Marketing spending is critical. It directly affects both corporate revenues and earnings. That's why companies need to treat the marketing budget as a precious and scarce resource. Figuring out how to generate the highest possible long-term returns on how and where marketing spends money should be a priority for business performance management (BPM) project leaders, but it's frequently neglected because marketing is typically viewed as out of bounds for BPM. It should be included.

The marketing and sales functions have long understood that to generate maximum financial return for their company from their budgeted spending, they need to determine which customers they should spend the most money attracting, retaining, growing, and recovering. In contrast, the finance and accounting function -- which usually spearheads companywide performance management projects -- has traditionally focused on cost reduction as the sole road to higher profits in the marketing realm.

The problem stems from managerial accounting systems' concentration of attention on product or service-line costs (which are often flawed by arbitrary, broad, average-based cost allocations). An analysis with an expanded scope would break down costs by customer. But financial accounting regulations require line expenses below the gross margin -- including costs related to distribution channels, sales, and marketing -- to be recognized during the period in which they were incurred. They cannot be capitalized and stored in the balance sheet the way product costs can be stored as inventories. However, just because expenses must be classified that way to comply with external financial reporting regulations doesn't mean that customer data can't be used differently in internal managerial accounting to support the analysis and decision-making of managers and employee teams.

Accountants should begin applying the same costing principles they use for product costing -- including activity-based costing principles -- to types of channels and types of customers so that there is visibility into all traceable and assignable costs. The finance department should also be involved in customer analytics activities in order to move customer relationship management to the next level. The day is coming when the CFO will need to turn his or her attention from the operations functions and cost controls to the support of decisions being made by the chief marketing officer and sales director about which kinds of customers and sales prospects they should focus on. Companies that fail to consider customer value from a rigorous finance and accounting perspective are losing an important opportunity to improve the company's economic value over the long term.

But the "why" behind customer value is not the main problem. It is the "how" that most frequently gets overlooked.

All Customers Are Not Created Equal

Analyses of customer value are growing in importance because, increasingly, profit growth for companies is coming from building relationships with the customers who contribute the most to the bottom line. Earning their loyalty has become mandatory, as technology -- through increased pricing transparency, product commoditization, product/service customization capabilities, and the Internet -- has shifted power irreversibly from sellers to buyers. The customer has more control than ever before, and acquiring a new customer generally costs more than retaining a current customer. Hence, from a supplier's perspective, retaining top customers has become paramount.

Nevertheless, many businesses do not have meaningful, consistent, or reliable metrics for gauging which customers to invest in. They try to build customer loyalty through blanket mass-marketing strategies and spray-and-pray programs, rather than by differentiating (i.e., "segmenting") their customers based on traits such as the likelihood that they'll respond to cross-selling (e.g., when I sell you golf clubs, I try to sell you a golf glove) and up-selling (e.g., when I sell you a shirt, I offer a second one at a lower price). To ensure that they're spending marketing dollars most effectively, companies must develop reliable methods for distinguishing their most-valuable customers from their less-valuable ones.

Business is no longer about just growing sales, but rather growing sales profitably. To be competitive, a company must know its sources of profit and understand its cost structure. A good customer relationship management (CRM) system includes end-to-end functionality from sales-lead management to order tracking, and ideally it's seamless. An activity-based costing (ABC) system can enhance CRM by showing the cost to serve each customer, including expenses for interactions like customer-service phone calls, returned products, the proportion of transactions that take place through high-cost channels, or special delivery requirements. When the profit margin and cost to serve for a customer's purchased product mix are combined in a performance analytics setting, companies can more clearly see which customers are generating the most profits for them. This generally leads to some surprises, as I explained in my article in BPM Magazine's March 2004 issue, Profit-Margin Math: Leveraging ABM Data for Exceptional BPM Results. For example, customers with the highest sales may not be the most profitable ones. A company doesn't get better by getting bigger; it gets bigger by being better -- which means getting smarter.

The organizations that are the most advanced in customer analytics have become competent in measuring current-period customer profitability. ABC and its supporting technologies have provided the capability to trace and assign the unique consumption of the company's resources by customers, channels, services, and products. Metrics to evaluate customers' current profitability might include customer loyalty rates; attrition rates; churn propensity (the likelihood a customer will defect to a competitor); and the standard trio of marketing metrics for describing a customer's purchase history: recency, frequency, and monetary spend (RFM).

Focusing on today's most profitable customers can have a large impact on the bottom line, but a company also needs to measure how much the customer will contribute to profits in the future -- in other words, the customer's lifetime value. Exhibit 1, below, shows how companies can segment customers based on both their current and their potential future value to the organization. Common CRM measures of current profitability, typically applying ABC, have been proven to accurately determine where customers fit on the vertical axis of exhibit 1. However, this knowledge is not sufficient for making optimal marketing decisions.

The potential future profit of some currently less-profitable customers, such as a promising young dentist or imminent university graduate, may be sizable, yet their current level of profitability does not reveal this marketing opportunity. In contrast, an established dentist near retirement may currently be a very profitable customer, but his or her longer-term value may not be substantial. Indirect factors including a customer's propensity to recruit new customers; sociodemographic variables like age, income level, and gender; and even attitudinal variables that marketers analyze to understand customers' tastes and preferences can help determine whether a customer belongs in the right or the left half of exhibit 1.

If a company identified each customer's position on exhibit 1 as a single point at the intersection of his current and potential future profitability levels, it could score and rank-order customers' financial value to the business based on their distance from the top right corner of the diagram. The customers in the top right corner are those in whom marketing resources should be prioritized for spending. The challenge is to determine the profit return on spending opportunities in order to shift customers directionally toward the upper-right corner to increase shareholder wealth. To remain competitive, businesses must figure out how to keep their customers longer, grow them into bigger customers, make them more profitable, and serve them more efficiently. Companies have to think beyond short-term revenue and profitability. They have to take the long-term view and manage their strategic customer relationships as assets. They must offer differentiated service levels based on the different levels of value that existing and future customers hold for the company.

Calculating Lifetime Value

To determine the future profit potential of customers, marketing and sales functions have begun exploring an equation called customer lifetime value (CLV), which can be defined as the net present value of the likely profit stream in future years from an individual customer or a customer segment. This involves multiperiod discounted cash flow investment-evaluation math that equates the future stream of net positive cash flow (profits) into a single cash amount stated in today's money. These calculations are trickier than measuring historical customer profitability levels because they need to consider factors other than what happened in the past month, quarter, or year.

CLV treats each customer (or segment) as if it were an investment instrument, similar to an individual stock in a portfolio. Like stocks, individual customers can be winners or losers, so customer lifetime value considers the probability of abandoning certain customers. CLV is appealing because it focuses on the customer as an influencer of the company's future profitability rather than focusing only on the products and service lines that the customer has purchased in the past.

If a company doesn't know each customer's value, then it is likely misallocating resources by underserving its more valuable customers and spending too much on those who are less valuable. Existing customers with high levels of CLV should be protected by the company; their retention must be a top priority, and earning their loyalty is critical. But lifetime value calculations can also be used by marketers, as they tailor marketing campaigns and differentiate the company's services and offers, to ensure that each customer segment's potential CLV materializes. Customers with relatively lower lifetime values should be managed for higher returns. And for new sales prospects, marketing can allocate an appropriate budget for acquisition programs to attract customers with characteristics similar to those of the most valuable existing customers. In effect, the goal of customer value management (CVM) -- a customer acquisition and retention strategy based on CLV math -- is to attain the highest profit yield for each incremental amount of spending in sales and marketing in order to maximize economic value creation for shareholders.

Ten revenue and cost elements are key to determining the lifetime value of a customer: recurring revenues throughout the customer's lifetime, additional revenues from the likelihood of the customer responding to up-selling and cross-selling, costs to serve the customer, credits and returns, required investment in renewal and retention programs, downward migration to less-profitable channels, the initial cost of acquiring the customer, bad debt and/or administrative removal costs when the relationship is severed, and churn and win-back efforts that affect the other factors (see exhibit 2 below). All variables in this calculation must be considered over the course of the individual's lifetime as a customer. That means the expected timing of future cash inflows and outflows, as well as the cost of capital, must be considered in calculating the net present value of the customer to the business. So, for example, if the financial cost-of-capital rate is 10 percent, then $1.10 a year from now will equal $1 today.

An individual customer's discounted CLV can be determined by the following equation:

CLV = Net present value [ SUM (Monthly profit margin) ] (sum) M -- Acquisition cost

where M is the probable number of months of retention as a customer. Calculating the discounted cash flow of a customer is not as complicated as one might imagine. Although the top portion of exhibit 3, below, may initially appear intimidating, the bottom section recasts key elements of the equation into a spreadsheet view that most businesspeople will be more comfortable with. The equations basically quantify the price, less the cost, for the expected purchased volume of each product or standard service line, less the cost to serve (including the cost to retain as a customer) for each time period. These costs are calculated for each customer -- or, to make them more manageable for most businesses, for each customer segment -- and then factored for probabilities.

Introducing this type of approach to support marketing decisions offers many benefits for a company. CLV can help the marketing operation contribute to higher company profitability by focusing marketing efforts on the right customers and by winnowing out less-valuable customers with limited potential for financial returns. (Sending an unprofitable customer to a competitor isn't a bad thing.) Approaching marketing investments from a CLV point of view can also be useful in understanding profit momentum because changes in customer behavior are usually not volatile. Unlike financial statement reporting, CLV measures are not interrupted by one-time charges or other short-term but substantial financial statement surprises.

Organizations intimidated by the idea of measuring all the factors that play into CLV may want to begin with simpler equations than that in exhibit 3. They can start by using computer modeling and by estimating the values for some of the elements in exhibit 2. The benefits of such simplified calculations lie in the organization's learning about how to view its customer segments and how to think about the probabilities for elements such as churn and win-backs.

Loyalty + CLV = Shareholder Value

Understanding the loyalty of a given customer is important because loyalty directly affects the amount of marketing spending that is required to retain the customer.

Companies that are advanced in their analytics capabilities use business intelligence software to understand some of the psycho-demographic characteristics of customers and to predict their future behavior. It is not unusual for the customer analytics departments in companies to claim that the accuracy of their customer "survival" projections is reliably high. They can almost predict which customer by name is likely to defect. The question, then, is whether it is worth the extra cost to attempt to retain that customer. Would shareholder value benefit from a marketing investment in that customer?

Excess spending on marketing to any customer segment can lead to shareholder wealth destruction; a company can overspend unnecessarily on profitable but loyal customers to retain their business. For example, bankers are known for lavish dinners or rounds of golf with VIPs, long-term customers who are unlikely to ever switch to another bank. Similarly, insufficient spending can lead to shareholder wealth destruction because an underserved customer may defect to a competitor or reduce spending volume, thus lowering the expected lifetime value for that customer. A company constantly makes marketing-investment decisions, both by actively pursuing customers with new offers or deals and by passively assigning them to a customer segment which is entitled to no offers or deals.

Exhibit 4, below, shows a grid on which a company can plot its customers. Their position on the vertical axis should be based on their lifetime value (i.e., the rank-ordering determined by the customer's distance from the top right corner of exhibit 1), and their location on the horizontal axis should be based on their loyalty. The location of a customer on exhibit 4's grid implies the level to which the company should offer incentives, deals, discounts, and the like to retain the customer's ongoing stream of purchases. The spending budget for sales and marketing is critical, but that spending must be treated as a scarce resource aimed at generating the highest possible long-term profits. This means answering the question: For the types of customers we want to target, how much should we spend attracting, retaining, growing, or recovering each segment?

An organization should calculate how much sales and marketing spending is too much or too little for each customer or customer segment. This is the first derivative of calculus -- similar to acceleration's relationship to velocity. It is about the next increment of change. What impact do I get by spending an extra dollar on each customer or by reducing that planned spending by an extra dollar? Combining customer financial value scores with customer loyalty measures can determine the optimal level of marketing and sales retention spending on each customer cluster.

Most senior managers treat customer intelligence analytics as a harmless curiosity in a permanent phase of development and trials. However, these same senior managers also wonder whether the fact that they do not understand the potential future value of their customers is a matter of "Do we know?" -- or "Should we know?" To optimize their investment decisions, most marketing executives need help from the finance department, from the analysts who have experience in choosing metrics and calculating performance for other areas of the organization. Such collaboration on customer value management initiatives helps a company's marketing department -- and executive team -- navigate shareholder wealth creation based on facts, not on hunches and intuition.

Good customer intelligence software helps companies make smarter decisions faster. To create higher shareholder wealth, an organization must continuously analyze its customer portfolio in innovative ways to discover new profitable revenue growth opportunities. By refocusing customer strategy, retooling measurement mechanics, and taking steps to realign the organization around customers, companies can unlock the vast profit potential of the customer asset. They can retain and grow existing customers and acquire new high-potential customers that will drive the greatest amount of profit today and in the future.

Gary Cokins is global product marketing manager for performance management solutions at SAS and a well-known expert in performance and cost management.