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The role of ABM in measuring customer value.

IT ALLOWS YOU TO ENHANCE YOUR RELATIONSHIPS WITH VALUE-CREATING RATHER THAN VALUE-DESTROYING CUSTOMERS

Imagine two customers--let's call them Customer A and B--who on the surface look very similar. Same demographics, about the same revenue levels for your organization over the past 12 months, they pay their bills on time, and their revenue growth rates are roughly comparable. On the surface you might conclude that these customers were of equal value to your organization. But digging a little deeper, you find that Customer A has been a loyal customer for many years, provides you with 100% of his business, refers friends and associates, orders products and pays invoices electronically, and demands little in the way of extraordinary care and attention. Customer B, on the other hand, has recently been reacquired as a customer for the third time in three years through significant sales and marketing efforts as well as price concessions. In addition, he buys your lowest-margin products, changes orders and delivery terms at the last minute, and requires a considerable degree of time and attention by your customer se rvice group.

Now do you think they're of equivalent value? Probably not. But how would you know whether you were spending enough to keep Customer A loyal or whether you should allow Customer B to take his business to the competition? Enter customer lifetime value (CLV)--a comprehensive, fact-based measure of customer worth over the lifetime of your relationship with your customers.

As organizations in every industry have reached out to grow their business through the use of advanced processes and technology, they have shifted their focus from being "product-centric" to being "customer-centric." Customer relationship management (CRM) is often at the forefront of their efforts. Understanding customer behavior and profitability and leveraging this information to more effectively manage customers in a one-to-one relationship is key to creating a competitive advantage in the new economy. According to AMR Research, the CRM market will be worth more than $16 billion by 2003--a phenomenon not to be ignored by anyone who's serious about staying ahead.

Customer relationship management initiatives aren't being employed without reason. The success or failure of corporations and their executives is being determined by their ability to create shareholder value. In a study conducted by PricewaterhouseCoopers and the Conference Board (CFO Conference Board Survey, 1997), leading CFOs said that the two most significant factors in creating shareholder value are revenue growth and margin growth. Clearly, no single constituency has a greater impact on these two measures--and therefore the value of your organization--than your customers.

CRM efforts are targeted at attracting new customers and retaining, up-selling, or cross-selling to existing customers. Incremental revenue is the most frequently used metric in measuring the success of these efforts. Yet companies are increasingly asking the questions: "Are these the right customers? That is, are these profitable customers?" "Are these the customers to whom I should devote my scarce and costly sales and service resources?" "Is revenue alone an adequate measure of customer value?"

Customer lifetime value (CLV) can help you answer those questions. It's a performance measure of long-term customer worth. And activity-based management (ABM) can be key in laying the foundation for quantifying customer lifetime value metrics and integrating the results into customer relationship management.

NOT ALL REVENUE IS GOOD REVENUE!

Customer relationship management is than growing revenue, getting closer to customers, and anticipating and servicing their needs. It's a business strategy that involves both front-end and back-end business processes. To be fully successful with CRM, corporations must be able to choose the right blend of customers who will drive value. But to understand which of these customers are--and aren't--driving value, it's necessary to understand their margin contribution from the goods and services they buy as well as their consumption of indirect corporate resources. Activity-based management is particularly well suited to enhance your understanding of who's driving value by:

* Making visible the cost of all activities required to create and maintain a relationship with customers.

* Exposing resource consumption patterns that traditional cost accounting practices can't.

* Attributing activity costs to customers based on their consumption of the "drivers" of those activities and their underlying resources.

As companies implement customer-centric business strategies and CRM solutions, it becomes increasingly important for them to understand the value of customer relationships. This takes on added significance in that, for most companies, 20% of customers contribute 80% of profits. Said differently, fully 80% of the typical customer portfolio is either marginally profitable, at break-even, or unprofitable. Unfortunately, few companies can quantify profitability at a customer or household level.

But customer revenue alone is an inadequate measure of customer value. Customer profitability gets closer to the answer. Yet profitability measurements are often highly aggregated to a customer segment level, which limits their effectiveness in one-to-one customer marketing efforts. In addition, few customer profitability models include costs beyond the most obvious and direct costs of sales. They rarely include the cost to acquire the customer or the cost to retain and serve that customer after the sales transaction is complete. In our experience, direct costs of sales rarely exceed 50%.

In addition, customer profitability typically provides only an annual or monthly snapshot of the customer's value. For companies with a high rate of customer turnover, as well as those with long-term customer relationships, periodic measures are usually insufficient. Such periodic measures typically exclude important costs that have been incurred in earlier periods (e.g., customer acquisition) or that may occur across multiple periods (e.g., cost to serve). For customer profitability to help you understand customer value, it should be viewed across more than a single year--ideally over the lifetime of the customer's relationship with your organization.

There are a few practical challenges to measuring a customer's lifetime value. One is actually defining a "customer." Is it an individual, an account, or a household or business address? A second challenge is linking customer information into a single customer record when they "churn"--or leave and return--multiple times during their lifetime. In spite of these challenges, we believe the benefits you can gain from an understanding of CLV are compelling enough to take on the challenges.

It's also important that, where applicable, customer lifetime value be evaluated at an enterprise level, rather than solely at a divisional level, particularly when a customer buys goods or services from multiple divisions in an organization. It isn't unusual for a customer to be unprofitable in one division yet highly profitable in another. Obviously a company's CRM strategy has to take this into consideration. Failure to take an enterprise perspective in measuring lifetime value raises the risk that a customer may be treasured in one division while being marginalized in another--hardly a recipe for customer loyalty.

As an enabler of CRM, customer lifetime value isn't a new concept. It's a common yardstick you can use to quantify and evaluate customer relationships over time. Unfortunately, many organizations base CLV only on a customer's revenue contribution rather than their profit contribution. The misconception that revenue alone is king is one of the primary reasons many Internet-based retailers have failed in the past year. It's imperative that companies understand their customers' lifetime costs as well as their lifetime revenue potential. The resulting value, essentially lifetime profitability, is the foundation for calculating customer lifetime value. Yet there hasn't been much practical guidance for calculating customer costs or profitability, and some of the basic tenets of CRM fall short of making this determination.

DEMOGRAPHIC SEGMENTATION ISN'T ENOUGH

One of the basic tenets of successful CRM initiatives is customer segmentation. This segmentation has traditionally been driven by demographic or behavioral characteristics in an attempt to predict how customers in a segment will react to a product or service being offered. An example of customer segmentation for a hypothetical telecommunications company is shown in Table 1.

Though demographic or behavioral segmentation is a good starting point in understanding your customer base, we believe neither goes far enough. They need to be further delineated to reflect the value of customers in that segment--a so-called "value segmentation." CLV provides the "filter" to accomplish such a "value segmentation" as reflected in Figure 1.

Here's an example of value segments that might appear within each of the demographic or behavioral segments:

* "Champions," such as our hypothetical Customer A, are your best customers. Typically they are loyal, regular, high-margin customers who are relatively easy to serve and consume little of your organization's support resources.

* "Demanders" are profitable customers, though they're high-cost customers as well and typically make heavy uncompensated use of your organization's resources.

* "Acquaintances" are low-profitability customers, yet they demand little in the way of your organization's resources. Though you wouldn't want to base your business on these customers, you would also hate to lose them because they contribute marginal profit and are relatively maintenance free.

* "Losers," such as Customer B, are at the other end of the spectrum from Champions. These are the customers who drain valuable resources from the organization yet provide little in return. "Losers" may include high-churn customers as well.

Clearly, the strategy around each of these customer groups will vary. Champions are to be nurtured and rewarded. The strategy around Demanders and Acquaintances should be to enhance their profit contribution by selling upward into more profitable lines while keeping the cost line flat for Acquaintances and managing it downward for Demanders. Losers must be converted into profitable customers through up-selling and a lower cost of service. If their lifetime value can't eventually be made positive, let these customers defect to your competition, and avoid them in future customer win-back campaigns.

ABM FOR BETTER INSIGHT

Once you've gained insight into the lifetime value of your customers, you'll need to educate them on how their activities drive your cost and their value. Activity-based management can be a useful means of:

* Helping these customers understand the value they receive for the prices they pay.

* Supporting a two-tiered pricing structure in which high-cost services are priced separately from products, particularly for Acquaintances and Losers.

* Modifying their behavior to reduce the "drivers" of cost and complexity that they historically have brought to their dealings with you.

The retail banking industry was an early adopter of this approach. Once these institutions began to better understand their cost structures and customer profitability, they began assessing fees for customers who didn't maintain a minimum level of deposits or buy high-profit services.

CLV isn't the only measure you can use to determine the value of a customer. There are many additional factors, both quantitative and nonquantitative, you must consider when determining the CRM strategy applicable to individual customers. Two of the most important ones are the customer's propensity to spend in the future and the likely duration of your relationship with the customer--the total "lifetime." Another important factor is their likelihood to refer new customers in the future. The ability to accurately forecast customer behavior is important, but it may be just as meaningful, and a good bit easier, to evaluate these factors in conjunction with, yet separate from, historical customer lifetime value.

Up to this point, we've focused on the need for customer lifetime value and how it's used to segment customers based on value. Now we're ready to explore how to use ABM to measure CLV and show how you can use CLV information to establish one-to-one customer relationship strategies. That's the focus of Part 2 in next month's issue.

Joseph A. Ness, CPA, is a partner with the Management Consulting Services group of PricewaterhouseCoopers in St. Louis, Mo. He's responsible for coordinating the firm's ABM consulting practice throughout the U.S.

Michael J. Schroeck, CMA, CPA, is a partner with the MCS group of PricewaterhouseCoopers in Rosemont, Ill. He's the global leader for both the Data Warehousing and iAnalytics practices of MCS.

Rick A. Letendre, CPA, is a sales account manager for the Management Consulting Services group of PricewaterhouseCoopers in Houston, Texas. He's responsible for supporting development of new service offerings and business development in the Financial Management Solutions practice.

Willmar J. Douglas, ACMA, is a principal consultant with the MCS group of PricewaterhouseCoopers in St. Louis. His major experience lies in designing and implementing financial and cost management systems, particularly ABC/M systems.
 Customer Segmentation by a Hypothetical
 Telecommunications Company
Market Segments Demographic Characteristics
SUPER USER * Upscale
 * Highest income level, highest
 communications spending
 * High bandwidth, second line, PC, and
 wireless ownership
TECHNOLOGY ASTUTE * Higher income with high communications
 spending
 * High PC, online, and wireless use
 * Interested in new technologies
FAMILY USER * Moderate to high income with high
 communication spending
 * High PC and moderate online use
 * Some interest in new technology
FREQUENT COMMUNICATOR * Moderate income
 * Moderate to high wireless, moderate
 PC, and limited online usage
 * Little interest in new technology
BASIC USER * Lowest communication spending
 * Low to moderate income and little
 interest in new technology
COPYRIGHT 2001 Institute of Management Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2001 Gale, Cengage Learning. All rights reserved.

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Title Annotation:activity-based management
Author:NESS, JOSEPH A.; SCHROECK, MICHAEL J.; LETENDRE, RICK A.; DOUGLAS, WILLMAR J.
Publication:Strategic Finance
Geographic Code:1USA
Date:Mar 1, 2001
Words:2136
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