Understanding customer equity

Customer equity, in its simplest form, recognises customers as the primary source of cash flows. By measuring the present and future value of customers, it is possible to better understand return on marketing spending and, ultimately, the value of the company itself.

While customer equity is a relatively new term, it builds upon previous concepts, including customer lifetime value and customer relationship management. These concepts have been successfully applied for years, in direct marketing and within the financial services industry. However, customer equity has the potential for a much broader application – not only to a range of industries, but to multiple marketing channels as well.

Customer equity versus brand equity

One way to understand customer equity is to compare it with the related concept of brand equity. The two are similar in some respects: they both attempt to measure the intangible value of marketing assets, and hold customer loyalty as a fundamental consideration. However, their differences are far greater.

First, the basic unit of analysis is different, as brand equity focuses on the product while customer equity is directly concerned with the customer.

Second, customer equity measures observable customer behaviours, whereas brand equity focuses on less tangible customer attitudes. Because customer behaviours and purchase decisions are directly linked, customer equity provides a more accurate understanding of the cause-and-effect relationships that ultimately drive revenues.

When combined with financial metrics such as net present value, a lifetime of customer revenue generation can be compressed into a single customer equity value.

Despite these advantages, customer equity is less well known than brand equity at the moment. While this may seem to indicate that brand equity is a more popular or effective metric, in truth it’s a result of timing. As more literature is published over the next few years, the popularity and use of customer equity will grow accordingly.

Why understanding customer equity is crucial

Companies that do not understand customer equity face the risk of making key marketing decisions without sufficient or appropriate information. Worse, they will be more vulnerable to a number of common and costly mistakes:

1. Companies may allocate resources to add new customers who provide short?term gains without any long-term benefits. This results from errors in targeting customers who are more likely to defect after a short period.
2. They can waste money by spending unnecessarily on activities with little or no influence on customer behaviour and purchase decisions.
3. Companies may focus exclusively on revenues and other figures that look promising from a financial perspective, while ignoring negative trends in the cost of acquiring and keeping customers that provide advance warning of problems that would otherwise go unrecognised.
4. Even well-intended investment in expensive customer relationship management platforms may prove a costly mistake, if the benefits are unrealised due to a lack of understanding of how to use them to grow customer equity.

How customer equity affects long-term profit

Customer equity provides information regarding what types of customers are most valuable, where their value comes from, and how to maintain long-term relationships.

In each case, the focus is to determine optimal levels of overall marketing spending, and to guide the most effective ways of allocating spending to maximise long-term profit.

This is achieved via three major drivers:

• customer acquisition
• customer retention
• add-on sales.

1. Customer acquisition

The key to this driver is identifying the best customers, recognising that all customers do not have equal value. While all customers provide revenue directly through purchases, the best ones also contribute by introducing other customers, indirectly leading to additional revenue streams.

Thus, customers with greater potential for word-of-mouth endorsements and influence have a greater customer equity value.

Another key factor is how responsive customers are to marketing, which validates whether efforts to reach them represent money well spent.

2. Customer retention

Differential costs required to maintain customers effectively offset some of the revenues they provide. This is an important – and frequently overlooked – consideration that is every bit as significant as situational factors such as switching costs.

3. Add-on sales

This driver focuses on each customer’s untapped potential from cross-selling and increasing purchase volume. Measuring this driver is complicated by a number of factors, including a lack of visibility into purchases from competitors, as well as other difficulties.

For instance, some customers who currently spend the lowest amount on purchases may have significant customer equity value if they are likely to realise their great potential for spending increases.

For more information or advice on calculating the true value of your customers, contact me by email or call me on +44 (0)20 7099 2621.

Terry Irwin is a management consultant with international experience in strategy development, business turnarounds, venture capital, sales and marketing, M&As and project management. He is a founder director of TCii Strategic and Management Consultants and has helped a broad portfolio of international clients to achieve profitable, sustainable business growth.

The above article is from TCii's library of best business practice snapshots.