Journal of Accounting Research

Vol. 36 Supplement 1998

Printed in U.S.A.

Are Nonfinancial Measures

Leading Indicators of Financial
Performance? An Analysis of
Customer Satisfaction
CHRISTOPHER D. ITTNER AND DAVID F. LARCKER*

1. Introduction
This paper examines three questions on the value relevance of customer satisfaction measures: (1) Are customer satisfaction measures leading indicators of accounting performance? (2) Is the economic value of
customer satisfaction (fully) reflected in contemporaneous accounting
book values? And (3) Does the release of customer satisfaction measures provide new or incremental information to the stock market? Many
argue that improvements in areas such as quality, customer or employee
satisfaction, and innovation represent investments in firm-specific assets
that are not fully captured in current accounting measures. According
to these authors, nonfinancial indicators of investments in "intangible"
assets may be better predictors of future financial (i.e., accounting or stock
price) performance than historical accounting measures, and should supplement financial measures in internal accounting systems (e.g., Deloitte
Touche Tohmatsu International [1994] and Kaplan and Norton [1996]).
University of Pennsylvania. The support of KPMG Peat Marwick, Ernst & Young, and
the Citibank Behavioral Science Research Council is gratefully acknowledged. We also
thank Pamela Cohen, John Core, Neil Fargher, Robert Kaplan, Richard Lambert, Michael
Maher, Richard Willis, an anonymous reviewer, and workshop participants at Harvard
Business School, the 1996 Stanford Summer Camp, and the 1998/ourna/ of Accounting Research Conference for comments on earlier drafts.

Copyright , Institute of Professional Accounting, 1999

ENHANCING THE FINANCIAL REPORTING MODEL: 1998

This same discussion has produced calls for disclosure of nonfinancial

information on the drivers of firm value (e.g., Wallman [1995], Edvinsson
and Malone [1997], and Stewart [1997]). A report by the American Institute of Certified Public Accountants [1994, p. 143], for example, concluded that companies should disclose leading, nonfinancial measures
on key business processes such as product quality, cycle time, innovation,
and employee satisfaction.
One nonfinancial measure emphasized in these discussions is customer satisfaction. We examine the value relevance of customer satisfaction measures using customer, business-unit, and firm-level data. The
customer-level tests provide evidence on the fundamental assumption
that future-period retention and revenues are higher for more satisfied
customers, making customer satisfaction measures leading indicators of
accounting performance. The business-unit tests extend the analysis by
examining the cost and profit implications of customer satisfaction, as
well as spillover effects such as growth in customers due to positive
word-of-mouth advertising and enhanced firm reputation. The businessunit tests also allow us to investigate the ability of typical business-unit
satisfaction measures (which are based on aggregated responses from a
small sample of customers) to predict accounting performance and customer growth. Finally, the firm-level valuation tests and event study examine whether customer satisfaction measures provide information to
the stock market beyond the information contained in current accounting book values.
We find that the relations between customer satisfaction measures and
future accounting performance generally are positive and statistically
significant. However, many of the relations are nonlinear, with some
evidence of diminishing performance benefits at high satisfaction levels.
Customer satisfaction measures appear to be economically relevant to
the stock market but are only partially reflected in current accounting
book values. We also find that the public release of these measures is
statistically associated with excess stock market returns over a ten-day
announcement period, providing some evidence that the disclosure of
customer satisfaction measures provides information to the stock market
on expected future cash flows.
Section 2 reviews the literature on the measurement and performance
consequences of customer satisfaction. Section 3 examines the relation
between customer satisfaction indexes and subsequent purchase behavior of individual customers. Section 4 presents our business-unit tests,
followed by firm-level tests in section 5. Section 6 concludes the paper.

2. Literature Review
Calls for greater emphasis on nonfinancial customer satisfaction measures are motivated by the perceived absence of information on one
of the key drivers of firm value. The marketing literature contends that

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

higher customer satisfaction improves financial performance by increasing the loyalty of existing customers, reducing price elasticities, lowering marketing costs through positive word-of-mouth advertising, reducing
transaction costs, and enhancing firm reputation (e.g., Anderson, Fornell, and Lehmann [1994], Fornell [1992], and Reichheld and Sasser
[1990]). These advantages are believed to persist over time, suggesting
that the net benefits from investments in customer satisfaction may not
be fully reflected in contemporaneous accounting performance (Anderson, Fornell, and Lehmann [1994]). However, achieving higher customer
satisfaction is not without cost. Economic theories argue that customer
satisfaction (i.e., customer utility) is a function of product or service
attributes. Increasing customer utility requires higher levels of these
attributes and additional cost, particularly at higher satisfaction levels
(Lancaster [1979] and Bowbrick [1992]). Likewise, traditional operations management theories maintain that the investments needed to improve product or service quality increase exponentially at high quality
levels (e.g., Juran and Gryna [1980]). Thus, improvements in customer
satisfaction may exhibit a diminishing, or even negative, relation to customer behavior and organizational performance.
Despite lack of agreement on the specific association between customer
satisfaction and financial performance, most firms track some form of
customer satisfaction measure (Ross and GeorgofF [1991]). These measures are inputs for improvement programs, strategic decision making,
and compensation schemes. Ernst & Young [1991] found that customer
satisfaction measures were of major or primary importance for strategic planning in 54% of the surveyed organizations in 1988 and 80% in
1991, and were expected to be of major or primary importance in 96%
by 1994. Ittner, Larcker, and Rajan [1997] found that 37% of firms using
nonfinancial measures in their executive bonus contracts include customer satisfaction measures, while William M. Mercer, Inc. reported that
35% of firms use customer satisfaction measures in determining compensation and another 33% planned to do so {HR Focus [1993]).
A survey of vice presidents of quality for major U.S. firms, however,
found that only 28% could relate their customer satisfaction measures
to accounting returns and only 27% to stock returns (Ittner and Larcker
[1998]). Similarly, a survey by Arthur Andersen & Co. [1994] indicated
that the top-two problems in implementing customer satisfaction initiatives were: (1) linking customer satisfaction and profitability, and (2)
understanding the point of diminishing returns for customer satisfaction initiatives. The accounting firm's study of the food, toys/games, airlines, and automotive industries also found little systematic relation
between customer satisfaction levels and profitability, leading them to
conclude that "the assumption that profits flowed inevitably from customer satisfaction simply didn't hold up" (Arthur Andersen & Co. [1994,
p. 1]). In contrast, Anderson, Fornell, and Lehmann's [1994] study of
the performance consequences of customer satisfaction in 77 Swedish

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

firms supported the hypothesis that customer satisfaction is positively associated with contemporaneous accounting return on investment, after
controlling for past return on investment and a time-series trend.
Banker, Potter, and Srinivasan [1998] also found that customer satisfaction measures were positively associated with future accounting performance in 18 hotels managed by a hospitality firm. Foster and Gupta
[1997], however, found positive, negative, or insignificant relations between satisfaction measures for individual customers of a wholesale beverage distributor and future customer profitability, depending on the
questions included in the satisfaction measures. Anderson, Fornell, and
Lehmann [1997] found positive contemporaneous associations between
customer satisfaction and return on investment in Swedish manufacturing firms, but weaker or negative associations in service firms.
Mixed evidence also exists on the extent to which customer satisfaction measures provide value-relevant information beyond that contained
in current accounting statements. Using surveys and revealed preference experiments, Mavrinac and Siesfeld [1997] found that institutional
investors ranked customer satisfaction indexes only eleventh most useful
among nonfinancial measures, and that participating investors put no
weight on customer satisfaction measures when valuing companies.
Related research by Aaker and Jacobson [1994] examined the association between stock returns and customers' perceptions of brand quality.
Using data on 34 brands included in the EquiTrend survey by Total
Research Corporation, the authors regressed stock returns during the
14-month period prior to the survey on "unexpected" accounting return
on investment, "unexpected" quality, and "unexpected" brand awareness.^
Aaker and Jacobson found a positive association between perceived brand
quality and stock returns after controlling for unexpected accounting
returns. Since the stock price returns preceded the measurement of perceived quality, their results suggest that the market (at least partially) impounds customer perceptions of brand quality into stock price. However,
the use of prior-period stock returns provides no evidence on whether
perceived brand quality is a forward-looking indicator of economic performance.
In summary, prior empirical studies provide mixed evidence on the relation between customer satisfaction indexes and financial performance,
and no evidence on whether there are diminishing or negative returns to
customer satisfaction. More importantly, prior research offers no support for claims that customer satisfaction measures provide incremental
information to the stock market on the firm's future financial prospects.

' The "unexpected" components of these measures represented the residuals from a
first-order autoregressive model pooling 102 time-series and cross-sectional observations
from each series. The accounting return on investment figures related to the fiscal yearend occurring during the 14 months prior to the survey period.

NONFINANCIAL MEASURES AS INDICATORS OF PERFORIVIANCE

3. Customer-Level Analyses
Our initial analyses examine whether current satisfaction levels for individual customers are associated with changes in their future purchase
behavior and firm revenues. One of the fundamental assumptions of
customer satisfaction measurement is that higher satisfaction levels improve future financial performance by increasing revenues from existing
customers (due to higher purchase quantities and lower price elasticities) and improving customer retention. We examine the effects of customer satisfaction on the purchase behavior of existing customers using
data from a major telecommunications firm. This analysis provides an
initial test of customer satisfaction measures' ability to predict future accounting performance and is similar to procedures used by firms to develop new marketing strategies and plans for individual customers.
The telecommunications firm has approximately 450,000 customers
for this service, which typically is sold to small businesses competing in
local markets. In 1995, the average customer had sales of $230,000 (median = $175,000) and had been in business 8 years (median = 10 years).
The mean (median) customer purchased approximately $3,000 ($1,150)
in services during 1995. The firm faces a number of national and regional competitors for this service, which is not regulated. To increase
revenues from existing customers and attract new customers, new or
enhanced services are introduced each year. The firm considers the
measurement of customer satisfaction and the identification of its determinants to be key inputs into their quality and customer service initiatives and overall corporate strategy. Given the characteristics of this
service and the firm's emphasis on customer satisfaction, we expect their
satisfaction measures should predict future-period customer behavior
and revenue.
The firm measured customer satisfaction for a random sample of
2,491 business customers buying a specific service in 1995. The customer satisfaction index (CSI) is based on three questions assessing: (1)
overall satisfaction with the service (from 1 = not satisfied at all to 10 =
extremely satisfied), (2) the extent to which the service had fallen short
or exceeded customer expectations (from 1 = has not met expectations
to 10 = exceeded expectations), and (3) how well the service compared
with the ideal service (from 1 = not at all ideal to 10 = absolutely ideal).
The index is constructed using Partial Least Squares (PLS) to weight the
three items such that the resulting index has the maximum correlation
with expected economic consequences^ (customers' self-reports of recommendations, repurchase intentions, and price tolerance^). The resulting
2 See Wold [1973; 1982] and Fornell and Cha [1987] for detailed econometric discussions of PLS.
^Recommendation ranges from 1 = not recommend to others to 10 = strongly recommend to others. Retention ranges from 1 = not at all likely to continue using this service

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

scores are rescaled to range from 0 (least satisfied customer) to 100

(most satisfied customer). Mean (median) CSIin 1995 was 62.3 (66.7).^
We assess future purchase behavior using 1996 retention rates and
revenue, and percentage changes in revenues between 1995 and 1996.
Retention rates allow us to test claims that more satisfied customers are less
likely to move to a competitor or stop using the service. The revenue level
tests examine whether more satisfied customers purchase more of the service than less satisfied customers. Finally, the revenue change tests examine
whether customers at higher satisfaction levels increase purchases more
than those at lower levels. The telecommunications firm has attempted
to increase revenues from existing customers by introducing new service
offerings and enhancing existing offerings. If it is easier to cross-sell new
products to more satisfied customers or to upgrade them to more expensive services, revenue growth should be positively associated with satisfaction levels. However, if highly satisfied customers tend to buy more
services but already had filled their requirements by 1995, revenue levels
for this set of customers may be higher but revenue growth may be zero.^
Customer retention is coded one for 1995 customers who purchased
services again in 1996, and zero otherwise (660 customers were not repeat purchasers). The one-year lag is typical in this business because customers sign annual contracts. Revenue was measured in 1995 and again in
1996, with percentage revenue changes defined as [(1996 revenue/1995
revenue) - 1]. The revenue change for lost customers is -100%. Obviously, many factors other than satisfaction levels may influence customer
purchase behavior; we are limited by data availability to two additional
control variables. Because larger firms are more likely to purchase more
services, we control for size using the customers' sales in 1995 (denoted
SITE). We also control for the number of years the customer has been in

to 10 = extremely likely to continue using this service. Price tolerance is based on three
similar questions asking whether the customer is likely to continue using this service if
prices increased by 15%, 10%, and 5% (1 = not at all likely to continue using this service
and 10 = extremely likely to continue using this service).
* One critique of studies using customer satisfaction measures such as these is that the
measures are ordinal rather than cardinal. Although a valid criticism, we are attempting to
provide evidence on whether the types of customer satisfaction measures used in practice
for decision-making, compensation, and disclosure purposes are associated with subsequent financial performance, despite limitations in their measurement properties.
^ We assume that revenue growth primarily captures additional sales to customers who
remained at a given satisfaction level, rather than customers who increased revenues because they moved to a higher satisfaction level between 1995 and 1996. This interpretation
is consistent with marketing research which finds that customer satisfaction levels are fairly
stable over time (Anderson, Fornell, and Lehmann [1994]). However, because we only have
customer satisfaction measures for a single period (i.e., individual customers typically are
not surveyed in multiple years), the revenue growth measure will capture both economic
effects.

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

TABLE 1
OLS Regressions Examining the Association between 1995 Customer-Level
Satisfaction Scores and 1996 Customer Retention, Revenues, and Revenue Change for
2,491 Business Customers of a Telecommunications Firm^
(t-Statistics in Parentheses)

Intercept

Retention
0.482***
(13.41)

Revenue
-535.29
(-1.38)

Revenue Change
-0.447***
(-8.89)

CSI

0.002***
(6.16)

19.464***
(4.92)

0.003***
(5.74)

AGE

0.013***
(3.99)

48.137
(1.34)

0.004
(0.90)

SIZE

0.000
(0.39)

0.003***
(9.85)

0.000
(1.44)

Adjusted R^
F-Statistic

0.021
19.04***

0.049
43.36***

0.013
12.07***

*** Statistically significant at the 1% level (two-tail).

"A customer in 1995 is defined as retained in 1996if that customer also purchased the service in 1996.
Revenue change is defined as [(1996 revenues divided by 1995 revenues)- 1]. Customers that were not
retained are given a revenue change score of -1.0. 1996 revenue from customers that were not retained
is set to zero. Customer satisfaction (CSI) scores range from 0 (least satisfied) to 100 (most satisfied).
AGE is the number of years the customer has been in business. SIZE is the customer's total revenue.

business (denoted AGE) to account for the high rate of business failures
in young firms.^
Linear regressions examining the associations between 1995 CSI scores
and customer retention, revenue levels, and revenue changes in 1996 are
reported in table 1. All three models are significant {p < 0.001, two-tail),
with adjusted Rh ranging from 1.3% to 4.9%. This low explanatory power
suggests that customer satisfaction is only one of many factors influencing customer purchase behavior in this segment of the telecommunications industry. For example, the small business customers surveyed are
likely to exhibit volatile and unpredictable cash flows, making it difficult
to forecast purchase behavior one year into the future. Therefore, it is
important to benchmark our results against the inherent difficulty of
forecasting customer behavior in this setting.
The point estimates for the regression coefficients, however, are economically significant. 1995 CSI was positively related to customer retention, revenues, and revenue changes in 1996 {p < 0.001, two-tail),
supporting claims that customer satisfaction measures are predictive of
subsequent customer purchase behavior.' The coefficients imply that a
also included measures for the customers' metropolitan statistical area (MSA) to
control for regional differences in economic environments, competition, etc. These measures were not statistically significant and are excluded from the reported tests.
'We also estimated the retention model using logit. The results were virtually identical
to those using OLS.

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

ten-point increase in CS/was associated, on average, with a 2% increase

in retention, a $194.64 revenue increase, and 3% higher revenue change.
Revenues also increased with customer size and retention with customer
age, but neither control variable was significantly associated with revenue
growth.
So far, we have assumed a linear association between satisfaction and
customer purchase behavior. The large sample of customers allows us
to test for potential nonlinearities in these associations. The nonlinear
functions linking retention, revenue levels, and revenue changes to satisfaction are developed using additive nonparametric regression with variance stabilization (S-Plus [1991, chap. 18]). This method, an extension
of the transformation procedures developed by Box and Cox [1964], fits
an additive nonlinear regression model to the criterion and predictor
variables. The nonlinear transformations of the variables (selected using
the supersmoother procedure^) are selected to maximize the correlation
between the transformed criterion and predictor variables such that the
residual variance of the transformed criterion variable is constant.
The nonparametric functions linking 1995 CS/levels to 1996 customer
retention, revenue levels, and revenue changes are presented in figures
1-3, respectively. The figures plot the predicted values of the dependent variables (selected using the optimal nonlinear transformation of
CSI) versus actual CSI.^ Regressions of the dependent variables on their
nonlinear transformations of CSI yield adjusted i?s for the retention,
revenue, and revenue change models of 1.72%, 0.90%, and 1.40%, respectively (p < 0.001, two-tail), and ^statistics for the associated regression coefficients of 6.68, 4.85, and 6.04, respectively {p < 0.001, two-tail).
Figure 1 indicates that over much of the CS/range, average 1996 retention was increasing in 1995 CSI. For example, a customer with a CSI of
30 in 1995 (on a 0 [least satisfied customer] to 100 [most satisfied customer] scale) had a 64% retention rate, while a customer with a CSI of
60 had a 75% retention rate. The plot shows a distinct increase in retention at a CSI of about 67, while scores above 70 produced no increase in
retention rates. Over 25% of customers were above this score, which
suggests that investments to increase the satisfaction of a large proportion of the customer base would yield little change in retention.
The revenue levels function in figure 2 shows a nearly linear relation
between 1995 CS/and 1996 revenue. A movement in CS/from 40 to 60,
each observation, the supersmoother procedure estimates a linear regression using data on each side of that point (i.e., ft-nearest neighbors). The smoothed value is estimated using the regression coefficients and the actual x value for the observation. The size
of the span (i.e., k) is selected using a complex cross-validation technique that minimizes
the mean square error between actual y and the smoothed value of y. See S-Plus [1991, 1840-18-44] for additional details.
^The plots in figures 13 do not control for AGE and SIZE. Plots using residuals from
regressions of the three dependent variables on AGE and SIZE had very similar shapes.

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

0.8

>
0.75

0.7

./

0.65

0.6

0.55
20

40

60

80

100

Customer Satisfaction Index in 1995

FIG. 1.Retention analysis for business customers of a major telecommunications firm
(n = 2,491). The nonlinear function linking retention to satisfaction is developed using additive nonparametric regression using variance stabilization. The nonlinear transformations
of the variables (selected using the supersmoother procedure, where the span is chosen
using local cross-validation) are selected to maximize the correlation between the transformed criterion and predictor variables such that the residual variance of the transformed
criterion variance is constant. Figure 1 plots the value of retention predicted using the optimal nonlinear transformation of customer satisfaction versus actual customer satisfaction. A
customer in 1995 is defined as retained if that customer also purchased the service in 1996.

for example, increased predicted customer revenue by roughly $400 per

year. Like the retention results, the revenue function also shows a distinct "step" at a CSI of about 70. Because this service can be purchased
in several difFerent "sizes," the revenue step suggests that this CSI threshold explains customer moves to a larger service offering. In contrast to
retention rates, predicted revenue levels continued to increase until CSI
was maximized at 100, although the predicted revenue difference became progressively smaller. For example, a six-point CSI difference was
associated with a predicted revenue difference of $74.80 per year when
moving from a CSI score of 88 to 92, $37.52 from 92 to 96, and $25.81
from 96 to 100.
Figure 3 displays the function linking revenue changes to the previous
year's CSI. Predicted revenue changes are negative throughout the range
of CSI scores, because of the loss of existing customers (which was more
than offset by the addition of new customers) at all satisfaction levels,
with the negative values driven by the -100% change in revenue assigned

10

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

3000

2800

2600
^^

2400
i

"o
O 2200
2000

u.

.z'

1800
1600

a 1400

:
a. 1200

>
^'

1000
20

40

60

80

100

Customer Satisfaction index in 1995

FIG. 2.Revenue analysis for business customers of a major telecommunications firm
(re = 2,491). The nonlinear function linking revenue dollars to satisfaction is developed
using additive nonparametric regression using variance stabilization. The nonlinear transformations of the variables (selected using the supersmoother procedure, where the span is
chosen using local cross-validation) are selected to maximize the correlation between the
transformed criterion and predictor variables such that the residual variance of the transformed criterion variance is constant. Figure 2 plots the value of revenue predicted using
the optimal nonlinear transformation of customer satisfaction versus actual customer satisfaction. The 1996 revenue for customers that were not retained is set equal to zero.

to lost customers.'*^ The predicted revenue change increased until CSI

reached approximately 80, indicating that average revenue reductions
for current customers declined as satisfaction increased. However, consistent with the retention function, revenue changes generally stopped
'" Overall, the firm experienced a 13% increase in customers and a 19% increase in total
revenues between 1995 and 1996. Revenue growth for the retained customers in our sample ranged from -97.6% to 500.0% (mean = 7.5%, median = 4.2%). We do not restrict the
revenue levels and change tests to retained customers to avoid selection biases. However,
when we repeated the linear and nonparametric regressions using only retained customers,
CSI was positive and significant {p < 0.10, two-tail) in both the revenue level and revenue
change models. The shape of the estimated revenue function from the nonparametric
regression was very similar to the plot in figure 2 and again exhibited steadily declining
differences in revenues at high satisfaction levels. In the revenue change plots, revenues increased until a satisfaction score of 45 was reached, after which there was almost no change
in revenues until CSI = 80. Revenue then continued to grow almost linearly between CSI
scores between 80 and 100. These results indicate that highly satisfied customers, if they
were retained, purchased more of the service in the future.

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

11

3-0.15 -

0.2

(u-0.25
u

(0

O -0.3
-0.35
-0.4
! r"

2-0.45
20

40

60

80

100

Customer Satisfaction Index in 1995

FIG. 3.Revenue change analysis for business customers of a major telecommunications
firm (n = 2,491). The nonlinear function linking revenue change to satisfaction is developed using additive nonparametric regression using variance stabilization. The nonlinear
transformations of the variables (selected using the supersmoother procedure, where the
span is chosen using local cross-validation) are selected to maximize the correlation between the transformed criterion and predictor variables such that the residual variance of
the transformed criterion variance is constant. Figure 3 plots the value of revenue change
predicted using the optimal nonlinear transformation of customer satisfaction versus actual
customer satisfaction. Revenue change is defined as 1996 revenues divided by 1995 revenues minus one. Customers that were not retained are assigned a revenue change of-1.0.

above this score, indicating that on average increasing the CSI of current customers above 80 did not produce greater revenue changes after
taking lost customers into account.
Further evidence is provided in table 2. Rather than using nonlinear
estimation techniques, we form ten portfolios based on the customers'
CSI and then compare mean retention, revenue levels, and revenue
changes for each decile using general linear model {CLM) methods. This
portfolio approach makes no assumptions about the functional form underlying the associations. Instead, CLM conducts an analysis-of-variance
test of differences in means across portfolios, after controlling for SIZE
and ACE. Least squares means, which represent the means for each performance measure after controlling for the two covariates, can then be
compared to assess whether mean performance was statistically different
across the deciles.
The GLM results suggest that the relation between CS/and retention is
characterized by several customer satisfaction "thresholds" that must be

12

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

TABLE 2
Least Squares Means from General Linear Model (GLM) Estimates ofthe Association between
Portfolios Formed on the Basis of Customer-Level Satisfaction Levels and Subsequent Customer
Retention and Revenue Change far 2,491 Business Customers of a Telecommunications Firm
Dependent Variable ^
Decile
1
2
3
4
5
6
7
8
9
10

Mean 1995
Customer Satisfaction

Mean 1996
Retention

Mean 1996
Revenue

Mean 1996
Revenue Change

14.20
38.94
47.99
55.81
64.44
69.63
76.26
81.35
88.23
98.30

0.60
1393.23
-0.38
0.701
1714.55
-0.271
0.701
1548.02
-0.231
0.721
2266.75'-3
-0.211
0.741
2238.761
-0.201
2477.071-3
-0.121-5
0.811-5
2250.801-3
-0.181-2
0.781-"
0.771-2
2291.111-3
-0.201
0.78'-"
3I88.141-8
-0.141-2
2776.811-3
-0.141-2
O.771-"
0.024
0.051
0.015
F-Statistic for CS/Effect
4.74***
3.14***
3.84***
/^-Statistic for Model
5.61***
12.18***
3.44***
*** Statistically significant at the 1% level (two-tail).
''The reported least squares means for each dependent variable represent the means for each category after controlling for the customers' size (revenues) and years in business. The coefficients on the
two control variables are not reported to simplify presentation. Customer retention and revenue change
were measured between 1995 and 1996, customer satisfaction (CS/) in 1995, and revenue levels from
customers in 1996. Superscripted numbers next to the least squares means indicate that the mean is
significantly larger (p < 0.15, two-tail) than the mean for the indicated decile (e.g., a superscripted 1
indicates that the mean is significantly larger than the mean for decile 1).

reached before retention increases. The lowest retention rates (60%) are
found in the bottom decile of C5/scores. Deciles 2-5 have higher retention {p < 0.15, two-tail) than decile 1 (70%-74%), but mean retention
rates within these four deciles are not statistically different. Mean retention increases to 81% in decile 6, significantly higher than retention in
deciles 1-5. Retention rates in deciles 7-10 (the highest CSI scores)
range from 77%-78%. These rates are larger than those in deciles 1-4
in most cases {p < 0.15, two-tail) but are not statistically different from
each other or from the 81% retention rate in decile 6. The statistically
equivalent results in the upper deciles contradict claims that customer
retention is maximized when satisfaction scores are at their highest levels
(e.g., Jones and Sasser [1995]).
Revenue levels also exhibit a series of satisfaction "thresholds." The
lowest mean revenue levels ($1393.23) are found in the bottom decile
of CSI scores. Revenue is marginally higher but statistically similar in
deciles 2 and 3 ($1714.55 and $1548.02, respectively). Mean customer
revenue increased to $2266.73 in decile 4 (/> < 0.15, two-tail) and remained close to this level through decile 8. In decile 9, mean revenue
peaked at $3188.14, greater than revenues in the lower eight deciles
(p < 0.15, two tail). Mean revenue levels in decile 10 ($2776.81) were
lower than (but statistically similar to) those in decile 9 but were not statistically greater than mean revenues in deciles 4-8.

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

13

Similar to the retention and revenue results, revenue changes were

lowest in the bottom decile of CSI scores (-38%). Revenue changes were
larger in deciles 2-5 than in decile I {p < 0.15, two tail), but revenue
changes in these deciles were not statistically different from one another.
Revenue changes increased significantly in decile 6 (-12%). Results are
mixed in the remaining deciles, ranging from -20% in decile 8 to -14%
in deciles 9 and 10. In most cases, revenue changes in the top four deciles
are significantly larger than in deciles 1 and 2, but revenue changes in
deciles 7-10 are not statistically different from one another.^
While the customer-level results generally support claims that customer
satisfaction measures are leading indicators of customer purchase behavior, the evidence also indicates that the retention and revenue growth
benefits from improved customer satisfaction diminished at higher satisfaction levels. Finally, the GLM tests provide some evidence of customer
satisfaction "thresholds" that must be reached before customers change
their purchase behavior.
One potential explanation for the customer-level results is the firm's
use of Partial Least Squares (PLS) to compute its satisfaction measure.
Some marketing researchers claim that customer satisfaction measures
computed using PLS have superior measurement properties relative to
the satisfaction measures used by most firms (Fornell [1992] and Fornell
et al. [1996]). To provide some evidence on the relative ability of alternative satisfaction measures to explain customer behavior in this firm, we
examine six additional customer satisfaction measures commonly used in
practice. "Top box" represents customers answering in the "top box" of
the scale for a single question on their satisfaction with the service (e.g.,
a response of 5 on a 1-5 scale, where 5 = very satisfied). Since this firm
uses a ten-point scale in its satisfaction survey rather than the more common five-point scale (Ryan, Buzas, and Ramaswamy [1995]), we code "top
box" 1 if the customer answered 9 or 10 to a question on their overall satisfaction with the service (from 1 = not at all satisfied to 10 = extremely
satisfied), and 0 otherwise. Similarly, "top-two box" is coded 1 if the customer answered 7 or above to the same question, and 0 otherwise. The
"secure customer index" {SCI), a measure of customer loyalty, is coded 1
if the customer answered 7 or above (on ten-point scales) to each of
three questions (overall satisfaction with the service [from 1 = not at
all satisfied to 10 = extremely satisfied], likelihood of recommendation
" CLM tests using only retained customers found the lowest revenue change in the
bottom-two deciles (3.4% and 4.7%, respectively) and the highest change in deciles 9 and
10 (11.0% in each), with the rates in the two groups significantly different (p < 0.15, two
tail). However, revenue changes in deciles 1, 2, 9, and 10 were not statistically different
than those deciles 3-8. CLM revenue tests using retained customers found somewhat
lower revenue levels in decile 10 ($3544.75) than in decile 9 ($4140.37), though the figures
were not statistically different. Mean revenues in decile 9 were significantly greater than
those in deciles 1-8, while mean revenues in decile 10 were only statistically larger than
those in deciles 1-3.

14

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

[from 1 = not recommend to 10 = strongly recommend], and expected

retention [from 1 = not at all likely to 10 = extremely likely]), and 0 otherwise.^^ "Equally weighted" is the equally weighted standardized response to these three questions. "First principal component" is the first
principal component factor score for the three questions. Finally, "single
question" is the customer's response to a single question on their overall
satisfaction with the service (from 1 = not at all satisfied to 10 = extremely
satisfied).
The linear regression results in table 3 indicate that the choice of customer satisfaction measures has little effect on the significance of the
customer satisfaction coefficients or the explanatory power of the models. Despite the use of PLS estimation methods, the firm's CS/measure
explains future customer purchase behavior no better than the simpler
methods used by most firms. Thus, the customer-level results do not
appear to be driven by the firm's customer satisfaction measurement
methodology.

4. Business-Unit Analyses
Although the customer-level tests indicate that customer satisfaction
measures predict subsequent purchase behavior of existing customers,
they provide no evidence on the costs or profits associated with higher
satisfaction levels, the effects of customer satisfaction on growth in new
customers, or the extent to which organization-level customer satisfaction indexes, which are typically based on aggregated survey responses
from a relatively small sample of customers, are leading indicators of
financial performance. We therefore extend the analyses to examine the
extent to which business-unit customer satisfaction measures predict future accounting performance and number of customers.
We conduct these tests using data from 73 retail branch banks from
the western U.S. region of a leading financial services provider.^^ The
bank is a relative newcomer to this region and faces considerable competition. To achieve its strategic goal of gaining substantial worldwide
growth in customers, the firm has made customer satisfaction one of five
corporate "imperatives" (along with achieving financial results, managing costs strategically, managing risk, and having the right people in the
right jobs) incorporated in its "balanced scorecard" performance measurement system. Customer satisfaction scores form a major component
of quarterly performance evaluations and bonuses for branch-level managers and above.
'2 The "secure customer index" and SCI are registered trademarks of Burke Customer
Satisfaction Associates.
'After deleting "outliers" (i.e., observations with studentized residuals greater than an
absolute value of three in the regression analyses), the number of observations in our tests
ranges from 71 to 72.

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

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16

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

The firm computes quarterly customer satisfaction measures based on

the average of three monthly surveys of 25 retail customers per branch.
The customer satisfaction index {CSI) is a composite of 20 items. Scores
for each of the items equal the percentage of customers responding in
the "top-two boxes" of the question's scale (i.e., 6 or 7, where scores range
from 1 = not satisfied to 7 = very satisfied). The most heavily weighted
item (45%) asks customers to rate "the overall quality of [the branch's]
service against your expectations." The remaining items include the quality of tellers versus expectations (7.5%), six additional items concerning tellers (7.5%), six items concerning nonteller employees (7.5%), the
quality of automated teller machines (ATMs) versus expectations (7.5%),
three additional items concerning ATMs (7.5%), and one item measuring problem incidence (10%). In the second quarter of 1996, branch
satisfaction scores ranged from 43 to 70 (mean = 57.2, median = 58)
on a scale from 0 (no top-two box responses) to 100 (all top-two box
responses).
The firm provided customer satisfaction and accounting data for the
third quarter of 1995 through the second quarter of 1996. Although this
time period is short, the frequent repurchase cycle and relatively low
customer switching costs in retail banking imply short lags between a
customer's experience and observed changes in purchase laehavior and
economic performance. We examine six performance variables: revenues {REV), expenses {EXP), margins {MAR), return on sales {ROS), retail customers {RETAIL), and business and professional customers {B&fP).
Margins are defined as revenues minus expenses, and return on sales as
margins divided by revenues. We estimate three basic models:
PERFit.,1 = a + PiCS/j ( + Pg PASTPERFit +
= a

P i i t

^^

+ P4%AB6'P,-j^i + 8,-

=a

p%ACSI
1 + ,-,+ 1

where PERF is either revenues, expenses, margins, return on sales, retail

customers, or business and professional customers, CSI is the branch's
customer satisfaction index, PAST PERF is the dependent variable's
value in the prior period, t denotes the third and fourth quarters of 1995,
and t + 1 denotes the first and second quarters of 1996. Averages over
these quarters are used for levels variable, and percentage changes between the quarters for change variables. To control for other factors that
may influence accounting performance (e.g., product mix, demographics, regional growth rates, etc.), we include RETAIL and B&P when the
four accounting measures are dependent variables, and we include PAST
PERF, both to control for time-series trends and to examine whether CSI
provided incremental information on future performance.

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

17

To assess whether branches with higher satisfaction levels have more

customers and more revenues per customer, we examine the association
between CSI levels in the third and fourth quarters of 1995 and accounting and customer levels in the following quarters (table 4, panel A). CSI
has a stadstically positive association with revenues (p < 0.05, two-tail)
and the number of business and professional customers (p < 0.10, twotail), after controlling for performance in the prior period. Since the
revenue model controls for the number of customers, these results
indicate that, on average, branches with higher satisfaction scores had
higher revenue per customer. However, CSI is not statistically associated
with expenses, margins, ROS, or retail customers.^* The number of B&P
customers in the first and second quarters of 1996, in turn, is positively
associated with revenues, expenses, and margins {p < 0.10, two-tail) and
with ROS {p < 0.15, two-tail). This evidence suggests that higher customer satisfaction levels have an indirect effect on accounting performance by attracting new customers, one of the bank's strategic goals.
The efFects of CSI levels on subsequent percentage changes in performance are reported in panel B of table 4. Like the customer-level
tests, this model examines whether branches with higher satisfaction
levels experienced greater improvement in accounting performance and
customer growth. Customer satisfaction levels are positively related to
subsequent percentage changes in margins and ROS {p < 0.10, two-tail),
after controlling for prior changes in margins and returns, implying
that branches with higher satisfaction levels increased future profits at
a greater rate than other branches. Percentage changes in retail customers also exhibit a positive association with changes in each of the
accounting measures, while business and professional customers are positively associated with changes in revenues and negatively associated with
changes in expenses. However, CSI levels are not statistically related to
subsequent growth in either customer group. Finally, the coefficients on
PAST PERF are negative in each of the financial performance models,
suggesting mean reversion in accounting performance.
Results using percentage changes in CS/are presented in panel C of table
4. Customer satisfaction changes exhibit no significant direct effect on
subsequent changes in revenues, margins, or ROS. However, CS/changes
are positively associated with future changes in retail customers, and
retail customer changes are positively related to changes in revenues
and margins. Similar to the levels tests in panel A of table 4, CSI changes
appear to have an indirect effect on accounting performance through
growth in customers. Consistent with this interpretation, percentage
changes in CSI are positively associated with changes in revenues and

''' The insignificant results for these variables are not due to the inclusion of past performance in the models. In fact, none of the CSI coefficients was significant when past
performance was not in the model.

TABLE 4
OLS Regressions Examining the Association between Customer Satisfaction Scores and
Subsequent Accounting Performance and Customers for 7B Retail Branch Banks'
(t-Statistics in Parentheses)

Panel A: Perfonnance Levels on Customer Satisfaction Levels in Prior Period

Dependent Variables''
RETAIL
MAR
ROS
EXP
REV
0.074
91.978
-33.453
-25.42
Intercept
-73.985
(0.70)
(0.67)
(-0.42)
(-0.92)
(-1.42)
CSI

2.089**
(2.35)

0.731
(1.20)

0.714
(0.49)

PASTPERF

1.178***
(21.82)

0.998***
(14.19)

1.058***
(13.98)

RETAIL

-0.046***
(-5.05)

0.009**
(2.20)

-0.037***
(-3.32)

0.114*
(1.83)

0.097**
(2.47)

0.370***
(3.86)

0.97
482.20***

0.87
128.83***

B&P

Adjusted R^
F-Statistic

0.91
191.59***

-0.001
(-0.55)

0.929
(0.42)

B&fP

-22.425
(-1.40)
0.489*
(1.78)

0.953***
(79.38)

1.056***
(42.46)

0.0002*
(1.65)

0.68
40.27***

0.98
3165.07***

0.96
906.26***

0.874***
(9.47)
-0.000
(-0.91)

Panel B: Percentage Changes in Performance on Customer Satisfaction Levels in Prior Period

Dependent Variables''
%ARETAIL
foAB&P
%AMAR
%AROS
%AEXP
%AREV
0.024
-0.098
-0.454
-0.406*
0.157
-0.520
Intercept
(0.69)
(-0.68)
(-1.70)
(1.54)
(-0.37)
(-1.22)
CSI

%APASTPERF

0.002
(1.16)
-0.376***
(-2.93)

-0.002
(-1.32)
-0.042
(-0.64)

0.012*
(1.86)
-0.245
(-1.37)

0.009***
(2.18)
-0.187
(-1.39)

-0.001
(-1.17)

0.001
(0.39)

0.518***
(8.29)

0.200*
(1.48)

%&RETAIL

0.972***
(3.97)

0.975**
(5.47)

1.713***
(2.69)

0.802*
(1.96)

%AB&'P

0.272*
(2.48)

-0.152*
(1.83)

0.414
(1.37)

0.201
(1.03)

Adjusted R^
f-Statistic

0.52
9.11***

0.30
8.84***

0.16
4.23***

0.11
3.10***

0.49
34.39***

0.01
1.23

Panel C: Percentage Changes in Performance on Percentage Changes in (Gustomer Satisfaction

Dependent Variables
%ARETAIL
%AB&P
%AROS
%AEXP
%AMAR
%AREV
-0.042**
0.225***
0.109***
-0.021***
0.027***
0.110***
Intercept
(-2.64)
(4.57)
(-5.73)
(6.13)
(2.70)
(7.28)
%ACSI
%&PASTPERF

0.130
(1.22)

-0.074
(-0.99)

0.293
(1.07)

0.073
(0.41)

0.080***
(2.74)

0.000
(0.00)

-0.324**
(-2.48)

-0.037
(-0.56)

-0.139
(-0.78)

-0.130
(-0.95)

0.495***
(6.42)

0.205*
(1.50)

1.28*
(1.91)

0.600
(1.37)

0.439
(1.43)

0.217
(1.07)

0.05
1.83*

0.45
29.64***

%ARETAIL

0.849***
(3.13)

%AB&P

0.256**
(2.19)

Adjusted R^
F-Statistic

0.29
8.41***

1.062***
(5.69)
-0.149*
(-1.85)
0.30
8.56***

0.13
3.54**

0.00
1.15

***, **. *. * Statistically significant at the 1%, 5%, 10%, and 15% levels (two-tail), respectively.
'Outliers are deleted from the models. The resulting sample sizes range from 71 to 72.
''REV= revenues, EXP = expenses, MAR = margins (revenues- expenses), ROS = return on sales (margin/sales),
RETAIL = the number of retail customers, B&T = the number of business and professional customers, CSI = the customer satisfaction index, and PAST PERF = the level or percentage change in the dependent variable in the prior
period. Percentage changes in CS/and past performance are measured between the third and fourth quarters of 1995. All
other percentage changes are measured between the first and second quarters of 1996. Customer satisfaction and prior
performance levels ate the averages for the third and fourth quarters of 1995. All other levels variables are the averages
for the first and second quarters of 1996.

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

19

margins {p < 0.10, two-tail) when retail and 56^customers are excluded
from the model (not reported).
Because the small sample size prevents us from estimating the nonparametric regressions used in the customer-level tests, we examine
potential nonlinearities by forming quartiles based on CSI levels or percentage changes in CSI}^ GLM then is used to test for differences in
mean performance changes across quartiles, after controlling for the
covariates. GLM tests of the associations between performance levels and
CSI levels, provided in panel A of table 5, indicate that revenues are
higher in the top quartile of CSI scores than in the lower three quartiles
{p < 0.15, two-tail). Margins are also larger in quartile 4, but significandy so only relative to quartile 3. Branches in the top quartile of CSI
scores also exhibit greater expenses and more retail and B(fP customers, but the differences are not statistically significant at the 0.15 level
(two-tail).
The GLM tests in panel B of table 5 examine the association between
percentage performance changes and quartiles based on CSI levels. The
smallest accounting changes are found in branches with the lowest satisfaction levels (quartile 1). Mean changes in revenues, margins, and
ROS are not statistically different from zero in this group and all are
significantly lower than means in the other quartiles {p < 0.15, two-tail).
Although the least squares means for quartiles 2-4 are significantly
larger than those in quartile 1, the performance changes in these three
groups are not statistically different from one another. Changes in expenses were statistically lower in branches in the top quartile of CSI scores
than in the bottom quartile (-1.3% in quartile 4 vs. 2.6% in quartile 1).
Percentage changes in retail customers were significantly higher in the
third quartile (1.8%) than in the first quartile (0.5%) but fell slightly
(though insignificantly) to 1.5% in quartile 4. Changes in B&'P customers were negative in every quartile except the fourth, but the differences
were significant {p < 0.15, two-tail) only between quartile 2 (-5.7%) and
quartile 4 (0.5%).
Results using percentage changes in C5/ (table 5, panel C) indicate that accounting improvement rates were not significantly different until branch
CSI changes ranked in the top quartile. Quartile 4 reported significantly
greater improvement in revenues than quartile 1 (12.1% vs. 8.3%), in
margins than quartiles 2 and 3 (28.2% vs. 15.9% and 11.0%, respectively),
and in ROS than quartile 3 (12.7% vs. 3.8%). None of the other comparisons of quartile means is statistically significant. The top-two quartiles
alternative methods for examining nonlinearities in a sample of this size are the
introduction of squared terms for C5/or the use of interactions between C5/levels and CSI
changes (e.g., if the changes term was statistically positive and the interaction term was
statistically negative, the results would suggest that the effect of CS/changes is contingent
on the branch's CS/level). However, when we attempted to implement these approaches
using the branch data, we encountered serious levels of multicollinearity, with correlations
between the independent variables exceeding 0.90.

20

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

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NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

21

both experienced significantly lower retail customer losses than quartile

1, but CSI changes were not statistically associated with percentage
changes in B&P customers. In general, the change tests in panel C sugr
gest that relatively large increases in customer satisfaction were necessary
to improve performance.
The business-unit results indicate that satisfaction measures computed
using aggregated responses from a small sample of customers have some
predictive ability for future accounting performance. However, many of
the accounting gains appear to come indirectly through growth in new
customers, rather than direcdy through increased profits from existing
customers. There also appear to be customer satisfaction "thresholds" that
must be reached before branch performance improves. We find no evidence that branches with higher satisfaction scores had greater expenses,
and some evidence that the highest-rated branches were able to control
costs better than low-rated branches in subsequent quarters. Finally, portfolio tests using CSI changes indicate that fairly large improvements in
customer satisfaction were necessary to produce significant changes in
the number of customers or accounting performance.

5. Firm-Level Analyses
Although the preceding tests provide qualified support for claims that
customer satisfaction measures are leading indicators of financial performance, they provide no evidence on whether the stock market views
customer satisfaction as a forward-looking performance indicator. We
provide evidence on this issue usingfirm-leveldata from the American
Customer Satisfaction Index (ACSI), a national economic indicator of
customer satisfaction managed by the National Quality Research Center
at the University of Michigan Business School and the American Society
for Quality. Each firm's customer satisfaction score is estimated using
telephone survey data obtained from several hundred consumers who
purchased or used the company's product within the past six months.
ACS/scores are based on 15 questions rated on ten-point scales. The
questions are formed into four latent variables (perceived quality, customer expectations, perceived value, and customer satisfaction) that are
linked in a causal model to two latent variables for expected outcomes
(self-reported customer complaints and customer loyalty). The customer
satisfaction construct (i.e., the ACSI) is a combination of three questions
(overall satisfaction, confirmation of expectations, and comparison to
ideal) weighted using Partial Least Squares {PLS) such that their linear
combination is maximally correlated with the customer complaint and
customer loyalty constructs. The scores for individual customers are rescaled to range from 0 (least satisfied) to 100 (most satisfied). Firm-level
ACS/scores represent average scores for customers using the firm's products. Additional details are provided in National Quality Research Center [1995] and Fornell et al. [1996].

22

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

The ACSI scores are based on a uniform measurement methodology

and represent independent assessments by an external organization. In
addition, the sample is not biased toward a self-selected group of companies that voluntarily disclose customer satisfaction measures. However,
the ACSI's minimum sample size requirements and random sampling
techniques constrain the sample to very large firms with substantial
market share (mean [median] market value of equity = $12,528 [$7,283]
million). The survey also focuses on consumer products and ignores customers' satisfaction with commercial products (i.e., business-to-business
products). The ACSI may also provide noisy measures for diversified
consumer products firms, which can be represented in only one product
category (such as Proctor 8c Gamble, included only in the "Personal Care
and Cleaning" category) or which can receive scores in multiple categories (PepsiCo appeared in the "Soft Drinks" category and three times in
the "Restaurants-Fast Food-Carry Out" category for KFC, Pizza Hut, and
Taco Bell).^^ This measurement error will cause estimates of the coefficients linking ylCS/scores to firm performance to be inconsistent.
5.1 VALUE RELEVANCE OF CUSTOMER SATISFACTION MEASURES

ACSI scores for individual firms were released publicly for the first
time in the December 11, 1995 issue of Fortune (Fierman [1995]). The
article provided scores from the initial 1994 ACSI survey, as well as updated 1995 scores computed 3, 6, 9, or 12 months after the initial ACSI
measurement (the timing varied by industry).^' The Fortune article reported 1994 ACSI scores for 138 firms and 1995 scores for 140 firms,
with the scores ranging from 63 to 90 (mean = 78).
We examine the extent to which the ACSI scores are associated with
the market value of equity, after controlling for information contained
in contemporaneous accounting book values, using a cross-sectional valuation model of the form:
i = Po + Pi ASSETSi + Pg LIABi + P3 ACSIi + e,,

where MVEj is the market value of equity for firm i, ASSETS^ is the book
value of assets, LIAB^ is the book value of liabilities, ACS/j is the satisfaction score, and e, is random error (e.g.. Landsman [1986] and Barth
and McNichols [1994]). Since data collection for the 1994 AC5/ended
on July 22, 1994, we use Compustat data for the fiscal year-end closest to
July 1994 to measure MVE, ASSETS, and LIAB when 1994 ACSI scores
are used in the model. Starting with the 1995 ACS/survey, different industrial sectors are measured during different calendar quarters, so we
'^When a firm is represented more than once in the ACSI, we use the average of the
multiple scores in our analyses.
I'The 1994 and 1995 ACS/scores have a correlation of 0.91. Consequently, we do not
conduct firm-level tests using changes in satisfaction scores.

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

23

TABLE 6
OLS Regressions Examining the Association between the Market Value of Equity and the American
Customer Satisfaction Index (ACSI) Scores' Published in Fortune
(t-statistics in parentheses)

Intercept
ASSETS
LIAB
ACSI

Adjusted R'^
i^-Statistic
n

1994 ACSI Scores

1995 ACSI Scores

-16775.01***
(-2.23)
1.73***
(16.95)
-1.77***
(-15.89)
243.20***
(2.53)
0.74
126.16***

-16917.10**
(-2.21)
2.19***
(18.22)
-2.25***
(-17.13)
235.67**
(2.39)
0.77
149.20***

121
124
***, **, * Statistically significant at the 1%, 5%, and 10% levels (two-tail), respectively.
"The dependent variable in the models is the market value of equity for the fiscal year-end closest
to the month the ACS/scores were collected. ASSETS is the book value of assets, IJAB is the book value
of liabilities, and ACSI is the customer satisfaction score. Outliers and firms without complete IIBIEIS,
CRSP, and Compustat data were deleted from the sample.

use Compustat data for the fiscal year-end closest to the month of data
collection for MVE, ASSETS, and LIABin analyses of 1995 scores. Incremental value relevance of the ACS/implies Pg > 0.
Our goal is to determine whether an aggregate nonfinancial measure,
such as customer satisfaction, provides incremental information for explaining differences in the market value of equity, after controlling for
balance sheet information. We use an aggregate customer satisfaction
measure, rather than individual determinants or drivers of customer satisfaction, because firms use similar measures for decision making and
performance evaluation. Moreover, extending the analysis to individual
perceptual drivers of customer satisfaction is not feasible with the ACSI
because the necessary data are not available. We also ignore income statement accounts (e.g., advertising or marketing expenditures) in the crosssectional valuation model, even though these may affect the statistical
significance of customer satisfaction. Our objective is not to identify the
drivers of customer satisfaction but to determine whether this measure
provides incremental explanatory power in a traditional cross-sectional
valuation model.
Results from the valuation tests are provided in table 6.^^ The coefficients on v4CS/are positive and significant {p < 0.05, two-tail) using
either 1994 or 1995 scores, implying that customer satisfaction measures
(or information correlated with these measures) provide insight into
elimination of firms without complete data and the deletion of outliers reduce
the sample sizes to 121 using 1994 AC5/scores and 125 using 1995 scores. White's [1980]
test revealed no evidence of heteroscedasticity in any of the models.

24

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

firm value that is not reflected in current accounting book values.^^ The
coefficients on ACSI imply that a one-unit difference in the index was
associated with a difference in the market value of equity of between
$236 to $243 million, after controlling for accounting book values.
We augment the association tests reported in table 6 with analysis based
on the Edwards-Bell-Ohlson (EBO) or residual income valuation model
(e.g., Ohlson [1995] and Feltham and Ohlson [1995]) which maintains
that equity market value is a function of equity book value plus discounted
residual future earnings. The EBO model can be characterized as:
= Po + Pi ASSETSi + Pg LIABi + P3 EUTUREi + e^,

where MVE, ASSETS, and LIAB are defined above, and EUTUREi is * e
discounted value of future earnings in excess of a capital charge based
on the opportunity cost of capital for firm i. If current customer satisfaction levels are incorporated into forecasts of future cash flows, ACSI
should be positively associated with the variable EUTURE. We test this association using a variant of the forecasted residual earnings measure in
Frankel and Lee [1995]. The first available median consensus earnings
and long-term growth forecasts for years +1 and +2 (where the year of
ACSI computation is denoted year 0) are obtained from the IIBIEIS files.
Earnings forecasts for years +3 to +5 are computed by multiplying the
earnings forecast for the previous year by one plus the long-term growth
forecast. Capital charges are computed by multiplying the equity cost of
capital by book values at the end of the previous year. The equity cost
of capital is estimated using the systematic risk over year 0 (where the
market is approximated by the value-weighted daily CRSP index) and
the average risk-free rate (0.06) and market risk premium (0.074) provided by Ibbotson [1996]. The actual book value of equity for year 0 is
used to compute residual earnings for year +1. Book values for computing residual earnings in subsequent years are computed using the book
value calculated for the preceding year plus the preceding year's forecasted earnings multiplied by one minus the dividend payout rate (proxied by the average dividend payout over the five years ending in year 0).
Forecasted residual earnings are computed as the present value of the
five annual residual earnings forecasts (year +1 to year +5), discounted

provide further evidence on the value relevance of customer satisfaction measures, we repeated the analysis using two alternative measures of market value: the earnings-price ratio and the market-to-book ratio. Following prior studies of the determinants
of these ratios (e.g., Beaver and Morse [1978], Ohlson [1990], and Alford [1992]), we estimated earnings-to-price and market-to-book ratios as a function of systematic risk, dividend payout, median IIBIEIS consensus forecasts for long-term earnings, and the ACSI.
The coefficients on ACS/were positive and statistically significant (p < 0.10, two-tail), again
suggesting that customer satisfaction measures provide value-relevant information to the
market.

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

25

TABLE 7
OLS Regressions Examining Long-Term Forecasted Residual Earnings
as a Function of ACSI Scores and Current Earnings ^
(t-statistics in parentheses)

Intercept
ACSI
EARN

Adjusted R^
F-Statistic
n

1994 ACS/Scores
-3226.09*
(-1.96)
39.23*
(1.87)
1.41***
(13.68)
0.62
97.08***
121

1995 ACS/Scores
-4442.75**
(-2.49)
55.44**
(2.41)
1.49***
(14.23)
0.64
109.46***
125

**, **, * Statistically significant at the 1%, 5%, and 10% levels (two-tail), respectively.
' The dependent variable in the models is the discounted value of future earnings in excess of a capital charge reflecting the opportunity cost of capital for firm i, and is based on the median consensus
long-term growth and earnings forecasts in IIBIEIS. ACSI is the firm's customer satisfaction score, and
EARNis annual earnings for thefiscalyear-end closest to the month the ACS/scores were collected. Outliers and firms without complete IIBIEIS, CRSP, and Compustat data were deleted from the sample.

using the equity cost of capital. Residual earnings beyond year +5 (and
the terminal value) are assumed to be zero.^^
Results in table 7 indicate that ACSI measures are positively associated
with forecasted residual earnings. Even after controlling for current annual earnings, both 1994 and 1995 ACSI scores are predictors of analysts'
long-term forecasts of residual earnings {p < 0.10, two-tail). This evidence suggests that at least some of the expected benefits from customer
satisfaction are already impounded into earnings forecasts.
Similar to the approach used in the business-unit analyses, we test
for potential nonlinearities in the market's valuation of customer satisfaction by dividing the sample into quartiles based on the firms' ACSI
scores. A GLM model is estimated with the ACSI quartiles as predictor
variables and the book values of assets and liabilities as covariates. Results in table 8 indicate that the lowest mean market values (after controlling for book values) are found in quartile 1 (the lowest ACS/scores).
When the valuation model is estimated using 1994 data, quartiles 2-4
all have larger mean market values than quartile 1 {p < 0.15, two-tail).
However, mean values within these three quartiles are statistically equivalent. Similar results are obtained using 1995 data. This plateau in the
benefits from higher customer satisfaction levels is similar to the thresholds found in the branch bank and suggests there are diminishing returns at higher satisfaction levels.

adjusted I? for a base case model regressing market value of equity on book
values of assets and liabilities is 0.73 (0.77) using 1994 (1995) data. The addition of our
residual earnings variable increases the adjusted fC to 0.92 (0.94). Thus, our proxy for residual earnings appears to have some descriptive validity.

26

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

TABLE 8
Least Squares Means of Market Value from General Linear Model (GLM) Estimates of
the Firm-Level Associations between Portfolios Formed on the Basis of Customer
Satisfaction Scores Reported in Fortune and the Market Value of Equity'-

Quartile 1
(Mean CS/= 71.7/70.1)''
Quartile 2
(Mean CSI= 77.2/76.2)
Quartile 3
(Mean C5/= 81.2/80.3)
Quartile 4
(Mean CS/= 85.7/84.8)
Model i?2
f-Statistic
n

1994 Scores
8273.76

1995 Scores
10213.87

10939.28'

10367.86

12064.36'

12991.19''2

12153.57'

12153.57'

0.75
75.89***
121

0.78
90.07***
125

*** Statistically significant at the 1% level (two-tail).

'The least squares means represent mean market values for each quartile after setting the two covariates (book values of assets and liabilities) equal to their means. Outliers and firms without complete
data are deleted from the models. Superscripted numbers next to the quartile means indicate that the
figure is significantly larger {p < 0.10, one-tail) than the figure for the indicated quartile (e.g., a superscripted 1 indicates that the mean is significantly larger than the mean for quartile 1).
^The first figure is the quartile's mean 1994 ACSI score; the second figure is the mean 1995 ACSI
score.

5.2 INDUSTRY DIFFERENCES

The preceding tests assume that custotner satisfaction's effect on firm

value is similar across industries. However, Anderson, Fornell, and Rust
[1997] find significantly different contemporaneous associations between
customer satisfaction and accounting returns in different industries.
Based on these results, they predict that high customer satisfaction is associated with higher performance in manufacturing firms and in most
service businesses. However, in retailing, where customer satisfaction is
more dependent on providing customized services, high satisfaction may
be associated with lower accounting returns because of the high cost of
increased customization. Anderson, Fornell, and Rust [1997] also contend that customer satisfaction is less important in monopoly businesses
or in industries with high switching barriers, such as regulated utilities.
However, other authors note that utilities and telecommunications providers now realize the need to increase customer satisfaction as markets
are opened to competition (Bertrand [1989], Electric World [1994], and
Schlossberg [1993]).2'
We examine industry effects by estimating separate valuation models
for five industry categories with ten or more observations (nondurable
2' The increased emphasis on customer satisfaction in regulated industries is consistent
with research finding greater weight on nonfinancial measures such as customer satisfaction in utility and telecommunications executives' bonus contracts than in other industries (Bushman, Indjejikian, and Smith [1996] and Ittner, Larcker, and Rajan [1997]).

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

27

TABLE 9
OLS Regressions Examining the Association between the Market Value of
Equity and the 1995 ACSI Scores for Broad Industry Categories
(t-statistics in parentheses)

Nondurable Manufacturing

Intercept
-14045.66
(-0.87)

ASSETS
0.77*
(1.89)

UAB

0.55
(0.82)

ACSI
180.77
(0.90)

Adjusted
0.88**

42

Durable Manufacturing

14514.59
(0.36)

1.13***
(9.20)

-1.10***
(-7.95)

-128.22
(-0.26)

0.87***

18

Transportation, Utilities,
Communication

-35712.12**
(-2.83)

0.68*
(1.98)

-0.08
(-0.16)

451.53**
(2.71)

0.66***

40

Retail

-52956.32*
(-2.02)

1.93***
(4.13)

-1.58**
(-2.50)

-703.22*
(-1.99)

0.82***

18

Financial Services

-20750.92
(-1.14)

0.86***
(3.09)

-0.84**
(-2.80)

353.18
(1.43)

0.88***

10

***, , * Statistically significant at the 1%, 5%, and 10% levels (two-tail), respectively. See table 6 for variable
definitions.

manufacturing; durable manufacturing; transportation, utilities, and

communications; retail stores; and financial services).^2 Based on Anderson, Fornell, and Rust's [1997] predictions, we expect ACS/to be positively associated with market values in the manufacturing and financial
services industries and negatively associated with market values in retailers. We make no predictions about the expected associations in the
transportation, utilities, and communications groups.
Industry-specific tests using 1995 data are provided in table 9. Although the sample sizes are small, the evidence suggests that the value
relevance of customer satisfaction measures varies across industries. The
coefficients on ACSI are positive but statistically insignificant in durable and nondurable manufacturing firms, and are statistically positive
in transportation, utility, and communication firms. Coefficients on ACSI
in financial service firms are also positive but not statistically significant
(due in part to a sample size of only ten). In contrast, the negative association between ACSI and market value for retailers supports Anderson, Fornell, and Rust's [1997] claim that in retailing, the benefits from

22 The desirability of estimating industry-specific models is unclear. If customer satisfaction levels are a function of the level of competition in an industry, the effect of competition on customer satisfaction will be removed. This will tend to produce conservative
tests of the association between satisfaction levels and market value. In addition, the industry samples are limited to a relatively small number of large, surviving firms. If there is
little cross-sectional variation in customer satisfaction measures within these firms, we will
find little association between satisfaction and firm value, even if customer satisfaction is
important.

28

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

increased customer satisfaction can be exceeded by the incremental

cost.23
Differential industry efFects also emerge when we examine the two industries (food processing and utilities) with ten or more observations
(not reported). The coefficient on ACS/is positive for utilities and negative for food-processing firms {p < 0.15, two-tail). The negative result for
food processors may be due to the already high scores in this industry.
Moore [1997] argues that firms in industries with high customer satisfaction levels have less opportunity to use customer satisfaction to differentiate themselves from competitors. Consistent with this claim, the
highest-rated food-processing firms had the top satisfaction scores in
the ACSI survey, and the group as a whole was second only to the three
farms in the soft drink industry (mean ACS/score = 84 vs. 86). Utilities,
on the other hand, had some of the lowest satisfaction levels in the survey (mean = 74), potentially providing room to improve economic performance by enhancing customer satisfaction.
5.3 STOCK MARKET REACTIONS TO THE RELEASE OF THE ACSI

Results based on valuation tests indicate that customer satisfaction indicators can be incrementally value relevant to stock market participants but provide no evidence that the public release of customer satisfaction measures provides new (or incremental) information to the stock
market. We investigate the information content of customer satisfaction
measures by examining the stock market response to the initial disclosure of individual ACSI scores. Although the cover date for the Fortune
article was December 11, 1995, this issue was received by many American subscribers on November 27, 1995 and was loaded into Lexis/Nexis
on December 1, 1995.^^ Given the wide distribution period, we compute
cumulative abnormal stock market returns using two trading periods:
the five trading days from November 27, 1995 to December 1, 1995, and
the ten trading days from November 27, 1995 to December 8, 1995. Expected returns are computed using the market model:

where Rji = the return on the security of firm i in period time t, R^t the return on the market portfolio in period t (measured using the

2* When the industry models were estimated using 1994 data, the signs on ACS/did not
change from those using 1995 data and remained positive and significant for the transportation, utihties, and communications group. ACSI was also positive and significant in
financial services. However, the coefficients on ACSI, though still negative, were no longer
statistically significant in the retail group.
2*1996 ACS/scores for individual firms were released in the February 3, 1997 issue of
Fortune. However, the time period surrounding the distribution of this issue was confounded by earning announcements by most of the firms. As a result, we do not examine
the market's response to the release of the 1996 scores.

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

29

value-weighted index in CRSP); a, = the rate of return for firm i when

Rmt = 0; P, = the systematic risk for firm i; and 8,7 = the random error
for firm i in period t.
Market model parameters are computed using the 100 observations
preceding day -10 (i.e., day -110 to day -11). Abnormal returns for each
firm are estimated using the formula:
e,7 = ^it- a,-- ^iRmt

for -10<t< +10.

To be included in the final sample, each firm requires complete stock return data for the estimation and event periods and no significant confounding events from November 20, 1995 to December 18, 1995. These
requirements eliminate 28 firms.
We estimate the following cross-sectional regression of cumulative abnormal returns (CAR) following the release of the ACSI scores on the
firm's customer satisfaction index:
CARti = Po + Pi ACSIi + Ej,

where CARt, represents cumulative abnormal returns for firm i over the
five or ten days following the ACSI disclosure and ACSI, is the customer
satisfaction score published in Fortune. If the ACSI scores released in Fortune provided new, economically relevant information to the market, Pj
should be positive.^^
The results are reported in table 10.^6 Coefficients on ACSIzre positive
but insignificant whenfive-dayabnormal returns are examined (panel A);
however, ten-day abnormal returns are significantly related to both 1994
and 1995 ACS/scores (panel B).^' The coefficient on 1994 ACS/implies
that a five-unit difference in satisfaction (roughly one standard deviation

25 We do not have an expectations model for customer satisfaction. Consequently, our

models assume the market's ex ante beliefs were that customer satisfaction was the same
for all companies. We repeated the tests using changes in ACS/scores from 1994 to 1995.
AC5/changes were not statistically significant (p > 0.15, two-tail).
28 We also conducted the analysis using standardized cumulative returns, where the abnormal return for each firm is standardized using the estimated standard deviation of the
residuals from the market model and a factor reflecting the increase in variability due to
prediction outside the estimation period (Patell [1976]). The advantage of this approach
is that it controls for the likely cross-sectional differences in the distributions of stock
price return processes across the firms in our sample and should provide statistically wellspecified tests. The results using standardized returns were nearly identical to those in table 10.
2'One potential limitation with regressing cumulative abnormal returns on ACS/scores
is that the time period selected for computing the abnormal returns may coincide with
trends in firm-specific returns arising from factors other than ACSI disclosure. We therefore included an additional variable in the models representing cumulative abnormal returns over the five or ten days prior to the ACSI disclosure. The coefficient on ACSI
remained insignificant when examining five-day returns and significant when examining
ten-day returns.

30

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

TABLE 10
OLS Regressions Examining the Association between Cumulative Abnormal Retums at the Release of
the ACSI Scores in Fortune and the Firm's Customer Satisfaction Index "
(t-statistics in parentheses)

Intercept

ACSI

Adjusted R^

i^-Statistic

Panel A: Five-Day Abnormal Retums

1994 Scores

-0.050
(-1.05)

0.001
(1.08)

0.00

1.16

1995 Scores

-0.042
(-0.98)

0.001
(1.03)

0.00

1.05

Panel B: Ten-Day Abnormal Retums

1994 Scores

-0.123*
(-1.96)

0.002*
(1.97)

0.03

3.90*

1995 Scores

-0.102*
(-1.73)

0.001*
(1.76)

0.02

3.11*

'Statistically significant at the 10% level (two-tail).

"Outliers are deleted from the models. The resulting sample sizes range from 103 to 105. The
dependent variables in the models are cumulative abnormal returns following the initial public release
of the firms' ACSI scores. Cumulative abnormal returns are computed using the market model, with
the return on the market portfoho measured using the vahie-weighted index in CRSP. Five-day (tenday) returns are measured over the five (ten) trading days following the initial release of individual
ACS/scores in Fortune.

from its mean) was associated with a 1% increase in ten-day cumulative

ahnormal returns.^^
We investigate potential nonlinearities in the market's response to
ACSI disclosure by forming quartiles based on the firms' ACSI scores and
testing for differences in mean abnormal returns across the portfolios
using CLM. The quartiles are computed by assigning firms to portfolios
based on their 1994 or 1995 satisfaction scores. The 28 firms with confounding announcements during the event period or firms with missing
returns are then deleted. The resulting quartiles range in size from 24
to 33 observations.
The GLM results are presented in table 11. ACS/scores are significant
predictors of cumulative abnormal five-day returns using 1995 scores,
and of cumulative abnormal ten-day returns using scores from either
year (p < 0.15, two-tail). All four models exhibit negative CARs in quartile 1, with an average ten-day return in the 1994 (1995) model of -1.9%
(-0.5%). Least squares means are also negative in quartile 2 using 1995
scores, with an average ten-day return of -1.1%. With the exception of

^* We repeated the analyses in table 10 using broad industry groupings with ten or more
observations (manufacturing nondurables; manufacturing durables; transportation, utilities, and communications; and retail). Transportation, utility, and communications firms
had significant positive ACS/coefficients using ten-day returns and 1994 scores or five-day
returns and 1995 scores. In the two specific industries with ten or more observations, food
processors had statistically negative associations between satisfaction and market performance in all four models, while utilities had statistically positive ten-day returns using eiher ACSI score.

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

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32

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

ten-day returns using 1994 scores, mean CARs in the two bottom quartiles were statistically equivalent. The negative or insignificant returns
in these groups indicate that the market did not react favorably to the
disclosure of ACSI scores for firms with satisfaction scores below the
median.
The largest positive responses occurred in the top-two quartiles, providing some evidence that the market viewed higher satisfaction scores
as positive indicators of future cash flows. Least squares means in these
quartiles were significantly larger than means in the first quartile using
1994 scores, and significantly larger than means in the first and/or second quartiles using 1995 scores. The average ten-day abnormal return in
the models was 0.75% in quartile 3 and 1.075% in quartile 4. However,
the least squares means in the top-two quartiles were not statistically
different, providing further evidence that improving customer satisfaction beyond a certain point may yield little additional economic gain.
Overall, the results in tables 10 and 11 generally are consistent with
the release of ACSI scores providing new information to the stock market. While the survey and experimental results of Mavrinac and Seisfeld
[1997] indicated that institutional investors place little or no weight on
customer satisfaction measures when valuing firms, our valuation models and event study results provide some support for the hypothesis that
nonfinancial measures such as customer satisfaction affected the market's assessment of future cash flows.

6. Conclusion
This study contributes to a growing body of accounting research on the
predictive ability and value relevance of nonfinancial performance measures (e.g.. Amir and Lev [1996], Foster and Gupta [1997], Mavrinac
and Seisfeld [1997], and Banker, Potter, and Srinivasan [1998]). Using
customer and business-unit data, we find modest support for claims that
customer satisfaction measures are leading indicators of customer purchase behavior (retention, revenue, and revenue growth), growth in the
number of customers, and accounting performance (business-unit revenues, profit margins, and return on sales). We also find some evidence
that firm-level customer satisfaction measures can be economically relevant to the stock market but are not completely reflected in contemporaneous accounting book values.^^ However, some of the tests suggest
that customer behavior and financial results are relatively constant over
broad ranges of customer satisfaction, changing only after satisfaction
moves through various "threshold" values, and diminishing at high sat^ Compared to prior studies, an important difference in our firm-level tests is the analysis of the market's response to newly released measures (i.e., the American Customer Satisfaction Index) rather than to nonfinancial information that is not contained in financial
statements but is readily available to market participants (e.g.. Amir and Lev [1996]).

NONFINANCIAL MEASURES AS INDICATORS OF PERFORMANCE

33

isfaction levels. Taken together, our results offer qualified support for
recent moves to include customer satisfaction indicators in internal performance measurement systems and compensation plans (Kaplan and
Norton [1996] and Ittner, Larcker, and Rajan [1997]).
There are a number of limitations to our analyses. First, although customer satisfaction is a choice variable for firms, our tests assume that this
metric is exogenous. The issue of endogeneity is particularly problematic when assessing the relation between performance and customer satisfaction. If all firms optimally select customer satisfaction levels based on
exogenous factors, there should be no statistical relation between performance and customer satisfaction, after controlling for the exogenous determinants. We also assume that our results are due to nonoptimizing
behavior by firms rather than to model misspecification. Second, the
customer satisfaction measures in our tests, like all satisfaction measures
used in practice, have somewhat arbitrary measurement properties (e.g.,
weighted questionnaire scores are transformed to range between 0 and
100), as opposed to being measures with cardinal properties. The arbitrary nature of these measures makes it difficult to identify the function
linking customer satisfaction to customer behavior and organizational
performance. Third, customer satisfaction is likely to be measured with
error (e.g., the ACSI surveys only individual consumers and not business-to-business customers), causing a variety of well-known econometric problems. Fourth, the appropriate functional form linking customer
satisfaction to future customer behavior and financial performance is
unclear. Although we used several common models, we are uncertain
whether customer satisfaction is best measured in absolute or relative
terms, whether the variables in the models should be expressed in levels,
changes, or percentage changes, and what is the correct lag between customer satisfaction and performance. Finally, the low explanatory power
of our customer satisfaction measures precludes a strong substantive interpretation on the appropriate role of this measure in predicting accounting performance and explaining economic value.
Our analysis is also limited to customer satisfaction metrics; research
using a broader set of nonfinancial metrics may provide insight into the
modest ability of customer satisfaction measures to explain future accounting and stock market performance. In addition, future research
might probe the reasons for the differential results across industries.
For example, the competitive structure of an industry, customer switching barriers, the length of customer repurchase cycles, and other related
factors may help explain industry differences in customer satisfaction's
impact. Perhaps the most interesting extension would be a sophisticated
analysis of the negative relation between customer satisfaction and performance in selected industries. In particular, it would be useful to
determine whether these results are due to model misspecification or to
situations where firms in a given industry have "overinvested" in customer satisfaction.

34

CHRISTOPHER D. ITTNER AND DAVID F. LARCKER

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