We are often struck by a sense of déjà vu when reading the “latest” thinking in business, especially in the wake of the recent financial crisis. Pundits and analysts across the business spectrum have emphatically announced the business world’s entry into the Age of the Customer. To stay competitive, they say, today’s firms must reorganize their operations around the customer, treat different customers differently, and build trusting relationships.
The concept of “customer-driven capitalism,” for instance, as expounded in a recent article for Harvard Business Review by Roger Martin, dean of the Rotman School of Management at the University of Toronto, is something we heartily endorse. According to Martin, the biggest problem with a business model that rewards managers more or less exclusively for increasing shareholder value (usually via stock options) is that, when managers try to maximize their own compensation they end up manipulating shareholder expectations in unhealthy ways. Indeed, the practice of pushing current earnings so as to improve shareholder expectations (thereby boosting the stock price) has contributed significantly to the rampant short-termism plaguing businesses now. It is also a primary cause of the financial meltdown and economic trauma of the past 18 months, vaporizing a vast amount of wealth around the world.
Instead of trying to maximize shareholder value, Martin argues, “companies should seek to maximize customer satisfaction while ensuring that shareholders earn an acceptable, risk-adjusted return on their equity.” He suggests that this is the only practical way to focus on customers while still maintaining financial viability, because no company can serve two masters, and financial success is of course necessary for a business to survive over the long term. Obviously, companies would “quickly go bankrupt if they made customers happier by charging ever-lower prices for ever-greater value,” he says.
This optimization-within-constraints idea is good advice, as far as it goes, and we’re always happy to see prominent business advisors embracing the customers-first agenda. But the optimization-within-constraints formula for customer-centric business still has a significant weakness, leaving customer-friendly strategies highly vulnerable. When your business model treats customer satisfaction as a separate, nonfinancial goal, this goal can and will be undermined by the routine corporate budgeting and financial management process, as different units and activities compete for funds and support within the organization, especially when cash gets tight.
The plain and simple truth is that a business enterprise can only operate efficiently if it can balance the financial benefits of improving customer satisfaction against the costs of doing so. Relying solely on customer satisfaction (or loyalty, or willingness to recommend) or any other nonfinancial metric denies a company the ability to prioritize its customer tactics or to compare and contrast specific initiatives. What, exactly, is the financial benefit of increased customer satisfaction? If surveyed customer satisfaction were to increase by, say, 5 percent, what would that really be worth, in dollars and cents? This quarter? In a year? This is the point at which Martin and most other business advisors, from professors to management consultants, encounter a problem.
In the final analysis, of course, by definition, customers are the only reason any business ever creates any shareholder value at all. But despite this undeniable fact, the overwhelming majority of businesses don’t link their financial metrics directly with customers. Instead, they count the number of products that move off the warehouse floor, or the number of contracts signed, or the profits earned in each quarter. Historically, these have been the only practical metrics available to a business. With the advances in computer technology and analytics that we’ve seen in the past couple of decades, however, businesses now have a whole new suite of tools available to them, if they choose to use them.
Measuring customer value
This is the subject we tackled in our book Return on Customer: Creating Maximum Value From Your Scarcest Resource (for details on ROC, see “Return on Customer: A Core Metric of Value Creation,” page 46). We sounded a warning about the dangers of short-termism, and we suggested that short-term thinking was driven primarily by a failure to recognize that customers create both long-term and short-term value for a business, every day. When customers buy things, this generates current-period revenue, or short-term value. But every experience a customer has with a product or brand also creates long-term value, because the customer’s own attitude will change, increasing or decreasing the likelihood that that particular customer will buy additional things or positively influence others, in the future. This builds or destroys customer equity, which is a more telling indicator of the future value of a company than current share price. Consider Martin’s comments about P&G Chairman, President and CEO Alan George “A.G.” Lafley: “Lafley came to realize that increases in shareholder value had very little to do with real business performance and a lot to do with the fertile imaginations of shareholders.” But a firm’s customer equity, combined with current-period customer profitability, has a direct connection to how well a company can perform in the future.
The value a customer will create in the future can be captured quantitatively by modeling, analyzing, and estimating customer lifetime value (CLTV), which we define as the net present value of the stream of all future cash flows attributable to a customer. CLTV is a statistically calculated forecast, and can never be precisely measured. But then, a hard look at the traditional measures we have all treated with so much reverence shows that they are not always that consistent or accurate either, truth be told. And, as analytical techniques and computer technologies have improved, it has become increasingly practical for businesses in all industries to model the lifetime values of their customers in a probabilistic way, and to begin to understand the various factors—such as customer satisfaction, likelihood to recommend, or intention to purchase—that cause these lifetime values to increase or decrease, and by how much. This is the missing link between concepts such as “customer-driven capitalism” and a company’s actual operations and financial performance.
We’re happy to see business analysts hopping onto the customer-centric bandwagon with us. There’s no doubt that the more folks come to believe customer satisfaction is crucial to long-term financial success, the better off our entire economic system will be. But we predict that, as more companies try to develop a better picture of what it really means to put customers first, more will “discover” the Return on Customer metric and put it to productive use, in order to build steady growth, quarter after quarter – growth that isn’t planned with desperation during “this quarter,” but is instead laid out methodically and steadily for future periods, by emphasizing the conservation and improvement of customer equity over the long term.
Customers really are the reason any business exists, and the time is coming when businesses will be respecting this reality.