Return on Customer coauthors Don Peppers and Martha Rogers typically write about one-to-one marketing and customer-centric behavior. This book, their seventh, is no exception.
The central thesis of the book is that a company's "Return on CustomerSM" is a mix of current period cash flows and the long-term equity of its oscillating pool of customers. The long-term customer equity is a function of lifetime customer values, which is a function of how long customers are retained, how much and how often they buy, and the cost of acquiring and serving them, among other things. In writing about the significance of customers, Peppers and Rogers write that "Without customers, you don't have a business. You have a hobby."
Another overriding theme in the book could be termed "the horizon problem." It deals with the difficulty of balancing the needs of managing the short-term and hitting quarterly numbers with the need to increase the long-term enterprise value of a company's portfolio of customers.
In essence, it's similar to managing a portfolio of investments. A portfolio manager has questions about liquidity needs (e.g., current period customer cash flows), investment objectives (e.g., current cash flows vs. customer equity appreciation), and risk profile (e.g., which customers are at risk of defection)—all of which are relevant to a portfolio of customers.
Defining Return on Customer
The authors start their book with a cogent discussion of why in today's business world customers are scarcer than capital. There are often too many offerings chasing too few customers. The authors also define (and title of the book) "Return on Customer" (ROCSM), which they say is a breakthrough financial metric that can quantify shareholder value changes via various business actions and initiatives.
Pepper and Rogers implore the analyst and investor communities to focus on encouraging the creation of long-term, enterprise value rather than managing and manipulating short-term results. They write that financial analysts are "blind" to one of the most significant factors driving business success.
A company, at its roots, is a portfolio of customers that not only buys things in the current period but also increases or decreases in value over the long-term. You can think of the current period cash flows as interest or dividends, and the long-term value of the customer portfolio as capital appreciation, which is basically the definition of the ROC equation:
ROC = Πi + ΔCEi
CEi-1Πi = Cash flow from customers during period i
ΔCEi = Change in customer equity during period i
CEi-1 = Customer equity at the beginning of period i ROC equals a firm's current period cash flow from its customers plus any changes in the underlying customer equity, divided by the total customer equity at the beginning of the period.
If you analyze the above equation, it's clear that there are some components that are difficult to measure. The customer equity piece is not easily measured for many firms. Many companies are not as astute as they should be around retention or defection rates and customer lifetime values (LTV). The customer equity component is built on LTV, which is, quite simply, what a customer is worth to your organization over their lifetime as a customer. LTV can be calculated several ways, and the authors outline three methods in the appendix:
1. Fully allocated profit
2. Marginal financial contribution by customer
3. Cash flow
Each method has pros and cons, but it's the questions and process that are most important. For example, what is a specific customer worth to your organization? How much should you spend on acquiring a customer? What do you do that changes a customer's LTV?
Developing Customer Trust
The authors write that a firm's ROC is "maximized at the point that the customer most trusts the firm." A myopic focus and zero-sum attitude—characteristics of many companies—is not the way to build trust and a higher LTV. Peppers and Rogers present a model of trust from Charles Green, coauthor of The Trusted Advisor, which revolves around four characteristics of how a business conducts itself:
- Credibility: Does the company have a reputation for telling the truth, and is it accurate in its representations?
- Reliability: How does a company act on a day-to-day basis?
- Intimacy: This refers to safety, security, or integrity issues.
- Self-orientation: This characteristic could be considered the most important. A customer would view a self-oriented firm as greedy, sneaky, or devious.
In a nutshell, companies that score lower on the above characteristics are less likely to develop a long-term, enterprise enhancing, trusting relationship with their customers. The authors quote Robert McDemott, the former CEO of USAA, who says that the firm's "Golden Rule" is one reason for its success: "Treat the customer the way you would want to be treated if you were the customer."
In making their message relevant to the reader, the authors retell a friend's experience that at some point has probably happened to each of us and is emblematic of many companies' non-LTV behavior: A friend purchased a used DVD for $8 (as a gift for her young daughter) at a store where she typically spent about $20 a month. The used DVD had a lifetime warranty. It didn't work correctly, so she brought it back to the store to get a refund. The woman was told that she needed the original receipt to obtain the refund, even though the original receipt had a coupon on the back that she had already used at that store. Needless to say, even when the manager got involved, the store still did not refund $8 to a $240-a-year customer.
The store may have won the battle, but it lost the war. The friend vowed to never return to the store.
It's true that you don't have a guarantee that the woman will continue to frequent the store and spend $20 a month. But, then, I'm not sure any projection in business has guarantees. Many finance calculations are built on assumptions and projections that go out for 5-10 years, and often more. The authors conclude that "short-term concerns destroy value in a measurable way."
Determining Customer Needs
Peppers and Rogers tell us that customer needs is a boardroom issue. The objective is to see the business through the customer's eyes—their perspective. One of the challenges is that customer "need" is a complex variable and is multidimensional.
The authors present a couple of concise case studies in illustrating the benefits of intimately understanding customer needs. When companies understand exactly how various customers use their offerings as well as specific segment needs, they are in a better position to augment and extend the value that they offer and to uncover latent needs of their customers' business.
This discovery of latent needs can be conducted by talking to and interviewing the "lead users" of your offerings. These customers are likely to have already pushed your offerings to their limits and would have recommendations around augmenting and extending the value of them. Many Fortune 500 companies take a proactive approach to find customers that have "intense" needs, and then get them involved in the brainstorming of next generation offerings.
Peppers and Rogers also write about the importance of anticipating customer needs. They cite several benefits:
- You can better influence future customer behavior.
- You can improve customers' value to your firm by better aligning to their needs.
- You can improve customers' perception of your company.
- You can make it easier for a customer to select one of your offerings.
In the last part of this section the authors discuss some of the differences between brand and customer equity. Pepper and Rogers state that each equity perspective can provide insights into value creation, with the brand side being more an aggregate view, and the customer piece being more individualized.
The customer needs discussion ends with a key premise underlying the book: To create sustainable value for your business, you must first create value for your customers, which requires an understanding of what they truly value. Determining customer value drivers should be a key objective for every business.
ROC and Decision Making
Return on Customer can, and should, be used as a decision-making tool. Managers should understand how different factors impact LTV. The authors cite factors such as customer acquisition costs, service costs, up- and cross-sell rates, customer satisfaction and attitudes, among other variables.
It is the expected change in a customer's LTV, Peppers and Rogers write, that should drive business decisions. In essence, every business decision should be filtered through the customer LTV lens.
The authors also discuss short-term vs. long-term decisions in terms of current-period cash flows and building customer equity. Without any data to the contrary, most companies will revert almost exclusively to the short term, with overall destructive results. In addition, all companies need to know which customers are worth acquiring and which are not worth keeping, which customers have the most growth potential and which present the most risk.
The following table is adapted from the book in which a company could begin to predict LTVs. Variables could include gender, age, recency, frequency and monetary value (RFM), number of company offerings purchased, etc. The "LTV algorithm" is not a mathematical equation per se, but is derived by correlating the company's currently available customer data.
| Customer | Variable1 | Variable2 | Variable3 | Variable4 | Variable5 | LTV |
| A | ||||||
| B | ||||||
| C | ||||||
| D |
Once an organization identifies the key LTV variables, it needs to determine which ones it can have some impact on, and focus on those. The authors point out that a simple LTV algorithm is never completely accurate and is essentially a "statistically compiled approximation." Most models, in any discipline, do not replace business judgment or common sense. Lastly, Peppers and Rogers remind us that "correlation is not cause."
Next week: Peppers and Rogers, Part 2
