2005 Sep 01
Customer Value Models
David M. Raab
DM Review
September, 2005

The buzz words of the moment in business intelligence seem to be “predictive analytics”. These encompass two notions: all that data we’ve been gathering should be used to predict customer actions, in addition to reporting on them; and, these predictions should be used in operational systems to help guide interactions. In other words, we need headlights in addition to a dashboard and the headlights should be placed so the driver can see what they show.

This makes sense so far as it goes. But driving safely is one thing and knowing where to go is another. Most predictive analytics applications are strictly tactical: which offer is the customer more likely to accept or yield the most profit? Yet maximizing profit on a single interaction may actually reduce the value of the long-term relationship. An inappropriate offer might annoy many customers or preempt another offer with less immediate return but greater ultimate value.

Good businesspeople understand this intuitively. It’s why they offer special discounts to new customers and bend the rules when their most profitable clients have a problem. The challenge is translating this intuition into corporate policies that optimize results.

Such policies must be based on empirical analysis, but the proper data is rarely available. Unless a formal test of alternative treatments is in place, companies treat all customers according to the same business rules. Thus, the best an analyst can do is to look at how customers behaved after being given certain treatments in certain situations.

This may identify obvious problems, such as high attrition rates when an offer is made to a customer who just had a service problem. This suggests that something other than an offer would reduce attrition in that situation. But it’s a tenuous link at best, because the data can’t show what would have happened had the company done something else. Only a formal test–randomly making different offers to customers in similar situations and tracking their subsequent behavior–can really isolate the effect of that single decision. Such tests are often difficult to set up and take a long time to evaluate. Managers may also be reluctant to treat some customers differently than others, for fear that some will feel discriminated against.

These difficulties should not be overstated. In practice, some interactions are more clearly more important than others. First-time buyers, customers who have had problems, and customers approaching a renewal date are at obvious inflection points. Companies can test alternative treatments in these situations with reasonable assurance that differences in near-term results will correlate with differences in long-term value. Once the obvious candidates have been optimized, the company can work on more subtle options such as changes in contact frequency or different loyalty incentives.

If marketing treatments were the only choices that companies had to make, then offer testing would suffice to optimize results. But customers are affected by many things: product design, manufacturing processes, logistics, customer service, and even personnel policies. Many of these decisions compete for financial resources. All compete for management attention. Each needs to be assessed in terms of its impact on customer relationships. Despite being a cliche, it’s true that the aggregate value of these relationships is the value of the company itself. Thus, impact on customer value can be used as a standard metric to compare investment opportunities in all business areas.

Why use customer value instead of a traditional measure such as return on investment? Because calculating customer value requires modeling the major interactions between the company and its customers. In other words, it forces the company to simulate the customer experience. This leads to an understanding of the connections among different business decisions, which traditional financial analysis does not. Thus the focus on customer value helps to prevent short-sighted decisions that meet an immediate goal but harm the organization as a whole.

For example, one part of a simulation model will track how many customers interact with customer service and how they behave afterwards. This means that assessment of any proposal to reduce customer service costs will include the impact on later customer purchases. A return on investment calculation can incorporate such factors, but only if the analyst is clever enough to identify them. With a customer value analysis, they are included automatically. Similarly, the customer value model will highlight the downstream impact of business plans such as new acquisition programs, avoiding unexpected bottlenecks in distribution or service should volume suddenly increase.

Looked at another way, the customer value approach means the company is using the same framework to assess marketing treatments as staffing levels or business policies. This simplifies the task of the analysts and managers, who can work with a single tool. More important, it ensures that all opportunities are evaluated thoroughly and consistently.

The simulation model also provides a comprehensive inventory of customer interactions. This is more valuable than it may seem, because managers cannot otherwise be certain they are considering all of their opportunities for business improvement. Today’s businesses are so complex that even experienced managers can no longer be confident that they are intuitively focusing on the most important choices, or that they correctly understand how these choices interact. Thus a proper customer value model provides immense value for corporate planning.

A customer value model supplements, rather than replaces, tactical devices such as predictive analytics. More precisely, it provides a context to ensure that tactical decisions take into account their strategic consequences. Of course, finding the correct strategy itself is still a challenge: the customer value model cannot ensure a company gives the right answers. But it does help the company to ask the right questions. And that is an excellent start.

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David M. Raab is a Principal at Raab Associates Inc., a consultancy specializing in marketing technology and analytics. He can be reached at draab@raabassociates.com.

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