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Is Customer Equity the Path to Measuring Marketing ROI?

There is an increasing buzz around using the concept of "customer equity" as the ultimate yardstick of marketing effectiveness and efficiency. The premise is that customers and their expenditures represent the most tangible manifestation of economic value that can be correlated to marketing activities.

The concept is simple. Marketing is intended to influence how the customer thinks, acts, and behaves with respect to purchasing the company's products or services. Further, the goal of marketing is to stimulate consistent repurchase over time. Consequently, one can measure Customer Lifetime Value (CLV) — which is essentially the sum of all future profits to be derived from customers, discounted back using a Net Present Value adjustment. Increases or decreases in CLV then indicate the effectiveness of marketing at adding economic value to the organization.

A new study published in the Journal of Marketing has pushed the concept a bit further than any we've seen before. The study's authors are very well respected academics known for their work within the arena of customer-centric marketing:

Roland Rust is chairman of the department of marketing at the Smith School of Business, University of Maryland.
Valerie Zeithaml is senior associate dean of the Kenan-Flagler Business School, University of North Carolina, and co-author with Roland Rust of some of the leading books on customer service of the past decade.
Katherine Lemon is an associate professor in the Carroll School of Management at Boston College.

In their paper, the authors present a framework that enables competing marketing strategy options to be traded off on the basis of potential financial return using CLV as the metric of potential success. The lift in CLV (presumably in contribution margin terms), divided by the cost of achieving it, provides the ROI for that investment.

Recognizing that many marketing activities cannot be directly correlated to specific purchase behavior, the paper describes how companies can analyze various "drivers" of profit (i.e., quality, price, convenience, purchase intentions, positive brand image, etc.) to find those that have the greatest impact on CLV. This is assumed to be accomplished by correlating customer research on important decision factors underlying the purchase behavior back to actual customer behavior using historical purchase records. If you don't have historical purchase data by customer to reconcile with research, you might start by screening for most profitable, average, and least profitable customer segments and see if the research on drivers differs significantly between the groups.

Once you have identified the drivers and their relative correlation to customer profit, the study suggests you can assess the cost of a proposed marketing initiative against the likely change in related drivers by taking the forecast CLV profit impact of the change in drivers and dividing by the cost of each initiative to measure the relative ROI associated with investing more or less in various initiatives.

In a nod to practical reality, the authors also propose a means of adjusting their model for the impacts of competitive activity and external marketplace dynamics to bring a more robust "what if" element of scenario testing into account. Their approach is to use a brand-switching matrix, like the one below, to add the element of real-world behavior, and dialing up or back the customer's propensity to switch from one company/brand to another as a proxy for higher or lower levels of competitive market activity.

While this study is presented in full academic glory with all the requisite footnotes, attributions, and statistical regression formulae, it is worth slogging through if only for the perspective one can gain from the thought process underlying the approach and the logic of the model. It will stimulate your thinking about how to measure things that previously seemed unmeasurable.

Two caveats though. First, while this seems to be a reasonable approach to gauging the relative impact of various investment alternatives, it may have significant variability to actual results as the number of nested assumptions can get quite high. Second, there are so many variables that might affect CLV over time that using this approach to measure actual results may only shift the debate to the appropriateness of this approach compared to your current or prior ones. So if you're looking for an airtight approach to measuring marketing impact, keep looking.

However, if you're seeking to engage your CEO and CFO in a dialogue about relative measures of marketing effectiveness and efficiency, this is a worthy topic of conversation.

You can find the complete paper in the Journal of Marketing, "Return on Marketing: Using Customer Equity to Focus Marketing Strategy," by Ronald T. Rust, Katherine N. Lemon, and Valerie A. Zeithaml, Jan. 2004, Vol. 68, Issue 1. Available at www.marketingpower.com.