From Customer Profit to Customer Value

Abstracts
This chapter provides a holistic view from customer profitability to customer value creation. In
particular, it discusses a fuller range of measures of these two dimensions and their use to monitor
corporate performance. Customer profit and customer value are two interrelated concepts, but
there exists priority conflict.
Traditional customer profitability is an accounting concept, with less contextual meaning in
financial value. A complete view from customer profit to customer value creation permits
management to manage the firm from these two dimensions and strike the balance between short-
term to long-term goals. Furthermore, this chapter discusses in a great length the concept of
customer lifetime value and the application of this concept to evaluate customer value contribution.
The customer lifetime value concept is particularly relevant in today’s e-business valuation. Their
use and implications are discussed.

5.1 Introduction
Chapter 4 has discussed the types of valuable customers that are treasured by firms. Of the services
provided to customers, firms want to obtain financial benefits from customers. This chapter will
discuss in detail what these financial benefits are and how firms should prioritize the financial
benefits. Firms analyze customers’ profitability. Customer profitability is simply an equation of
sales minus all costs of goods and cost-to-serve customers. The customer profit model is simple,
easy to understand, and compliant with accounting practices. However, firms are often misled by
its simplicity, and the numbers created by accounting rules may not be apt for evaluation of
business performance with customers.
The major pitfalls lie in its short-term nature, omission of cost offinancial capital, absence of risk
measure, and disconnection with corporate value. Simple customer profitability analysis provides
a snapshot of operating performance. It tells a truth but not the whole truth of customer profitability
in a broader sense – business performance able to deliver ultimate value creation to the corporation.
This is also the ultimate aim and strategic goal of a corporation. However, this simple short-term-
based profit analysis falls short of some major management concerns. An obsession with short-
term profits has problems in many ways. Management may be misguided by the customer profit
contribution. Management myopia aims to seek short-term profitability at the expense of
sustainable long-term value. Also, sale teams have no clue in knowing how their efforts are related
to corporate value creation which supposedly is the legitimate base to reward good performers.
Furthermore, management has no rule to decide whether to invest or not on customers from a long-
term perspective, having regard to the fact that investment in customer acquisition or retention has
long-term repercussions on customer value.
The objective of this chapter is to provide a holistic view from customer profitability to value
creation. In particular, the chapter will discuss a fuller range of dimensional measures and their
relationship to prevalent financial indicators currently employed by firms. Customer profit and
customer value are two interrelated concepts, but there exists priority conflict. Traditional
customer profitability is an accounting concept, which is different from financial value. A
complete view from customer profit to corporate value creation enables management appreciate
the links between profit and value and strike a balance between short-term and long-term goals.
This chapter will elaborate more fully all these financial measures.
5.2 An Overview of the Customer Performance Reporting Model
To provide a fuller meaning of the range of choices, Fig. 5.1 outlines major components of this
reporting model, its dimensional focuses, and the choices of measures. The upper layer indicates
key attributes of customer profitability. These are the key value drivers for profitability. Customer
profit and customer value will dissipate when firms’ competitive advantages no longer exist. Can
firms continue to deliver product with a stable quality service level or even an improved service
level as perceived by customers? Are the functionalities unique, similar, or inferior to competitors?
All these help firms get premium prices from customers due to product/service differentiation. Are
they making good cost-to-price performance? Is the volume large enough to enable them to obtain
good profits even at a lower price rate? We know that cost advantage is an effective pricing strategy
to gain both market shares and profit margins. Is customer relationship management (relationship
and trust) effective to secure long-term customers? These are the conditions to determine the level
of compatibility between the firm and customer demand requirements and therefore the ability to
secure premium profit.

With the coming of the big data era, the analysis provides a valuable guideline for customer
behaviors. The second layer of the diagram denotes different dimensions of financial measures.
They are operating performance, financial efficiency, and corporate value. Operating performance
dimension measures customer financial performance. Customer’s operating profit (COP) is the
result of sale revenue generated from customers, after deducting all costs associated with good
and services provided to the customers. Operating performance simply focuses on absolute profits,
without questioning the relative profitability of the same amount of financial asset for other
investment opportunities. Financial efficiency dimension mends this handicap. It asks how
efficient the company employs scarce financial assets to generate corporate earnings. Return on
assets (ROA) is a typical measure of this dimension. ROA evaluates the profit % on each dollar of
asset invested. With the same dollar denomination, it is easy to evaluate the relative profitability
of investment among all customer accounts. This is an improvement of operating performance
dimension. However, this is still not good enough. Both operating performance and financial
efficiency are annual basis measures, not going beyond the short-term timeframe into the long-
term goal of the firm – value growth. In addition, profit concept is derived from accounting rules,
which is different from the financial value concept addressing “cash basis.” This alternative
dimension must embed value component. Corporate value dimension addresses shareholder value
directly. It attempts to link customers’ sale transactions to the corporate value. With the inclusion
of “value creation” element in the evaluating and monitoring reporting system, management will
pay more attention toward value creation activities. Two financial measures spring out during
recent decades and are representations of corporate value dimension.
Economic value added (EVA) represents the short-term measure of shareholder value creation,
and customer lifetime value (CLV) reflects a long-term component” in the calculation and put
more emphasis on value creation. Therefore, they provide meaningful insights in customer
contribution toward corporate financial performance and its ultimate value growth. These four
measures are the spotlight in this chapter. COP, ROA, EVA, and CLV have different roles and
implications. The first three measures represent short-term goals, and the fourth one reflects the
long-term goal. I will explore and discuss what they are, how to use them, their implications on
firms, and their limitations in application. Building financial measure system based on various
perspectives of the reporting pillars helps the firm navigate its corporate value more effectively.

5.2.1 Customer Operating Profits, Return on Assets, and Economic Value Added
Let’s examine the equation of customer operation profit:
• Customer operating profit (COP) = sale revenue – cost of goods – MSDA COP is the result of
sale revenue generated from customers, after deducting all costs associated with goods (cost of
goods) and services (MSDA) provided to the customers. MSDA include expenses incurred for
marketing, service, delivery, and administrative activities I like to use the case BAX Container Ltd
(please read Case 12.2, Chap. 12) to compare these three measures. As shown in the customer
profitability statement (see Case 12.2, Chap. 12), Daxing’s gross margin was $2.2 M and
Everbright was $1.2 M. Also, Daxing’s OP was $0.92 M and Everbright was $0.54 M. Daxing
was better than Everbright both in gross margin (27.5% vs. 20%) and profit (11.5% vs. 9%).
Tentatively, the results from the operating performance dimension can be interpreted as follows:
• Daxing is better than Everbright in terms of higher operating incomes.
• New product is better than standard product in profit margin (each dealer only deals with a single
product for BAX). However, it is premature to conclude the profitability performance because the
amount of financial capital has not been considered in the equation. Operating profit analysis
cannot tell how efficient the financial resources are being employed.Remember that firms always
have financial resource constraints. They will not have unlimited funds to do whatever they like
to invest. They have funding costs (cost of capital). The efficiency of asset employment becomes
one of the important measures to compare with other alternative investments how efficient these
assets are to generate the return (i.e., operating profits). Return on assets (ROA) provides
comparison of financial efficiency on these two customers:

• Return on assets (ROA) = net operating profits/average asset employed ROA is interpreted as
customer profits (before tax) compared with the average amount of assets being employed for the
customer account. In this particular context, customer assets include net fixed assets (after
depreciation) and working capital to support specific customer demand requirements, special
testing equipment (fixed assets), and special inventory and receivables (working capital). Average
assets are referred to the average amount of asset holding between opening and closing of the
period (say if opening period is $10 M and closing period is $6 M, the average asset will be $8 M
over the period). High ROA means that higher profits are generated with the same amount of
resources. Low ROA means that the company is relatively poor in asset employment. ROA
distinguishes customers making good financial returns from customers not making good returns
based on the same assetemployment basis. After applying the average assets employed for Daxing
and Everbright, the conclusionsof their financial performance have changed. ROAs for the
respective customer show
• Daxing: $0.92 M/$(3 M + 4 M)/2 = 26.3%
• Everbright: $0.54 M/$2 M = 27%

Both firms gained similar financial efficiency. Everbright was slightly better thanDaxing (ROA,
27% vs. 26.3%). In fact, relative profitability gives the firm a direction of how to allocate resources
to customers on the relative profitability of the asset assets (i.e., higher ROAs). However, ROA
cannot measure whether corporate returns are adequate to reward the firm? Also, it remains silent
on whether customers are contributing shareholder value. Let’s apply economic value added
(EVA) to find out which customer has a better contribution in shareholder value:
• Economic value added (EVA) = NOPAT (after tax) – (net assets X cost of capital %) Economic
value added (EVA) is the extra monetary value (in terms of net operating profits after tax
(NOPAT)), after deducting the calculated cost of capital1 based on net assets. Net assets are
defined as net fixed assets (net of depreciation) plus current assets (e.g., inventory or receivables),
less current liabilities (e.g., account payables) pertinent to a specific customer. Cost of capital is
the required rate of return (in %) computed by the firm to compensate the funding costs to finance
capital employed (both equity and debts). As NOPAT is profit after tax, a notional tax rate (i.e.,
corporation tax rate) is employed to reduce the tax portion of net operating profits.

EVA calculation looks complicated but the logic is simple and clear. Profits after funding cost of
capital and tax deduction are the remaining balance in the pocket of shareholders, which
contributes to an increase in shareholder value. EVA addresses shareholders’ key concerns about
the potentials of value creation. There is one major difference between ROA and EVA in
interpretation of the operating profit and asset employed concepts. ROA uses a gross concept,
meaning that operating profit is applied before tax (OPBT), while asset employed is calculated
before deduction of current liabilities. On the contrary, EVA employs a NET concept. It refers to
operating profit after tax (OPAT) and net assets employed after deducting relevant current
liabilities. Let’s review Case 12.2 again, tax rate was 25%, cost of capital was 10%, and current
liabilities were 5% of current asset employed; the EVAs for Daxing and Everbright are

• Daxing: $0.92 M × (100% − 25%) − $4 M × (100% − 5%) × 10% = $0.31 M

• Everbright: $0.54 M × (100% – 25%) − $2 M × (100% − 5%) × 10% = $0.22 M

With EVA, it is confirmative to say that Daxing is better than Everbright in generating more
shareholder value by $0.09 million. Now, more specific conclusions can be drawn from these two
customers: Daxing is better than Everbright in an absolute profit amount. Both financial numbers
are very close in terms of financial efficiency. However, Daxing generates more shareholder value
than Everbright using EVA analysis. This is an encouraging outcome as Daxing represents a hope
for BAX because of its exclusive sale for the new product.
Focus
Amazon Says Long Term and Means It
Amazon was selling so much but earning so little. A lot of money was spent on the long-term
growth activities. It was one of those long-term growth activities when Amazon wanted to become
not only an online retailer but a mega retailer. It built huge logistic hubs and shipping facilities and
undercut price and profits. The aim is to share the lion market share with Wal-Mart. Jeff Bezos’
mathematics was simply like that: the loss in short-term profits may
bring in long-term virtuous cycle that leads over the long term to much larger dollars and creates
more valuable Amazon.com.
The same logic also applies to the case when Amazon sold its Kindle e-reader devices and Fire
tablet at a loss. Amazon thought of the Kindle business in a totality, the economics not only the
devices but also the content. Profits will come down the road when Kindle users buy content
through Amazon. They think of the lifetime value of the devices. Jeff Bezos once explained what
he meant long term. It was the engagement in 5–7 years because very few firms were willing to
do it. By lengthening the time horizon, he could engage in endeavors that could never otherwise
pursue. Long-term growth coins two major benefits: (1) acquiring the kind of economies of scale
enjoyed by Wal-Mart and (2) eliminating or weakening competitors. Is Amazon doing the right
thing? Numbers speak to the fact. It is one of the leading growth firms, and its stock has soared
122 times since its IPO (up to the end of 2011), and it is 5 times faster than retail over all.
Source: James B. Stewart, New York Times, Dec 16. 2011

The above operating profit, ROA, and EVA analysis have explained how customers contributed
to corporate profit and value. However, all analyses are performed in the same year. These short-
term measures cannot effectively monitor a longer-term goal – value creation – because of its
inadequacy in translation from a profit-based measure to a cash-based measure. Customer lifetime
value (CLV) possesses these characteristics and therefore becomes a good candidate for this
monitoring role. CLV calculates all cashes (at present values) the firm can earn from the customer
over its specified lifetime period. However, CLV requires the employment of free cash flow
technique. Free cash flow analysis is a popular technique to convert profit concept into cash
concept. It can also easily expedite valuation of asset value over time. Prior to further discussion
of customer value, this is good at this point to give a brief review of free cash flow concept and its
computation method.

5.3 Free Cash Flows

Free cash flows concept can be defined as the net cash flows generated from the firm’s operating
activities. For the specific context of customer’s free cash flows, it is interpreted as the net cash
flows generated from business transactions with the customer. Free cash flow concept has
advantages over accounting rule at least for three aspects: (a) It comes from actual cash flows. It
is free of encumbrance or bias from accounting rules, which is always regarded the root cause of
corporate earnings management. (b) “Cash flow” is the basic unit to calculate firm value in
investment valuation appraisal. This is rather straightforward and comprehensible by layman. (c)
It is the cash that is available to provide a return on investors’ capital, or residual cash for investors.
It is self-explanatory.

For computing customer free cash flows, the following working format can beadopted.
Free Cash Flows Working Format
Net operating profit
+ depreciation and amortization
= earnings before depreciation and amortization (EBTDA)
− tax payments
= after tax cash flows from operating activities with the customer (EAT)
− increase (+ decrease) in net operating working capital (current assets less noninterest-bearing
current liabilities)
− investment in fixed assets and other long-term assets
= Free cash flows

The above computation format articulates how free cash flows are derived on a step-by-step basis.
Being a sectional analysis (by customers), certain expenses are apportioned on some
predetermined basis. Two assessment criteria are required when considering apportionment basis:
relevance and practicality. We should always ask ourselves these two questions:
(a) Is the subject matter relevant to the apportionment exercise? If we do not have the customer,
do we need to spend the money? (Relevance)
(b) Isn’t the approach of apportionment causing unnecessary administrative cumbersome? Is
benefit higher than cost in seeking very accurate numeracy? (Practicality)

In fact, the above free cash flows exercise is a conversion process to revert traditional accounting
profits back to actual cash profit basis by eliminating non-cash items (e.g., depreciation, accruals,
etc.) in the calculation. It also takes into computation the full cash effects of assets (both current
and fixed assets) over the acquisition year instead of asset-depreciated life according to accounting
rules. Let us go back to the BAX Case again and get more information from the case. Daxing
wanteda booth investment for exhibition of new product. The equipment was bought by BAX
during the year 2014 with an amount of $30,000 which had a depreciation life of 3 years. A total
amount of $100,000 was spent during the year for replacement of existing computing equipment
for the sale team. This is the company policy to replace computing equipment every 4 years. Let
us compute the free cash flows for the Daxing account. According to the above free cash flows
schedule in Table 5.1, Daxing’s net operating profit turns to be a negative free cash flows balance
(−0.51 M). With the free cash flow analysis, it is very obvious that Daxing account did not generate
free cash flows to BAX, mainly due to the need to invest in new product. BAX was looking forward
to future positive free cash flows at the expense of short-term financial loss from Daxing.

A few points deserve further explanations. First, depreciation on booth investment was added back
but not the computing equipment. Special equipment was acquired for Daxing exclusively and
therefore falls under the definition of relevance criteria. Computing equipment was purchased for
the general use, therefore not being counted. For this reason, purchase of special equipment was
included but not for computing equipment. Second, change of operating working capital was based
on the difference between year beginning and ending of the year. When the net change of working
capital is positive, there is an increase in working capital (e.g., current asset), and therefore less
current assets are being converted back into cash. It generates negative cash flow. On the contrary,
positive cash flow appears when net change in working capital decreases. Third, this is impossible
to apply actual tax payment basis as tax payment is often paid in arrear. A notional corporate rate
is used instead. Also, neither it is cost-effective nor practical feasible to match every transaction
of suppliers’ credit to customers. This is a practical and cost-effective way to apply an
approximation rule (e.g., corporate tax rate and % of current assets for the case) to deal with these
trivial or noncritical matters. Free cash flow is an essential concept for computation of monetary
cash flows or cash profits which is the base component for corporate valuation. In the next section,
cash flow concept is used to assess customer value.

5.4 Customer Value Concept

For a long-term financial measure, individuals’ customer performance has profound implications
to corporate value. Customer value emphasizes how much corporate value an individual customer
can accrue in the active business relationship, as customers are important company’s intangible
assets and key contributors for corporate value. A longer-term financial measure should reflect
this corporate value correlation. Customer lifetime value is a good measure in the customer
dimension. Customer lifetime value is a mature concept that has been widely used especially for
direct marketing or Internet sales. It is also popular for customer-centric firms as marketing
strategies are a pivotal role in their overall corporate direction. They would like to select a long-
term view on customers and nurture customer relations for a specific lifetime. However, firms
would be interested to know whether those marketing strategies are effective in acquisition and
retention of customers. They would also like to evaluate whether the measures lead to corporate
profitability or value creation in the long term. The use of customer lifetime value for a longer-
term performance measure has the following purposes. (1) It serves to support market decisions
(e.g., acquisition and retention of customers) in business transaction. (2) It serves to evaluate and
measure business performance with customers. (3) It serves as a proxy of corporate assets – linking
customers to the firm value. This is particularly true in Internet businesses in which subscribers
are the most valuable intangible assets apart from tangible assets. It is also true for telecom
operators whose active subscribers are the crux for the business success (will explain later). In
sum, customer value is a central theme to alert management to be rational in investing customer
relationship management (CRM) without depriving corporate value. It also reminds management
to take a longer term in customer profitability enabling maximized shareholder value as an ultimate
goal.

5.4.1 Customer Lifetime Value

By definition, customer lifetime value (CLV) is the summation of present values of all future cash
flow profits generated from a customer over the “specified life” of thecustomer relation. The basic
equation of CLV is similar to employment of traditional discounted cash flow technique
discounting all future cash flows to the present value:
• Customer lifetime value = FCF0 + FCF1/(1 + r) + FCF2/(1 + r)2 + FCF3/(1 + r)3 + ··· + FCFn/(1
+ r)n

As noted above, free cash flows (FCFs) are distributed over a period of time (n), and money has
time value. It is imperative to convert all future cash flows into a common timing yardstick, i.e.,
discounting all future cash flows into the present values (1/(1 + r)n). For this reason, we need to
select a discount rate (r) to make such conversion. There is a wide range of selections for discount
rate. However, it is recommended to use the weighted average cost of capital (WACC) in line with
EVA computation. Let us return to Case 12.2 again by adding a scenario as given in Chap. 12,
Case 12.3.

Table 5.2 provides Daxing’s forecast schedule of present values of free cash flows from year 2014
(actual) and forecast from the year 2015 to 2019. Customer lifetime value of Daxing account over
the next 5 years amounts to $5.79 M. Apparently, Daxing creates 5.79 M of customer value to the
company over 5 years based on a discount rate of 10%.

Management can put the yearly and 5-year free cash flows as a performance target for the sale
director. There are a few clarifications regarding the above schedule. First, present values of all
FCFs can be obtained by using the format of Table 5.1. For those cash flows that appear in the
current year can be grouped under year 0. It can also apply cash flows of prior years should there
be a necessity for reinstatement in the calculation. It is noted that present values of all free cash
flows over the period (5.79 M) must be lower than their nominal values (5.99 M) because nominal
value loses its intrinsic value over time (t). Second, there is a need to define a retention period
because it determines the period of cash flow stream. Retention period can be defined by reference
to a chronicle of customer of the similar type (e.g., segment, channel) or a specific period of
concern. Third, discount rate is critical in determining the present value of future cash flows as
this is the rate used in the discount factor ((1/(1 + r)n), bearing in mind that the higher the cost of
capital (discount rate), the lower will be the factor in discounting the nominal value. If the cost of
capital is 20% instead of 10%, a nominal value of $1 will be down to 0.4019 (based on 20%) by
year 5 instead of 0.9515 (based on 10%) of cost of capital (as noted in Table 5.2). Therefore, cost
of capital is critical in determining the economic value of free cash flows. For the time being,
weighted cost of capital (WACC) is the preferred discount rate. Because CLV also reflects creation
of corporate value, management can use it to make decisions on various options. As regards the
schedule of Everbright in Table 5.3, it reveals a few interesting observations. Firms have the same
free cash flows over 5-year period of the exclusive dealership. Everbright generates a slightly
better value creation of 5.82 M (Daxing,5.79 M). With the same nominal cash at 5.99 M on both
customers, Everbright has higher nominal cash at the beginning of the period than at the later stage.
Therefore, it gives higher present values of all cash flows over the period. The scenario
demonstrates the implications of cash flow streams over the period on customer value. It also
illustrates that CLV can distinguish which customers can generate a higher customer value even
they have the identical nominal value of cash flows. Using discounting cash flow technique
approach to calculate CLV requires a detailed analysis of individual customers with a reasonable
knowledge about the general sale pattern (including growth), expense requirements, and
company’s general retention rate for customers. It is time-consuming and requires a high level of
certainty about the cash flow outcomes. More recently, the emergence of new business models
emphasizing critical mass of customers (e.g., Internet and direct sale businesses, telecom
operation) requires massive acquisition and retaining investment to maintain a large customer base.
In these cases, CLV model needs to be adjusted to accommodate a more aggregated level of
analysis on customer value (e.g., sale program, the entire company, or customer segment). The
modified CLV model is particularly relevant to the recent business fads on direct marketing and
Internet sale businesses.

5.5 Modified CLV Model

Two Columbia professors, Gupta and Lehmann, modified the traditional CLV modelby making
the following assumptions on the model. (a) Margins are constant over time, (b) retention rate is
constant over time, and (c) projected period is infinite. In so doing, the modified model does not
require intensive data on individual customers and can work out the customer value with minimal
and generally available information.The revised CLV equation now becomes like this:

• CLV = m(r/1 + i − r)

(where m = average margin, r = retention rate, i = discount rate) Constant average margin (m) is
simply an annual revenue minus operating expenses divided by the number of customers. The
average margin assumption is based on the argument that there are two opposing forces that shape
average margin from customers. On the positive force, customers would increase sales (including
cross-selling) over time or reduce cost of doing business with that customer. Contrarily, the
negative force comes from those customers who do not spend too much money or decline in sale
over time. Therefore, average margin should be the reasonable estimation for all customers. Both
professors used empirical evidence to support the argument.
The modified CLV model uses constant retention rate (r) instead of the traditional estimated
projected length of customer value. It is not necessary to estimate the customers’ projected length
of stay as retention rate automatically accounts for the fact. For instance, if the retention rate is
80%, the chance of a customer staying in the company in 10 years is (0.8)10 = 0.1, and the chance
of staying for 20 years is (0.8)20 = 0.01. Though the modified CLV model is applying an infinite
time horizon, the financial impact will be very minimal after a certain period (say, 10 years). As a
matter of fact, the part of (r/1 + i − r) in the equation can be regarded the margin multiple. A
margin multiple table in Table 5.4 shows margin multipliers based on the parameters of retention
rate (r) and discount rate (i). Margin multiple table provides a reference for computation of
multipliers for every dollar of margin. For instance, the multiplier of a retention rate of 85% with
a discount rate of 14% is 2.93, meaning that every dollar of margin can contribute $2.93 of
customer value to the company. The table also demonstrates the implications of retaining
customers. Again, the effort to increase retention by 10% from 80% of retention rate at a discount
rate of 12% will change the multiplier value from $2.5 to $4.09, an increase of 63.6%. The numbers
reflect the value of retaining customers. As a general rule, multiplier values are low when discount
rates are high (i.e., risky venture). For example, the value of 60% retention rate with a discount
rate at 10% (1.2) is higher than the same retention rate but with a discount rate of 18% (1.03). On
the contrary, higher retention rates generate higher multiplier values. For example, the multiplier
value of 90% of retention rate with a discount of 10% (4.5) is higher than the multiplier value of
60% retention rate with the same discount rate (1.2). With the assumptions on constant values on
margins and retention rate, the conditions to apply free cash flow concept can be relaxed, and
estimated customer lifetime can be replaced by retention rate. Constant values can be reasonable
proxies for cash flows and lifetime. Customer value can be computed based on the available
information on retention rate (or churn rate). This is of particularly relevance to the emerging new
economy (telecom, e-business). The following examples help explain how the modified model
facilitates management analysis and decision making.

5.5.1 Examples
The following provides examples on application of the modified CLV model.

Example 1 Evaluation of sale and marketing program for the telecom industry CnT, a telephone
carrier in China, launches a new sale program for a bundled voice and data usage package. This
phone subsidization plan provides new customers with a new 4G mobile phone by signing a 2-year
service agreement at a monthly fixed sum of rmb90. CnT subsidizes each customer rmb800 for the
new phone. CnT has budgeted rmb20 million for this program including 25% of the budget on
advertising. Assuming general operating expenses are 30% of the tariff revenue, averagechurn
rate is 40%, and discount rate is 14%:
(a) What is CnT’s customer lifetime value? Should CnT launch this sale program?
(b) What is the break-even point (in customer no.) for the sale program?
(c) Should CnT’s churn rate fall to 50%, what additional retention cost can CnT pay to maintain
the existing churn rate, assuming the same 14% discount rate?

Solutions
(a) CLV of CnT:
Margin = rmb90 × 24 × (1–30%) = rmb1512
Retention rate (r) = (1–40%) = 60% (churn rate = 40%)
Discount rate (i) = 14%
Margin multiplier = (r/1 + i − r) = 0.6/(1 + 0.14 − 0.6) = 1.11
CLV = margin × margin multiplier = rmb1512 × 1.11 = $1678
This sale program is workable as the customer value at rmb1678 is higher than
the acquisition cost of $ rmb 800. The sale program contributes additional customer
value to the firm.

(b) New customer target no. is rmb20 M × (1–25%)/rmb800 = 18,750 customers.

The media ads budget for the new program is rmb20 M x 25% = rmb5 M.
For the break-even, there is no value creation. Let Z be the ultimate no. of new
customers; zero value creation is equivalent to
rmb1678 × Z = rmb800 × Z + rmb5 M
Z = 5,000,000/(1678 − 800) = 5695
1/3 of the new target customer (5695/18,750) = 30%.

(c) Margin multiplier with retention rate of 50% and discount rate at 14% = 0.78
CLV = margin × multiplier = rmb1512 × 0.78 = rmb1179 when churn rate is 50%.
CLV falls to rmb1179 from rmb1678.
CnT can pay up to additional rmb499 retention cost to maintain the churn rate level
at 40% (retention rate 60%).

The above example exemplifies the parallel significance of new customer acquisition and retention
of existing customers. This is particularly true for telecom industries characterized by high
investment costs, fierce competition, changing technology, and dynamic market environments. A
fall in retention rate destroys corporate
value heavily particularly with its high-risk leverage (meaning high discount rate). In this case, an
increase in 10% of churn rate will deprive the operator of around $499 per customer. Retention
expense can be spent on customer royalty program or improving customer service level. Having
said that, the fundamental premise is the same to upkeep customer contribution margin which is
the source of all spending.

Example 2 Online banner ads versus direct mail

Woohoo Plc. is a direct sale company which has a budget for advertising and promotion. Woohoo
has identified two media sources: banner ads and direct mail. A web portal has an active
subscriber base of 10 million and offers to sell banner ads at $28,000 per week, while electronic
direct mail (EDL) charges each mail at $50.

A behavioral research reports that the click rate for subscribers on banner ads is 0.5% and the
purchase rate for those subscribers who click and buy is 1%, whereas the response rate for direct
mail is 1%. Assuming that the direct sale company has an average margin contribution of $50 for
each buyer, the retention rate from Internet customer is 80% and from direct mail customer is
50%. With a 10% discount rate, (a) what is the acquisition cost for each option; (b) which media
channel should be selected?
Solutions
(a) Acquisition cost of EDL = $50 per customer; acquisition cost of banner ads = acquisition
cost/(subscriber base × click rate × purchase rate) = $28,000/10,000,000 × 0.5% × 1% = $56 per
customer

(b) CLV for each channel:

From EDL customer = $50 × (0.5/(1 + 0.1–0.5)) = $50 × 0.83 = $41.5
From banner ads = $50 × (0.8/(1 + 0.1–0.8)) = $50 × 2.67 = $133.5
The acquisition cost for direct mail ($50) is lower than banner ads ($56).

However, the retention rate for each type of customer is different. It may be due to positive brand
equity effect of banner ads on customer retention. With a higher retention rate for the banner ads,
CLV is higher for banner ads customers ($133.5) than direct mail customer ($41.5). In fact, low
CLV of direct mail customer has generated negative value for the new customer ($41.5–$50 =
−$8.5).

5.5.2 Customer Retention

Customer retention rate is rare to be shown in profitability analysis reports despite the fact of its
important impact on customer management (even an internal report for management). Its
significance is grounded on three main causes. First, customer retention rate is highly associated
with customer satisfaction that is a key performance indicator for any customer-centric company.
Second, a combined review of margin and customer retention rate has brought to the management
some clues in pricing and operation decisions. High margin with high customer retention reflects
a good match between pricing and service level. High margin with low customer retention rate
indicates potential sale problems. Low margin with high customer retention rate signals customers’
sensitivity to price. Firms have to be consistent with the cost and competitive strategies. Finally,
low margin with low customer retention rate predicts a very difficult business that the management
should take an immediate rescue action. Furthermore, retention rate is crucial information to
compute customer value. It creates a link from sale performance to corporate value, which is the
ultimate corporate objective for most of firms. Corporate value drivers derive from sale
performance. Sale team should have an overall understanding of how they contribute to company’s
value creation. In sum, retention rate links present business performance to future business
prospect and predicts what will be the business outlook. The following example demonstrates how
customer retention and CLV are interpreted in a reporting system.

Example 3 Market segment analysis

MX Internet sale company has three separate brands for its B2B, B2C, and C2C businesses. The
first two brands use a direct sale model of selling its own goods. The third brand provides a trading
platform between customers for sale exchange and receives commission fees out of the
transactions. The 2015 annual information wasgiven below:

(a) B2B – sale, $35 million; customer, 5500; gross margin %, 10%; operating expenses, 3% of
sale; churn rate, 35%.
(b) B2C – sale, $60 million; customer, 100,000; gross margin %, 12%; operating expenses, 10%
of sale; churn rate,
15%.
 (c) C2C – commission, $10 million; customer, 90,000; operating expenses, $9 M; churn rate 50%.
Analyze market performance for each brand given an industry benchmark of 14% discount rate:
(a) evaluate brands’ profit performance, (b) comment on the CLV of each brand and the overall
future prospect, and (c) propose corporate direction.

Solution The sale performance for each market segment (brands) of MX Internet Sale Co. was
summarized in Table 5.5:
(a) B2B had the highest profit contribution ($2.45 M) for the company, followed by B2C ($1.2 M)
and C2C ($1 M). B2B contributed one third of total revenue and more than 50% of profit, whereas
C2C had the highest margin ($10 M) but was the last in profit contribution ($1 M). C2C had
incurred the highest operating expenses among three business lines (more than 50%).

(b) The CLV of each brand was provided at the appended note as shown above. B2B had a good
customer value though with a moderately low retention rate. Both B2C and C2C had low customer
values. C2C’s poor retention rate (50%) dragged down its customer value below even the average
profit per customer. The company made great effort to keep the sizable customer base exemplified
by high operating expense for the C2C brand. Among all brands, B2B can contribute more profit
margin and customer value. B2C had more loyal customer than the other two brands. B2C could
be further developed. C2C was most vulnerable business given the low retention rate and high
operating expenses. Due to its aggregator role in the C2C business, it is rather difficult to manage
the service level on both buyers and sellers and make the business more volatile.

(c) MX should keep the sale performance of B2B business but needs to improve the retention rate.
Apparently, it should promote more direct sale business (B2C) and if possible migrate C2C
customers to B2B. B2B has loyal customers, lower operating expenses per customer, and higher
customer value. It can generate more stable business. Given the low C2C margin and retention
rate, MX may study to position on direct sale only, both for the business (B2B) and general
customers (B2C). No matter whether the traditional DCF approach or a short-cut approach of
modified CLV model was applied, the message of CLV is the same. The company should (a) avoid
taking a short-term view on profit margin of a customer, (b) consider the lifetime of customers,
and (c) recognize the importance of customer retention (i.e.,lifetime) which has impact on
customer value. As noted in the margin multiple –Table 5.4 – the margin multiplier will be less
than 1.0 if retention rates are 50% orless, meaning that the actual value of customer is less than the
current year short-term profits. If the short-term profit target is employed for rewarding the sale
team, the incentive purpose may be misaligned. If customer acquisition plan is based on the short-
term profits, financial criteria for investment of new customers may be misguided. Emphasis on
customer lifetime value leads the management away from taking a short-term dimension in
evaluating and managing customer base. It also directs the management to think from the corporate
value perspective – as customer value contributes significantly on the overall corporate value. As
a matter of fact, CLV changes the customer relationship management strategy in two directions:
both embracing a long-term customer relationship and investing the relationship wisely. They are
working in tandem. Customer value is a significant intangible asset for the firm. It accounts for a
firm’s high market capitalization that can be many times above the net worth of a firm. For those
firms which do not have high tangible assets, customer value can be a good proxy for corporate
value. This is especially applicable to e-businesses in the new economy in which new ideas,
customers (subscribers), employees, e-portal, and business networks are the core assets of the firm.
Company earnings and financial track records are yet to be tested. Customer base is the key driver
for corporate value. Therefore, it is natural that customer value can provide useful insights about
the value of the firm. Gupta, Lemann, and Stuart3 performed statistical correlations between
corporate value and customer value in five US firms – E*Trade, Ameritrade, Capital One, Amazon,
and eBay – using published annual reports information in 2002. The results show that the first
three e-firms have the market value fitted to the customer value, while the market values of
Amazon and eBay were underestimated. They claimed that the underestimation was due to the
growth rate not being included in the formula. The results suggest that CLV provides a good
guideline (especially the new economy). However, caution should be made that they may not
account entirely the total source of market value of a company.

Focus
What was a hell of a price to pay!
Deutsche Telekom offered an unexceptional high price of $5.6 billion to acquire VoiceStream in
mid-2000. VoiceStream at that time was only a year’s old wireless carrier with a subscriber base
of 2.3 million. The stock price of DT plunged by 10% the day after the announcement. Why did
the DT management pay such a hell of a price, as commented by Dennis Gross of Williams De
Broe, a wealth management and investment research organization. DT wanted to be the global
telecom after other European counterparts such as Vodafone and BT. Building a foothold in the
USA could make DT a true global player in the telecom industry. At that time, VoiceStream was
the only independent telecom company in the USA owning wireless licenses covering two thirds
of the population. VoiceStream was the fourth largest wireless carrier nationally after Verizon,
AT&T, and Sprint PCS. The consideration for thedeal was about $22,000 per customer, while
prior telecom acquisition deals were in the range of $3000–$7000 per customer (e.g., Vodafone
acquired AirTouch at $7000 per customer). Was it a good deal? Let us work out the value of
customer by using the modified CLV model. The average ARPU of VoiceStream in 2001and 2002
was about $50 per month, resulting in an annual margin of $600. The average churn rate for the
first 2 years was around 45% (i.e., retention rate 55%). Assuming the discount rate was 12% (a
common WACC for large firms at that time), the margin multiple is therefore 0.965 (0.55/(1 +
0.12 − 0.55). This produces a customer value $$600 × 0.965 = $579. With the acquisition cost of
$22,000 per customer, it requires 38 years to make the deal breakeven, not to mention that it was
not the sale of 100% stockholding of VoiceStream. Apparently, DT was too generous for the deal
though it is admittedly easy to make this comment in a hindsight. Anyway, CLV can provide a
quick check.
Source: Background information extracted from Wall Street 24, June, 2000; ARPU numbers by
reference of Statista data.

5.6 Key Driver Performance and Financial Outcomes

The above sections have mentioned that customer profitability should be viewed both from the
short-term and long-term dimensions. Firms may suffer in the long-term if management is
interested in the short-term profits only. Management should strike a balance in the priority
between customer profit and customer value should this dilemma arise. To facilitate the use, I
summarize the relationship flow of the key drivers and the four measures in Figure 5.2, which
provides a structural view of how the four measures are operated. As depicted above, key driver
performance level is equivalent to first layer in customer performance reporting model. These key
drivers can be viewed into three key groups – product drivers, service drivers, and customer
relationship management (CRM). Different firms have their own choice of main attributes of these
key drivers, and their performance influences the second level – cost/price performance. Cost/price
performance level has significant meaning in two aspects. First, it affects how the firm gains profits
from customers. It also influences how customers perceive the value of goods and services based
on their relative cost/price performance with the firm’s competitors. Does the firm deliver higher
perceived cost/price performance or not in the eyes of customers? The perception will then
determine customers’ intention to continue purchase with the company and the amount of orders
subsequently. This level has important impact on subsequent business transactions with the
concerned customer. The customer account level indicates three categories of outcomes. The first
category is financial contribution outcome. It pertains to customers’ profit contribution. Is the firm
making profits from customers? The second category relates to productive commitment outcome
– how much asset the firm has provided to customers to make sales. It is the firm’s pledge of
service level commitment (e.g., special facility, working capital).
The third category is the relationship outcome. Customers’ willingness to stay with the firm
depends on cost/price performance, cost-to-service (retention cost), and also CRM performance.
This level affects directly the four financial measure outcomes. The four financial measures in the
final level of financial outcomes have been discussed extensively in this chapter. One point is
noted here that customer account outcome components affect each measure differently. OP and
ROA measures affect shareholder value indirectly because corporate value is absent in their
calculation. EVA and CLV are more value-centric with direct measure on value creation. In
particular, CLV is a long-term measure. It is more relevant for monitoring customers’ long-term
profitability. Finally, discount rate is outside the chain flows because it is related to the firm’s
overall risk lever than on individual customers.

5.7 Concluding Remarks

Prior chapter has cautioned firms to select customers carefully. Not all customers are contributing
profits and values to firms. There should be a means to evaluate customer profitability and value.
Customer profit and customer value are two distinct concepts that always have priority conflict.
These two measures are included in company’s ultimate objectives. Very often, management is
myopia in the short-term profit while putting the long-term value at risk. Long-term goal is the
company’s ultimate aim, and this vision must be cascaded throughout the management control
system – the system that presents customer profit, customer value, and the priority clearly. The
system should also reward sale team based on value creation. Jeff Bezos is the founder and
chairperson of Amazon. He has an unconventional view on profit. Jeff once said, “every minute
spent thinking about the short-term stock price is a minute wasted.” He leads the world by example,
and Amazon’s stunning financial performance confirms his conviction.

Takeaway Tips
• There are many ways to measure customer profit. Profitability is only the starting point.
• There is a cost of capital for the assets invested in customers. It needs to be counted.
• Firms need to measure both customer profit and customer value. These are two different concepts
and in priority conflict.
• Customer lifetime value makes the firms aware of the importance of customer retention to
generate customer value.
• Firms need to justify the spending of acquisition and retention activities from customer value.