Return on Customer ROC(SM)

by Chris Kenton on December 20, 2006

When I went off on a rant the other day about social media metrics, I stepped on some unexpected toes. In casually dismissing all kinds of derivative ROx metrics, I also impugned ROC–the "Return On Customer" metric proposed by Peppers and Rogers. Don Peppers came to set me straight on ROC. He posted a comment defending the integrity of ROC and explaining its value:

"..the Return on Customer (sm) concept is not just a clever way to say "marketing." It is a genuinely different financial metric, based on a common-sense principle that is often overlooked by marketers: Customers are limited in number, and they should be treated as a scarce productive resource."

I couldn’t agree more about the value of customers. And when I read the opening chapter of Return On Customers, I can say that I agree wholeheartedly with the underlying premise that businesses need to take a much longer view of how they create value and how they treat their customers in the process. But there’s a thread that runs through the book that leaves me unsettled. It’s too shiny. Right down to the conspicuous trademark that declares ROC(SM) as intellectual property. It’s evident that ROC isn’t so much a theory open to professional discussion as it is a product, and one designed to generate substantial revenue.

Now don’t get me wrong. If I could figure out a meme that could sell thousands of books and bring business to my door, I’d be ecstatic. Peppers and Rogers have done it not once, but numerous times, with One-to-One marketing, with Managing Customer Relationships (CRM), and now with ROC. Their marketing effectiveness is genius. But that doesn’t mean that ROC as a financial metric stands up the hype. And that’s what I want to explore in more depth, starting out just with the bit that Peppers cites in his comment:

Let’s say you were trying to evaluate which of two possible marketing initiatives to undertake. Initiative A requires you to spend $10 per customer and yields a profit of $5 per customer, for a 50% ROI, while Initiative B requires you to invest $20 per customer and yields $7 in profit, for a 35% ROI.

Any sane person would choose the 50% ROI, right? Wrong. Since both the 35% and the 50% ROI are clearly in excess of your cost of capital, your supply of funds is unlimited, but your supply of customers is not. Suppose you had just that ONE customer? Then Initiative B would create $7 in profit, compared to just $5 for A.

But here’s the punchline: You should still choose Initiative B even if you "only" have a million customers, or 100 million.

We’re not saying that ROI isn’t important. Money does cost money, and you have to pay attention to the return you get on the money you use. But ROI is not sufficient, by itself.

So, while we couldn’t agree more that almost all of the RO[X] ideas out there are not very helpful, we beg to differ when it comes to ROC, which will actually lead to different decisions.

I must be missing something. This is simply capital budgeting. Yes, most marketers need to get up to speed to understand finance, but are you actually saying a CFO wouldn’t be able to figure out such a financial insight without ROC(SM)? Or is ROC just a concept for marketers who don’t understand finance?

The difficulties continue the more you dig into the numbers. A big part of ROC relies on another metric called Customer Equity, which would be a great metric of actual customer value, if mere mortals could actually measure it. But it’s much more difficult than it sounds to match up the theoretical value of concepts like customer equity, or even customer lifetime value, with the practicality of actually measuring it. And that, in the end, is my whole point. The theoretical concept behind ROC(SM) is something many intelligent people have argued from many different angles–companies need to value their customers, they need to measure the value customers generate, and they need to sustain those efforts beyond our quarterly-driven myopia. But supporting those theories with financial constructs opens those metrics up to honest and professional criticism. And I can think of no better way to leverage our emerging social media networks to do just that.  

{ 9 comments… read them below or add one }

Jim Lenskold December 22, 2006 at 8:20 am

Chris,
You are right on target with your assessment of Return on Customer(sm). On one hand, Peppers and Rogers is delivering the right message to marketing and corporate executives. There is a lot to learn from Return on Customer (the book) and I recommend it.

On the other hand, ROC(sm) the methodology is not all that unique as you point out. I won’t get into the details of the math but as I interpret it, discounted cash flow is used to determine customer lifetime value which is then used to determine customer equity which is then combined with short term cash flow to get a ROC figure. If you use a marketing ROI correctly, accounting for the full impact on cash flow over the long-term (both positive and negative impact), you’ll make the right decisions to improve profitability and economic value.

ROI is a very actionable approach for marketing decisions. It also builds huge credibility by aligning with the language and approach used by the CFO and CEO. It is important to note that you use marketing ROI to achieve the goal of maximizing profits, which does not necessarily mean you are maximizing ROI (you’ll have to read my book for the detailed explanation on that one).

I also have to take this opportunity to correct Don’s math example which does not lead a marketing professional to the right decision (I’ve seen this exact example used multiple times from P&R so they can all learn from this).

Don wrote:
Let’s say you were trying to evaluate which of two possible marketing initiatives to undertake. Initiative A requires you to spend $10 per customer and yields a profit of $5 per customer, for a 50% ROI, while Initiative B requires you to invest $20 per customer and yields $7 in profit, for a 35% ROI.

Any sane person would choose the 50% ROI, right? Wrong. Since both the 35% and the 50% ROI are clearly in excess of your cost of capital, your supply of funds is unlimited, but your supply of customers is not. Suppose you had just that ONE customer? Then Initiative B would create $7 in profit, compared to just $5 for A.

He argued that you want to make the decision based on the highest profit and not the highest ROI. In his example, however, the higher ROI would lead to the higher profits. The reality is that a marketer will be deciding how to invest their budget and not which customer to pursue.

So with a budget of $20, you can either acquire 1 customer that will generate $7 in profit or 2 customers that generate a total of $10 in profit. Which would you choose?

The example that Don and his team should be showing to support the theory of ROC is that we don’t want to run the financials on just the first purchase or the returns from just the first investment. We need to show that 1) better customers will provide better returns on future investments (what I refer to as Incremental ROI) and that 2) managing customer relationships should be assessed as the total investment from acquisition, retention, and growth initiatives relative to the total return that customer generates (what I refer to as Aggregate ROI or Customer ROI).

I will say that creating new variations on ROI or other financial metrics is beneficial if it helps to support better decision making and ROC may be playing this role effectively for some companies. As long as marketing gets better insight on its financial impact and takes greater accountability, it is a positive move forward.

Tom Asacker December 22, 2006 at 2:56 pm

Look. It’s all based on assumptions, right? If you want to prove something, do what any scientist would do: design an experiment that tests those assumptions for accuracy. If they’re not repeatable, they’re simply theories. And marketers have plenty of theories. They don’t need any more.

Chris Kenton December 22, 2006 at 4:00 pm

Jim–

Thanks for the insight. I hadn’t noticed the obvious issue with the example provided. But even more salient is your point about alignment with the CFO. Personally, I’d rather see a lot more marketers mastering existing financial concepts before championing new derivatives.

/chris

Chris Kenton December 22, 2006 at 4:09 pm

Tom–

Good to see you here again. I think part of the challenge is that getting from concepts like Customer Lifetime Value or Customer Equity to practical, and testable, metrics that any company can actually use is a lot more difficult than the pronouncements that make for compelling book jacket copy (just wait until you get to the point of negotiating cost allocation). But that’s not a new problem, is it… getting from theoretical strategy to practical application?

/chris

Victor Cook December 26, 2006 at 11:48 am

RETURN ON (X)

This discussion and the associated comments highlight some of the long-standing gaps between the finance and marketing views of markets. My intention is to explain the reasons for these gaps in the hope you will begin thinking of ways to close them.

The Story of Linda Tan

Linda Tan, a recent M.B.A. graduate and a financial news reporter, was given an assignment to analyze the financial performance of various Asian and American companies. It was her job to present her findings in a front-page feature on “identifying value creators.” She compared a number of public Asian and American companies on the basis of sixteen value creators. These included sales revenue, net income, earnings per share, return on capital, return on assets, market value of equity, share price, price earnings ratio, beta, and debt to equity ratio.

Notice that the lion’s share of these “value” creators is found on a company’s balance sheet. Sales revenue was the only marketing measure included in Linda’s list, because this is what she learned in her MBA program. The implication is that brand equity and customer life-time value are not among the value creators.

What is Value?

CFOs as a rule do not believe marketing creates “value” in their understanding of the word. And here’s an important fact of life for marketers: to C level managers the word “value” means “shareholder” or “market” value. This value has an unambiguous financial definition: the closing price of the company’s common stock multiplied by the number of shares outstanding.

Shareholder value is created by the factors in Linda’s list, plus a host of other financial value creators like stock buy-backs, stock splits, PIPS, and dividend pay-outs. In the typical CFO’s mindset the word “value” does not conjure up satisfied customers, or brand equity, or any other marketing term. So, when marketers claim that only customers create value this is what the CFO thinks: If marketing really creates value, show me what effect it will have on the closing price of my stock at the end of the next fiscal year!

What is an Asset?

There’s a critical difference between capital and customers: 
a company owns capital assets but it does not own customers. As a result customers are not financial assets. No matter how much we like to think they are.

That’s why companies can’t borrow money on “customers” or count their “value” in a balance sheet. Return on (X) is a marketing — not a financial — metric. I’ve participated in countless executive seminars where marketers explain the newest “financial” metric based on marketing performance. When asked if they understand the importance of this new RO(X) the CFO nods his/her head in agreement. Then, walking down the hall after the meeting he or she says to the CEO: That guy needs to take a course on valuation. Yes, there are entire courses taught on financial valuation where the word marketing never is mentioned. If you don’t believe me, open that copy of basic Corporate Finance you have on your shelf and look up the word “Marketing.” It’s not there.

How Risky is a Market Opportunity?

The interaction between the markets that serve customers and those that create capital — and make no mistake these are separate markets – are complex and subtle.

The interactions between customer and capital markets depend fundamentally on the business model. For example, even though Google ™ has virtually unlimited capital, the millions of YouTube (sm) visitors as yet has no financial value other than the speculation by Google™ that they can successfully monetize that base.

It turns out that creating shareholder value in customer markets is thought by many CFOs to be far more risky then creating shareholder value in financial markets. Yet marketers have no objective way of quantifying customer market risk. So C-level officers are left to assess marketing risk from the constant news of product market failures in the business press.

Bottom line? Don’t put that Corporate Finance book back on your shelf. Instead, study it to figure out some way to make marketing matter using the financial accounting data that your CFO understands.

Hakim Aly February 14, 2007 at 2:04 pm

It seems to me that the ROC formula involves a bit of doublecounting. ROC is measured as (Cashflow from customers during period i + change in customer equity during the period i ) divided by customer equity at the begining of the period i.

Customer Equity is, in turn, equal to customer lifetime value (CLV) which is the net present value of the FUTURE stream of cashflows a company expects from the customer. Thus, CLV includes cashflow from period i. As such, cashflow from period i is counted twice!

The analogy I believe that P&R was trying to use is the concept of Total Return typically used in stock analysis. It is calculated as (Divdend from stock in period i plus change in the stock’s market value during period i) divided by the stocks market value at the begining of the period i (or, equivalently, the market value of the stock at the end of the previous period).

The difference is that the stock’s value and changes in value are objectively determined by the market, whereas CE is a calculated, not an observable, number.

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