Strategy Byte - Week 8 : Customer Value

Recap

Last week, we explored the importance of customers to a company's strategy & ultimately it is all about the customer & trying to solve a pain point or add value to their lives personally or professionally.

A company's winning aspiration or core purpose should start with the customer in mind, their problems & pain points. This is then reflected in their choices & actions through better products or services.

We then explored customer segmentation which is the process of dividing customers into group based on common characteristics so companies can serve each group effectively & appropriately.

Now, if a company's strategy is based on customers being happy & then translating that to economic returns, how can both be linked? - The link is in Customer Value.

Customer Value

Before we get into customer value, two key points need to be emphasized

1. Strategy is something that you do & not what you say (Source : Roger L Martin)
2. Strategy exercise is an ongoing activity & not only when a company is at a start up stage

Why are the above points important? A company can have lofty aspirations & still not take the required steps to acquire customers & keep them loyal to the company on an ongoing basis. Acquiring & retaining customers help the company succeed in it's winning aspiration which reflects ultimately in the bottom-line.

What is a company's bottom-line?

Now, let's get a little nerdy. How do we measure company performance for a period? Through it's income statement, which comprise two major parts. These are :

1. Income - Revenue generated through operations
2. Costs - Amount spent to carry out those operations

What is the source of income for any company? It is obviously the customer (Duh!!). Only if a company puts in efforts to make their customers happy by sorting out their pain points or adding value will the customers open their purses to the company.

A company incurs costs to generate that revenue & ensure customers keep spending on their products or services.

The net result of generating revenue & costs incurred is Net Profit.

A company has a successful strategy if

1. Customers are happy with the company & higher number of customers stay loyal to the company for a longer period of time &
2. The company acquires new loyal customers,

The company can be assured of consistent revenues which combined with an efficient cost structure results in consistent net profits showing the success of it's strategy. Otherwise, losing customers is a strategic problem for any company.

If you have noticed, I mentioned "new loyal customers" & not "new customers". This is because just acquiring new customers does not add long term value. These customers have to be loyal to the company (in other words "sticky") in that they use the company's products over a longer period of time.

We are all familiar with pushy salespeople trying to add customers just to meet their targets without considering the quality & stickiness of those customers.

How do companies measure customer loyalty or sticky customers?

Customer NPV

Before we explain Customer NPV, let us understand what is NPV.

NPV stands for Net Present Value. Without getting too technical, let us take an example of a lemonade stand :

Assume the income of that lemonade stand is $5 per year. So, the income over the next five years (assumed lifetime) will be as below :

Year 1 - $5

Year 2 - $5

Year 3 - $5

Year 4 - $5

Year 5 - $5

Total = $25

Total Revenue over the next five years = $25. So if someone wants to buy the lemonade stand, they just pay $25. Simple right? But there is one small issue.

The issue is that $5 today is not equal to $5 next year or going forward. It will always be less each year & decreasing, say $4 or $4.5 due to economic factors like inflation.

Now, assuming the value of dollar decreases by $0.5 every year (this is called discounting where we use a rate to reduce the future cash flows to bring it to today's value), the income flow in today's value will be as below :

Year 1 - $4.5

Year 2 - $4.0

Year 3 - $3.5

Year 4 - $3.0

Year 5 - $2.5

Total = $17.5

Thus, the income for each year converted to today's value totals to $17.5. This amount is called the Net Present Value which is nothing but cash flows for future years discounted to arrive at current year value so that each year cash flow is converted to a common base year value.

So, the lemonade stand owner will be paid $17.5 instead of $25 (Ignoring other factors like premium etc).

So, what is a customer NPV? It is nothing but the present value (discounted value) of cash flows expected over the lifetime of a customer . In simple terms, what can be expected from a customer over his / her tenor in today's cash value.

Another factor to be considered is the company spends money to acquire customers like advertising, marketing costs etc. So the net value generated from a customer is

Hence from the above, we can see that a company's strategy should focus not only on acquiring customers but also :

1. Retaining existing customers as the marginal cost of retaining them will be less as existing customers tend to stick longer & spend more.
2. Acquire new loyal customers
3. Have an efficient cost structure to ensure low & consistent customer retention & acquisition costs.

Customer Churn

If more customers leave the company than new customers acquired (high churn rate), this will result in less customer value & ultimately lower revenue for the company going forward coupled with high costs.

Thus. lower a company's churn rate, the higher it's customer retention rate & longer its average customer tenor. High customer loyalty means low churn rates.

Also, the cost to retain existing customers is less & these customers tend to spend more as long as they are happy with the services or products the company provides. Think apple customers who have cult-like devotion towards apple products. They will stick to apple products due to it's ease of use & beautiful UI / UX.

Revenue Model

How can companies practically measure customer cash flows? It depends on the business model the company follows & the data analytics capability. Companies following subscription revenue model (e.g., SaaS - Software as a Service) should be better positioned to measure customer NPV compared to companies with retail or channel sales revenue models (e.g., fashion products). But with data analytic capabilities, there are always ways to compute customer NPV irrespective of revenue model.

Competition & Industry Life Cycle

Customer retention & cash flows cannot be computed or considered in a vacuum. A company needs to consider

1. Competition &
2. Industry stage (meaning whether it is in introduction, growth, maturity or decline)

As an industry matures, acquiring new customers gets more difficult & hence acquisition costs tend to rise. Also, number of competitors & how they compete are important factors. For example - customers who are used to a product or service typically tend to stick with them unless circumstances warrant otherwise. Hence, competitors like Apple & Samsung have to make additional efforts to acquire each other's customers if they want to increase market share compared to the time when they initially released their products.

Also, as an industry matures, companies need to add new products / services or improve it's existing suite of products / services to ensure customers stick with it.

For more deep dive into customer profitability, you can refer here (The Economics of Customer Business)