We're often asked by clients about the key strategic insights a company should take from our Return on Customersm metric. We devised a metric that can be applied at the individual customer level, or against particular customer groups or segments, or against a company's entire customer base. At the enterprise level -- when you are considering how your whole customer base is creating value for your business -- what does ROC really tell you?
Probably the most important question you can answer by looking at your firm's Return on Customer is whether your income and growth level can be sustained in the future. It takes customers to create value, and you need to know whether your customers (both current and future customers) are capable of creating enough value to fuel whatever financial growth ambitions you have. In short, are you building enough customer equity to sustain your financial plans?
Just because you make a profit today does not mean that you'll make a profit tomorrow. To illustrate what we mean, we devised a chart showing five hypothetical companies. These companies are all in different situations with respect to both the level of customer equity they are sustaining, and their profit levels. We have categorized them as "Value Creators," "Harvesters," and "Value Destroyers."
Each of the companies above starts the year with a baseline customer equity of $1,000. Customer equity, as we've covered before, is basically the net value of all future cash flows a firm expects customers to generate. Think of it as the sum total of all the lifetime values of all of a company's current and future customers. Companies 1 and 2 end the year with an increase in customer equity, while the other companies suffer some loss of customer equity. When you factor in the differing profits of these five companies, we can calculate ROC for each one, and it ranges from 25% (Company 1) all the way down to -5% (Company 5).
Beyond shareholder return
At the enterprise level ROC is the same number as Total Shareholder Return. This is because customer equity is virtually equal to the discounted-cash-flow value of a business, so when you add the profit taken during a period to the change in value of the underlying customer equity, what you get is the overall value created by the firm. So, at a minimum your ROC has to be higher than your cost of capital or you aren't creating any value at all.
Companies 1 and 2 are "Value Creators" because the ROC for each company is comfortably higher than either company's cost of capital. It's important to note that each of these companies could report the same level of profit the next year and still have a company that was more valuable than it was before. In other words, these companies have a profit that is sustainable.
Companies 3 and 4 are what we call "Harvesters," because while each one's ROC is non-negative, neither one has an ROC higher than its cost of capital. These companies, essentially, are eating their own customer base and reporting the meal as a profit for shareholders. This can happen when a firm "harvests" business from the customer base. It is part of a normal business lifecycle but is not a practice that can be overused.
For example, a bank may put a full-court press on its mortgage department in order to drive business. A car dealer may opt for zero percent financing to clear inventory. This will take some customers out of the market and therefore while it may increase revenue, it damages the value of the customer base over time. Any company that continues to harvest value from the customer base in this manner will eventually run out of customer equity. Like a farmer burning out his land by over- planting, sooner or later a Harvester will find that the customer base can no longer support the harvest being taken from it.
Company 5 is what we would call a "Value Destroyer." This is a company that has reported a profit to its shareholders, but did so at an enormous cost in customer equity. In fact, the reduction in customer equity actually exceeded the profit reported, which means that the company actually destroyed value. It didn't just convert customer equity to profit; it spent more in customer equity than it earned in current profit.
By starting with the future-focused metric of customer equity, ROC demands that companies look long term at value creation. Factoring in changes in that equity along with profit it is an effective view as to whether a company's activities are creating, harvesting or destroying the value of its customer base. That customer base is just as valuable to you as land is to a farmer. How a company works its land makes all the difference.