on both dimensions of customer value and placed into one of four groups: Stars, Lost Causes, Vulnerable Customers and Free Riders.

Star Customers get high value from the firm's products and services and also provide high value in the form of high margins and long life. Of course, we want more of these customers, where there is a mutually beneficial relationship. On the other end of the spectrum, Lost Causes do not get much value from the firm and provide little value other than economies of scale from high volume. Vulnerable Customers provide high value to the firm but do not get much from the firm in return. These customers are likely to defect unless changes are made that give them more value than they are now getting. The last group of customers is named Free Riders because they get a lot of value from the firm but provide little to the firm in return. Consequently, the firm must reduce its service level or increase prices to this group.

The portfolio matrix suggests ways to manage customers as investments. For example, a financial services company like Fidelity might try to expand its range of products and services in order to turn "Vulnerable Customers," who provide high value to the firm but currently receive low value from the firm, into "Stars," who are high on both value dimensions. Fidelity also might try to reduce services to "Free Riders," who are now getting more than they bring.

In summary, the Customer Value Matrix gives marketers a framework to integrate the customer perspective represented by the value to customers provided by the firm with the financial or cash perspective represented by the value of customers to the firm.

3. Three Cs of Growth

Marketers have strategic business impact when their focus is on growth in three dimensions: Customer Acquisition, Customer Profitability and Customer Retention. These are the critical three Cs of marketing (not to be confused with the three Cs of market analysis, including customer needs, company core competencies and competition) because they link marketing to financial outcomes and growth.

To drive the business strategy, Gupta and Lehmann argue, marketing should be managed using these dimensions rather than the more commonly used four Ps—product, price, promotion and place—where the focus is purely on sales or market share, which may or may not result in desirable financial consequences.

Customer acquisition efforts should be evaluated based on costs compared with the estimated lifetime value of the customer. From company reports and their own analysis, Gupta and Lehmann report customer acquisition costs and estimates of CLV for Amazon ($8 vs. $26), Ameritrade ($203 vs. $1,126), Capital One ($74 vs. $173), eBay ($11 vs. $43) and E-Trade ($391 vs. $962). These five companies made wise decisions for customer acquisition, especially Ameritrade, but this is not always the case.

Customer profitability focuses on increasing the profits from each customer using different strategies, including share of wallet, cross-selling and redefining your product line. Share of wallet was a strategy Disney used successfully to grow its Orlando theme park business by building hotels and restaurants in the area. Cross-selling was a strategy used by Cox Communications, the fifth-largest cable TV business in the US in 2003, to lock in subscribers by getting them to buy two or more of the company's services, thus increasing retention rates. Redefining product line was a strategy employed by U-Haul when it starting selling packing supplies to folks to who rented moving trucks. Gupta and Lehmann warn that these strategies are easier said than done, because consumers are skeptical about change and companies often ignore their limited competence.

Customer retention, consisting of strategies designed to limit defection, has the greatest potential to increase long-run market share and profits because its impact occurs over multiple periods. As Gupta and Lehmann explain, "while short term financial results may favor cost-cutting (e.g., reducing acquisition costs), real financial value comes from intelligent allocation of resources for improving service to profitable customers." Also, conventional wisdom has it that it costs much less to retain an existing customer than it takes to acquire a new customer. Still, marketers must recognize that it is generally more expensive to reduce defection at higher and higher retention rates, and the cost of 100% loyalty is almost always far greater than the increases in revenues from the holdouts.

4. Customer Value Management

How can you improve the value of customers in your organization? Where should you focus resources? And how can you increase profits? To answer these questions, Gupta and Lehmann recommend creating a "profit tree" for your business. The profit tree is an illustration which "traces all the branches through which profit flows to the organization" and identifies where decisions are made that have outcomes that affect subsequent decisions (no decision can be made in isolation).

The authors describe its application using an example of an investment company that is a division of a large bank. The branches with decision points, questions and answers are as summarized in the following table:

Decision Points Question Answer
Targeting What is the target? Current bank customers with $300,000 or more in liquid assets in the bank, about 300,000 potential customers.
Referral (A) How will we acquire customers? Bank employees given incentive to refer customers.
Referral (B) What is the number of target customers referred by bank employees, given current incentive program? Is an adjustment necessary to meet objectives? Referrals from bank employees total 2,000 from a pool of 300,000. If too low, may need to increase incentive offered.
Conversion Is conversion rate (40%) too low? Higher referral rate may decrease conversion rate because more marginal customers are referred.
Business Mix What types of clients did the program generate? What is optimal mix? 80% immediate fee clients and 20% deferred fee clients.
Account Size What is the average asset size of immediate fee clients and of deferred fee clients? $450K for immediate fee clients, and $550K for deferred fee clients. If target is broadened, average asset size would decline.
Pricing Is price too high/low? Price determines conversion and retention rates.
Retention How would profit increase if retention increases three years? What programs are needed to increase retention rate? Retention is dependent on customer satisfaction; customer satisfaction is driven by service and rates.

The profit tree (represented in the table above) helps identify the customer management decisions and consequences to manage marketing as the driver of business strategy and growth.

5. Relationship of Customer Value to Firm Value

If profit and cash flow form the foundation of firm value, it follows that customers buying products and services, the primary source of cash flow, determines firm value. As Gupta and Lehmann assert, "the value of a single customer provides the building block for forecasting cash flow—and hence the value—of a firm.

Using data from 2002, the authors examine five customer-driven businesses to determine whether customer-based metrics are related to firm valuation: Amazon, Ameritrade, Capital One, eBay and E-Trade. Estimates of customer value track the market value for three of the five companies. Amazon and eBay have market values much higher than what customer value would suggest. Therefore, the authors conclude, Amazon and eBay at the time may have been overvalued Internet darlings of Wall Street.

Gupta and Lehmann acknowledge that the financial analysts—and MBA students—may be enamored with cost of capital and other financial measures of valuation. However, the authors demonstrate convincingly that marketing has a far more significant impact on firm value. For example, an increase in retention rate of 1% increases firm value by about 5%, while a decrease in discount rate of 1% increases firm value by only about 1%. The authors provide a detailed example of NetFlix, the movie rental firm, showing that decreases in customer churn from 2001 to 2004 have tracked very closely to the market value of the company.

* * *

In sum, with marketing in need of ways to increase its stature and power inside most organizations, Managing Customers as Investments has enormous strategic value for effective marketing management. The time you spend reading it will be your best investment in 2005.

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image of Roy Young
Roy Young is coauthor of Marketing Champions: Practical Strategies for Improving Marketing's Power, Influence and Business Impact.