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 Maximize your return on customer
 Understanding Allowable Cost Per Order

Yet this is exactly the way the overwhelming majority of today's companies assess their own finances. Just as a portfolio of securities is made up of individual stocks and bonds that not only produce dividends and interest but also go up and down in value during the course of the year, a company is nothing more than a portfolio of customers. These customers not only buy things from the firm but also go up and down in value during the course of their patronage.

Without customers, a company's value isn't even worth discussing. However, increases or decreases in the value of a company's customer base are never taken into account when a company calculates its own success and reports it to the world at large. Yet the company's shareholders or stock market analysts following the business do not object. Moreover, the firm's managers don't think about the value of their customer base in planning their own day-to-day, quarter-to-quarter actions, even though these actions will surely have an impact on the value of the firm's customers. The primary mission of management is to preserve and increase the value of the firm, but they make no attempt to measure their success by customer. Instead they leave it to "the market," which is largely driven by investors with access to even less information than the managers have themselves.

We would like to advance a new concept in measuring the value of a company. Companies, we believe, should measure their Return on Customers, (ROC).They should be held accountable for it, and managers should be rewarded by their ability to preserve and increase the value of the customer base as a financial asset. Without a handle on Return on Customer, companies frequently end up destroying a great deal of their own value in a single-minded quest for current income. If managers actually tracked their ROC, they would have a whole new perspective on growing their company's value.

Other measurements figure into this concept of ROC. Among them is "lifetime value," or LTV. The net present value of the cash flows a company expects to generate from any single customer is equal to that customer's LTV, and if we add together all the lifetime values of a firm's current and future customers, the result is "customer equity." This represents the net present value of all the future cash flows a firm expects to get from its customers. Customer equity is the customer-derived portion of any company's true economic value. It is closely aligned with enterprise value. Increasing a firm's customer equity is virtually equivalent to achieving organic business growth.

Note that we define customer equity as the sum of the lifetime values of all current and future customers served by a firm. This is an important distinction. Analysts and academics do not all define customer equity in this way, but nearly all businesses regularly do acquire new customers as a normal part of their ongoing operations. So the value represented by these new customers needs to be factored in to the overall value of the enterprise if customer equity is to serve as a useful management tool.. Additional profit (and greater customer equity) can be achieved by, for instance, acquiring more customers, or acquiring them more efficiently, or acquiring different, more profitable types of new customers. A rapidly growing company will have a much higher level of customer equity (and thus higher enterprise value) than a static firm with the same current profit, primarily because of the value expected from its future customers.

The customer-derived cash flows that make up customer equity should include costs, to the extent they can be attributed to particular customers or groups of customers. To calculate the enterprise value of a business, then, we need only subtract from its customer equity any unallocated costs of operating the business, as a business. Unallocated costs represent, in essence, all the activities that no particular customer sees or receives a benefit from -- in other words, all costs that cannot be fairly ascribed to any particular customer or group of customers. Many of these costs amount to what might better be called "infrastructure" -- overhead, research and development, corporate jet, headquarters building and the like.

To increase a company's value, a management team should pay close attention to customer equity in making all its decisions.The team needs to evaluate sales, marketing, production, distribution, business combinations and corporate strategy decisions based at least partly on the amount by which any proposed actions are likely to increase or decrease its customer equity. Clearly, the company's mission should be to create as much value from its customers as possible, while realizing that overall value will be driven not just by current profits, but also by changes in customer equity.

Creating value from customers should also be seen for what it is: an optimization problem. The firm must maximize (1) its current-period profits, offset or enhanced by (2) any negative or positive changes in the value of its customer equity.At the extreme, with a very aggressive marketing strategy, or by tricking customers out of their money, a firm could take maximum profit as soon as possible, but future sales would be negatively affected and customer equity would likely decline substantially. At some profit level below this extreme, however, there is an optimum level of overall value creation, measured in terms of customer equity, as well as current-period profit.

Return on Customer Defined
Actual calculations can be made to determine ROC. The rate at which a business is able to create value from any given amount of customer equity is its Return on Customer, or "ROC." Mathematically, ROC can be defined as the sum of a firm's current-period profit from its customers, plus any changes in customer equity, divided by the total customer equity at the beginning of the period.

At the first level, ROC is a kind of go/no-go indicator, describing a company's yes-or-no effectiveness at growing its business organically, from the value proposition it offers to customers. A positive ROC implies value creation, while a negative ROC implies value destruction. An ROC of zero indicates that value is neither being created nor destroyed, but simply is converted from customer equity to current-period profit.

At a second level, Return on Customer is a speedometer for organic growth. It is a quantitative measure of the efficiency with which a company is able to create value. The more efficiently a company creates enterprise value from an existing store of customer equity, the faster the company will grow its business organically, and the higher its ROC will be. Because of the constant trade-offs necessary to harvest current profits from customers, value is continually being consumed out of a firm's customer equity.

An ROC-efficient company will tend to conserve and replenish that value through investments in customer service, relationship building, customer prioritization and new customer acquisition, among other things. Moreover, a company is likely to experience different ROC levels with different groups of customers, so understanding which customers can produce the most value will allow the firm to be more efficient in prioritizing all its efforts. This includes not just marketing and sales, but also research and development, production, distribution, hiring, training, technology investment and so forth.

At a third level, ROC gives us a way to think more clearly about the true economic cost of interruptive marketing, including telemarketing, direct mail, e-mail and other forms of pro-active, outbound messaging. Research by advertising and direct marketing agencies, as well as by academic investigators, has shown that it often requires more than one "hit" to communicate a message to, or elicit a response from, a consumer. A television-advertising message, for instance, might require three to five exposures before most consumers actually absorb it and can "play back" its central message for a researcher.

But all of us as consumers can intuitively feel the negative effects of repetitive marketing messages. The difference between reinforcement and annoyance is a function of relevance and helpfulness of the message. A customer's tolerance for dialogue decreases with every unfruitful solicitation. Some may be welcome, but the vast majority of solicitations are indeed unfruitful. Marketers have traditionally judged campaigns to be successful on the basis of response rates that are rarely more than single-digit percentages, and often less than 1 percent. Even a "successful" campaign is likely to generate far more irrelevant contacts than relevant ones.

The more a firm solicits business from a customer without success, the less valuable that customer will be to the firm, meaning the firm's ROC on the customer declines, reducing the firm's ability to create value.The customer will simply become less likely to respond to future offers, less willing to pay attention to the company's various entreaties and less interested in the firm's information. The company itself is likely to experience this as an erosion of marketing efficiency. Managers trying to spend money to make money find that they make less with every new campaign. But the result is not just a decline in marketing efficiency; it is a destruction of customer equity.

ROC is simply a quantitative lens for viewing the results of your company's mission more accurately, and for managing it more responsibly and effectively. Doing the right thing for customers, delivering better value for customers, making your own business a safer, more hospitable place for customers as the fundamental way to build enterprise value -- that is your mission. Return on Customer is just a handy tool with which you can better drive that mission home to your own organization, teaching everyone how to make daily decisions that not only serve customers well, but also create genuine, long-term value for the business.

No matter what the branch of marketing a firm is in or where that branch fits on the continuum, every successful marketer knows that there is a finite amount that an organization can afford to spend on each customer to promote its product or service. We call this the "Allowable Cost Per Order" or ACPO.

This amount can be determined through a calculation based on a mix of the revenue the marketer expects to receive for each product unit sold multiplied by the number of units the marketer expects to sell, less all the costs of the manufacturing or production of the product and its distribution. Stated as a formula, this can be expressed as:

ACPO = Total Revenue - all expenses including profit and/or contribution.

This formula can be applied to a single or multiple sale, a subscription, a club or any sales sequence to consumers or businesses.

If the marketer's promotional efforts are very successful and sell more than originally contemplated, the organization benefits on the bottom line by being able to amortize promotional spend over a greater number of sales, thus reducing the amount of promotional money that must be allocated to each sale. Conversely, if sales to not achieve the desired level, each unit of merchandise is burdened with a greater marketing cost than had been anticipated and is reflected in lower profits or unexpected losses. A recent article in The Economist drew attention to this: "Last year…GM's (General Motors) profit per vehicle was a scant $350-providing a wafer-thin profit margin of 1-2%. With manufacturing costs these days cut to the bone, the only way for carmakers to raise their margins is to lower their marketing and warranty costs." [Emphasis added].

Even with the benefit of highly sophisticated models, "image" advertisers are subject to a high degree of risk. This risk reduces the closer we get to individual or one-to-one relationships with our customers. We can see them much more clearly, and they are many times more accountable than when we are marketing to the average consumer or even selected consumer segments. All marketers share a common objective, to obtain an actual cost per order lower than our allowable cost per order.

The concept of ACPO works at every stage of the marketing continuum. Although it is least applicable to image advertising, it still plays a positive and profitable role. But it becomes an increasingly powerful tool when applied to sales promotion, direct marketing and CRM.

The critical economic factor is always how much we can afford in marketing spend to make the sale, transform the prospect into a customer and retain the customer's loyalty.

How much we can afford to do each of these things depends on a number of factors. Some are more obvious than others. There is the revenue we expect to receive. From this must be deducted the cost of the product we intend to sell, the cost of any sales incentives, the cost of handling and delivering the order, of collecting the money and much more. There is also the attrition rate of customers when the product is delivered and paid for over time and there is the cost of maintaining the customer relationship.

Finally, and importantly, there is the profit or contribution we plan to make. What can we afford to spend for promotion is what's left after all these costs are deducted from the revenue.

This is the Allowable Cost per Order. It is arguably the most important economic factor in marketing and the one that most profoundly affects the profits on the bottom line. It informs every aspect of the marketing economics and media strategy. If you can't calculate the ACPO you are, so to speak, flying blind, an activity not known to contribute to getting you where you wish to go or even surviving the journey.

A Single-Product Example
Calculating the ACPO for different types of products and promotions depends upon the marketer having sufficient data and tools to develop appropriate models. To better understand the drivers that condition the ACPO calculation, it would be useful to look at a sale of a single product.

The simplest sale is a single sale to a single person. Its economic requirements are rudimentary and every merchant who stays in business uses them in one form or another as second nature whether or not he includes direct marketing in his marketing armory. While this examples assumes this sale is made at a distance-what is usually called a "mail-order" or direct marketing sale-most of the criteria are the same if the product is delivered at the retail level.

Before direct marketers discovered the many advantages of acquiring a "customer" instead of simply making a "sale," this was the most common form of responsive offer. It is still used frequently. It allows the user to input the important data and delivers the results including sensitivities (defined by the user) to aid planning.

The marketer needs the following information:
*The revenue value of an individual unit.
*How many units the person will buy.
*The total product cost per unit.
*The revenue from postage and shipping chargebacks if any.
*The cost of sales or other taxes.
*The total costs of fulfillment including distribution, handling, credit card charges, etc., if the product is to be delivered rather than sold at the retail. *An assumption for bad pay.
*An assumption for product returns.
*The costs of any premiums or incentives to be given including shipping them if separate from the product shipment.
*Any miscellaneous expenses.
*The desired profit or contribution.

From these inputs we can compute the "Net Margin before Promotion." Using an estimated total promotion cost per thousand, both the number of orders necessary to recoup the promotion expenses and the percentage response needed to get them are simple to derive.

In our example, we look at a single product with a unit price of $60,00 and a unit product cost of $15.00. There is also a "Postage Charge Back for Package," which is additional revenue to help cover the costs of postage or other distribution. The model contemplates the sale of two units of the same product to a single buyer. What we see when all the operational costs have been deducted is $29.22 (Net Margin before Promotion). The question is: How much marketing can we buy for $29.22 or put another way, what level of response do we need to attain the 15% profit or contribution margin that is our objective?

Using this model, we see that we would need a 2.74% response to meet the target. If experience teaches that this is unrealistically high, then the additional cost of making the sale will eat into the profit or contribution margin and may negate the project, sending its proponents "back to the drawing board."

To evaluate the effect of different response percentages, we also calculate sensitivities. The percentage in this case is 20%.

Let's say the target percentage response is 1.71% and reducing it by 20% gives us a percentage response of 1.37%. This allows us to do easy "what ifs": what if, for example, the response percentage was only 1.10%? How would this effect the profit? As can be seen, it would fall from the desired 15% or $18.53 to only 1.69% or $2.09.

Obviously, changing the promotion cost per thousand people promoted from $500 to, say, $800 would also substantially impact the results. The response needed for breakeven (including the desired 15% profit or contribution) has increased to 2.74%.

From Accountable Marketing, The Economics of Data-Driven Marketing 1st edition by ROSENWALD. Copyright 2004. Reprinted with permission of south-Western, a division of Thomson Learning: www.thomsonrights.com. Fax 800-730-2215. Copies are available online at: http://www.racombooks.com.