Seeking Higher ROI? Base Strategy on Customer Equity

Why CMOs Need to Pay Closer Attention to a New Metric to Focus Investments on the Most Profitable Actions

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Weighing in on Net Promoter
There are many ways to invest marketing dollars to try to grow revenue, but how many of them really work -- and how can we tell which ones will be profitable? Smart companies increasingly are realizing that marketing-investment decisions need to be based on apples-to-apples comparisons, and customer equity is the strategic metric that makes that possible. By basing strategy on customer equity, a marketing executive can focus investments on the most profitable actions and effectively evaluate return on investment.

Here's why: Customer equity is the sum of the lifetime values of a firm's current and future consumers. But what does that really mean, and why do we care? Think of customer equity as the discounted profit flows summed across all of a firm's customers.
Calculating ROI

Related Graphic:

Customer Equity Drivers
Computing Customer Equity
If you remember Finance 101, that is almost exactly the definition of the value of the company. That is, customer equity is a very good marketing proxy for the value of the firm, and in fact there are a number of studies that show that customer equity is usually quite close to the firm's market capitalization. Bottom line: If a chief marketing officer wants to drive shareholder value, increasing customer equity is the way to do it.

Three drivers
This also suggests that marketing executives should pay more attention to customer equity -- which considers both current and future profits -- and less attention to market share, which is only a current snapshot. In fact, marketers are increasingly paying attention to a new metric -- customer equity share -- which is the brand's customer equity divided by the total customer equity in the market.

How can a firm figure out a brand's customer equity and customer-equity share? It requires a combination of customer surveys and internal company information. The customer surveys are similar in time and length to customer-satisfaction surveys, but they are broader. It's useful to measure three main drivers of customer equity and industry-specific subdrivers within each of the three. The three drivers of customer equity are value equity (the rational and somewhat objective part of customer equity, which involves things such as quality, price and convenience), brand equity (the emotional and subjective part, involving things such as brand image and brand attitudes) and relationship equity (which involves relationship-building activities, such as loyalty programs, that bind the customer to the brand). (See customer-equity driver figure above.)

Customer ratings on these three drivers and their subdrivers should be obtained for all of the leading companies in the market. Also obtained on the survey is information about purchase frequency, volume per purchase, most recent choice and expectations about the next purchase. This is combined with internal company data on time horizon, discount rate and market shares. From this information, one can estimate the lifetime value of each customer, from which we get the customer equity of the brand.

Companies can build simulators from these data that can be used to examine what-if scenarios of marketing actions. One prominent example of this is TNS's Revenue Growth Manager. A number of leading companies worldwide already have implemented similar systems, and my colleagues Kay Lemon and Valarie Zeithaml and I have helped build several of them. One of the key advantages of a customer-equity system is that it can be used to identify the key drivers of customer equity. For example, an airline might find that value equity is the most important of the three drivers, and that passenger seating comfort is a strong driver of value equity. Kay and Valarie and I did just such a study of American Airlines' seating in research for our book, "Driving Customer Equity," and found that expanding coach leg room was likely to be profitable. Interestingly other airlines, such as United Airlines and JetBlue, ultimately followed American's lead and also invested in this way.

Key advantages
One of the advantages of a customer-equity decision-support system is its ability to evaluate marketing ROI. It is a poorly kept secret that many marketing expenditures are not held accountable in most companies, but top management increasingly insists on financial accountability. By projecting shifts in the driver ratings or subdriver ratings and taking into account the amount of money invested in the shift, it's possible to project marketing ROI for any marketing investment. The ROI is simply calculated as the projected increase in customer equity minus the discounted investment divided by the investment. This makes possible those apples-to-apples comparisons of competing marketing investments. And it's also possible to use customer equity to evaluate marketing ROI after the fact -- by inserting the actual shift in the driver or subdriver into the simulator and then calculating the ROI as before. (See ROI calculator figure.)

Basing marketing strategy on customer equity adds financial discipline that marketing has often lacked. It gives marketing executives a metric that maps closely to the value of the firm and therefore speaks in a language board members can understand. And, yes, all this should help move the needle on CMO tenure, because, as we all well know by now, the more marketing executives can quantify the impact of their investments and make them financially accountable, the more status and impact CMOs will have on the top executive team.
Roland T. Rust holds the David Bruce Smith Chair in Marketing at the University of Maryland, College Park. The winner of many lifetime honors and article and book awards, he is the editor of the Journal of Marketing and consults with leading companies worldwide.
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