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Return On Marketing: Using Customer Equity To Focus Marketing Strategy
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Return on Marketing:
Using Customer Equity to Focus
Marketing Strategy
The authors present a unified strategic framework that enables competing marketing strategy options to be traded
off on the basis of projected financial return, which is operationalized as the change in a firm’s customer equity rel-
ative to the incremental expenditure necessary to produce the change. The change in the firm’s customer equity is
the change in its current and future customers’ lifetime values, summed across all customers in the industry. Each
customer’s lifetime value results from the frequency of category purchases, average quantity of purchase, and
brand-switching patterns combined with the firm’s contribution margin. The brand-switching matrix can be esti-
mated from either longitudinal panel data or cross-sectional survey data, using a logit choice model. Firms can ana-
lyze drivers that have the greatest impact, compare the drivers’ performance with that of competitors’ drivers, and
project return on investment from improvements in the drivers. To demonstrate how the approach can be imple-
mented in a specific corporate setting and to show the methods used to test and validate the model, the authors
illustrate a detailed application of the approach by using data from the airline industry. Their framework enables
what-if evaluation of marketing return on investment, which can include such criteria as return on quality, return on
advertising, return on loyalty programs, and even return on corporate citizenship, given a particular shift in cus-
tomer perceptions. This enables the firm to focus marketing efforts on strategic initiatives that generate the great-
est return.
The Marketing Strategy Problem none of the above? Such high-level decisions are typically
op managers are constantly faced with the problem of left to the judgment of the chief marketing or chief executive
Journal of Marketing
Vol. 68 (January 2004), 109–127 Return on Marketing / 109
Customer Equity strategic portfolio literature by incorporating those
Although the marketing concept has reflected a customer- elements.
centered viewpoint since the 1960s (e.g., Kotler 1967), mar- Three related streams of literature involve CLV models
keting theory and practice have become increasingly (Berger and Nasr 1998), direct marketing–motivated models
customer-centered during the past 40 years (Vavra 1997, pp. of customer equity (e.g., Blattberg and Deighton 1996; Blat-
6–8). For example, marketing has decreased its emphasis on tberg, Getz, and Thomas 2001), and longitudinal database
short-term transactions and has increased its focus on long- marketing models (e.g., Bolton, Lemon, and Verhoef 2004;
term customer relationships (e.g., Håkansson 1982; Stor- Reinartz and Kumar 2000). Our CLV model builds on these
backa 1994). The customer-centered viewpoint is reflected approaches. However, the preceding models are restricted to
in the concepts and metrics that drive marketing manage- companies in which a longitudinal customer database exists
ment, including such metrics as customer satisfaction that contains marketing efforts that target each customer and
(Oliver 1980), market orientation (Narver and Slater 1990), the associated customer responses. Unless the longitudinal
and customer value (Bolton and Drew 1991). In recent database involves panel data across several competitors, no
years, customer lifetime value (CLV) and its implications competitive effects can be modeled. Our model is more gen-
have received increasing attention (Berger and Nasr 1998; eral in that it does not require the existence of a longitudinal
Mulhern 1999; Reinartz and Kumar 2000). For example, database, and it can consider any marketing expenditure, not
brand equity, a fundamentally product-centered concept, has only expenditures that are targeted one-to-one. We also
been challenged by the customer-centered concept of cus- model competition and incorporate purchases from com-
tomer equity (Blattberg and Deighton 1996; Blattberg, Getz petitors (or brand switching), in contrast to most existing
and Thomas 2001; Rust, Zeithaml, and Lemon 2000). For models from the direct marketing tradition.
the purposes of this article, and largely consistent with Blat- The financial-impact element of our model is foreshad-
tberg and Deighton (1996) but also given the possibility of owed by two related literature streams. The service profit
new customers (Hogan, Lemon, and Libai 2002), we define chain (e.g., Heskett et al. 1994; Kamakura et al. 2002) and
customer equity as the total of the discounted lifetime values return on quality (Rust, Zahorik, and Keiningham 1994,
summed over all of the firm’s current and potential 1995) models both involve impact chains that relate service
customers.1 quality to customer retention and profitability. The return on
Our definition suggests that customers and customer quality models go a step farther and explicitly project finan-
equity are more central to many firms than brands and brand cial return from prospective service improvements. Follow-
equity are, though current management practices and met- ing both literature streams, we also incorporate a chain of
rics do not yet fully reflect this shift. The shift from product- effects that leads to financial impact. As does the return on
centered thinking to customer-centered thinking implies the quality model, our model projects ROI. Unlike other mod-
need for an accompanying shift from product-based strategy els, our model facilitates strategic trade-offs of any prospec-
to customer-based strategy (Gale 1994; Kordupleski, Rust, tive marketing expenditures (not only service improve-
and Zahorik 1993). In other words, a firm’s strategic oppor- ments). We explicitly model the effect of competition—an
tunities might be best viewed in terms of the firm’s opportu- element that does not appear in the service profit chain or
nity to improve the drivers of its customer equity. return on quality models. Also different from prior research,
our approach models customer utility, brand switching, and
Contribution of the Article lifetime value.
Finally, we compare the current article with a recent
Because our article incorporates elements from several liter-
book on customer equity (Rust, Zeithaml, and Lemon 2000)
ature streams within the marketing literature, it is useful to
that focuses on broad managerial issues related to customer
point out the relative contribution of the article. Table 1
equity, such as building a managerial framework related to
shows the contribution of this article with respect to several
value equity, brand equity, and relationship equity. The book
streams of literature that influenced the return on marketing
includes only one equation (which is inconsistent with the
conceptual framework. Table 1 shows related influential lit-
models in this article). Our article is a necessary comple-
erature streams and exemplars of the stream, and it high-
ment to the book, providing the statistical and implementa-
lights key features that differentiate the current effort from
tion details necessary to implement the book’s customer
previous work. For example, strategic portfolio models, as
equity framework in practice. The current work extends the
Larreché and Srinivasan (1982) exemplify, consider strate-
book’s CLV conceptualization in two important ways: It
gic trade-offs of any potential marketing expenditures. How-
allows for heterogeneous interpurchase times, and it incor-
ever, the models do not project ROI from specific expendi-
porates customer-specific brand-switching matrices. In sum-
tures, do not model competition, and do not model the
mary, the current article has incorporated many influences,
behavior of individual customers, their customer-level brand
but it makes a unique contribution to the literature.
switching, or their lifetime value. Our model adds to the
Overview of the Article
1For
In the next section, on the basis of a new model of CLV, we
expositional simplicity, we assume throughout much of the
article that the firm has one brand and one market, and therefore we
describe how marketing actions link to customer equity and
use the terms “firm” and “brand” interchangeably. In many firms, financial return. The following section describes issues in
the firm’s customer equity may result from sales of several brands the implementation of our framework, including data
and/or several distinct goods or services. options, model input, and model estimation. We then present
Strategic Brand
Trade- ROI Can Be Net Present Switching
offs of Any Modeled Explicitly Applied to Value of Modeled at
Type of Marketing and Models Calculation Most Revenues and Customer Statistical
Model Exemplars Expenditures Calculated? Competition? of CLV? Industries? Costs? Level? Details?
Longitudinal Bolton, Lemon, and Yes Yes No, unless Yes No Yes No, unless Yes
database Verhoef (2004); panel data panel data
marketing Reinartz and
Kumar (2000)
Return on Current paper Yes Yes Yes Yes Yes Yes Yes Yes
marketing
( 7) CES j = CE j /∑ CE .
k
k Implementation Issues
Cross-Sectional Versus Longitudinal Data
Our approach requires the collection of cross-sectional sur-
ROI vey data; the approach is similar in style and length to that
of a customer satisfaction survey. The survey collects cus-
Effect of changes. Ultimately, a firm wants to know the tomer ratings of each competing brand on each driver. Other
financial impact that will result from various marketing necessary customer information can be obtained either from
actions. This knowledge is essential if competing marketing the same survey or from longitudinal panel data, if it is
initiatives are to be evaluated on an even footing. A firm may available. The additional information collected about each
attempt to improve its customer equity by making improve- customer includes the brand purchased most recently, aver-
ments in the drivers, or it may drill down further to improve age purchase frequency, and average volume per purchase.
subdrivers that influence the drivers (e.g., improving dimen- The logit model can be calibrated in two ways: (1) by
sions of ad awareness). This requires the measurement of observing the next purchase (from either the panel data or a
customer perceptions of the subdrivers about which the firm follow-up survey) or (2) by using purchase intent as a proxy
wanted to know more. for the probability of each brand being chosen in the next
A shift in a driver (e.g., increased ad awareness) pro- purchase.
duces an estimated shift in utility, which in turn produces an
estimated shift in the conditional probabilities of choice Obtaining the Model Input
(conditional on last brand purchased) and results in a revised
The implementation of our approach begins with manager
Markov switching matrix. In turn, this results in an
interviews and exploratory research to obtain information
improved CLV (Equations 4 and 5). Summed across all cus-
about the market in which the firm competes and informa-
tomers, this results in improved customer equity (Equation
tion about the corporate environment in which strategic
6). We assume an equal shift (e.g., .1 rating points) for all
decisions are made. From interviews with managers, we
customers, but this assumption can be relaxed if appropriate,
identified competing firms and customer segments; chose
because our underlying modeling framework does not
drivers that correspond to current or potential management
require a constant shift across customers.
initiatives; and obtained the size of the market (total number
of customers across all brands) and internal financial infor-
mation, such as the discount rate and relevant time horizon.
In addition, we estimated contribution margins for all com-
7If standard marketing costs (e.g., retention promotional costs) petitors. If there was a predictable trend in gross margins for
are spent on a time basis (e.g., every three months), they may either any firm in the industry, we also elicited that trend. From
be discounted separately and subtracted from the net present value exploratory research, using both secondary sources and
or be assigned to particular purchases (e.g., if interpurchase time is
three months, and a standard mailing goes out every six months,
focus group interviews, we identified additional drivers,
the mailing cost could be subtracted on every other purchase). which we reviewed with management to ensure that they
8We should also note that the expression implies that the first were managerially actionable items. On the basis of the
purchase occurs immediately. Other assumptions are also possible. combined judgment of management and the researchers, we
TABLE 2
Factor Loadings: Airline Industry
Inertia –.013 –.004 .033 .038 .015 .116 –.024 .984 .029 .043 .002
Quality .097 .058 .174 .076 .147 .212 .014 .049 .068 .904 .083
Price .044 –.007 .128 .054 .078 .023 .039 .030 .975 .059 .034
Convenience .078 .068 .219 .161 .043 .830 .066 .163 .018 .260 –.015
Ad awareness –.031 .130 .038 .938 –.010 .022 .048 –.011 .074 .101 .058
Information .216 –.077 .248 .656 .322 .299 –.207 .125 –.038 –.058 .016
Corporate citizenship .011 .122 .150 .093 .880 .001 .256 .021 .077 .137 .006
Community events .021 .100 .188 –.042 .226 .051 .921 –.026 .041 .011 .029
Ethical standards –.016 .044 .605 .105 .458 .266 .028 –.034 .104 .109 .218
Image fits my personality .098 .112 .878 .107 .069 .092 .203 .058 .110 .142 .081
Investment in loyalty program .921 .044 .090 .032 –.007 –.060 .018 .014 –.003 .137 –.103
Preferential treatment .898 .087 .082 –.002 .022 –.071 –.029 .032 –.007 .077 .104
Know airline’s procedures .708 .232 –.022 .116 .029 .166 .058 –.033 .010 –.069 .240
Airline knows me .681 .309 –.073 –.059 –.001 .356 –.012 –.061 .136 –.075 .219
Recognizes me as special .214 .851 .069 .077 –.036 .042 .138 –.004 –.044 .118 .092
Community .175 .876 .065 .031 .166 .035 –.015 .001 .036 –.042 .129
Trust .246 .227 .179 .069 .041 –.003 .031 .006 .038 .091 .889
Notes: Loadings greater than .5 are shown in bold.
Log-likelihood = –98.46
Chi-square (11 degrees of freedom) = 69.246**
*p < .05.
**p < .01.
TABLE 4
Driver Coefficients: Airline Industry
across the respondents. That is, expressed in terms of Equa- Correlated errors. Another way the independence from
tion 2, the βs may be different across respondents. To test irrelevant alternatives property can be violated is if the error
this, we employed a random coefficients logit model (Chin- terms in Equation 2 are correlated. For example, it is possi-
tagunta, Jain, and Vilcassim 1991) in which we permitted ble that people who prefer American Airlines more than the
the driver coefficients to be distributed as an independent model predicted will systematically dislike Southwest Air-
multivariate normal distribution. The log-likelihood lines more than the model predicted. To address this issue,
improved from –97.58 to –93.24, which is an insignificant we turned to a multinomial probit model (Chintagunta
improvement (χ211 = .8.68). Therefore, we conclude that the 1992). In this model, the error terms in Equation 2 are
random coefficients logit formulation does not produce a assumed to be normally distributed rather than extreme
better model and that it is not worthwhile in this case to value, and they are permitted to have a general covariance
model unobserved heterogeneity in the parameters. matrix.
Relative Frequency
50%
results in a nested test. We found that the uncorrelated errors
version of the model resulted in a log-likelihood of –98.46 40%
(slightly worse than the multinomial logit log-likelihood) 30%
and that the more general model produced a log-likelihood
of –97.57. The improvement is insignificant (χ23 = .82). We 20%
also can compare the general multinomial probit model with 10%
the original multinomial logit model by using the Akaike
0%
information criterion. The improvement from –97.58 to 0–99 100–199 200–299 300–399 400–499 500+
–97.57 does not compensate for the additional three esti- CLV ($)
mated parameters (we would need a log-likelihood
improvement of at least 3.0), suggesting that the general
multinomial probit model is not better than our multinomial
logit model. Thus, we conclude that the more general tion. For example, Figure 2 shows the distribution of CLV
covariance matrix is not warranted. across American Airlines’ customers. The $0–$99 category
Coefficient reliability. Given our relatively small sample includes more than 60% of American’s customers, and the
size (96 usable data points after the data are cleaned), we $500-plus category includes only 11.6% of customers, indi-
were unable to pursue split-half tests or complete holdout cating that the bulk of American’s customers have low CLV.
samples. However, to further understand the reliability of Figure 3 also indicates that American’s customers are fickle.
our model estimates, we randomly split our sample into Almost half of American’s customers have a 20% or less
three parts (A, B, and C) and estimated our model on AB, share-of-wallet (by CLV) allocated to American. Only
AC, and BC. The mean range (and median range) of the 10.5% give more than 80% of their CLV to American. This
coefficient estimates across the 11 factors was .14; that is, on percentage shows dramatically that the vast majority of
average, the swing between the largest and smallest coeffi- American’s customers cannot be considered monogamously
cient estimate across the three samples was .14, which loyal. Figure 4 shows a startling picture of the percentage of
comes out to about .6 standard errors, on average. Thus, the American’s customer equity that is contributed by each CLV
model appears to produce reasonably stable coefficient category. The $0–$99 category, though by far the largest
estimates. (more than 60% of American’s customers), produces less
than 10% of American’s customer equity. In contrast, the
CLV $500-plus CLV category, though only 11.6% of American’s
customers, produces approximately 50% of American’s cus-
Using Equation 5, we calculated CLV for American Airlines
tomer equity.
for each respondent in our airline sample. To operationalize
the equation, we assumed a time horizon of three years, a Comparison with the lost-for-good CLV model. Previ-
discount rate of 10%, and a contribution margin of 15%. The ously, we proposed that some models of CLV that do not
15% figure was approximately equal to the average operat- account for customers’ returning systematically underesti-
ing margin for the industry for the five years preceding the
survey, according to annual reports of the four firms we
studied (since our study, airline industry operating margins FIGURE 3
have declined). We also based our contribution margin fig- Distribution of CLV Share (Share of Wallet):
ures in the other four industries on financial data from American Airlines
annual reports. To extend the CLV figures to the firm’s U.S.
customer equity, we used U.S. Census data to determine the
50%
number of adults in the United States (187,747,000), and we
then combined this with the percentage of U.S. adults who
Relative Frequency
40%
were active users of airline travel (23.3%), yielding a total
number of U.S. adult airline customers of 43,745,051. To 30%
approximate the total customer equity, we multiplied this
20%
number by the average CLV across our respondents. Note
that though we used average CLV to project customer 10%
equity, we calculated CLV at the individual customer level
for each customer in the sample. 0%
0%–20% 21%–40% 41%–60% 61%–80% 81%–100%
Customer loyalty and CLV. Some insights can be CLV
obtained from examining American Airlines’ CLV distribu-
TABLE 5
Projected ROI from Marketing Expenditures
Percentage Dollar
Improvement Improvement
Company Area of Geographic Amount in Customer in Customer Projected
(Industry) Expenditure Region Investment Improved Equity Equity ROI
American Passenger United States $70 million .2 rating point 1.39% $101.3 million 44.7%
(airlines) compartment
Puffs Advertising United States $45 million .3 rating point 7.04% $58.1 million 29.1%
(facial tissues)
Delta (airlines) Corporate United States $50 million .1 rating point 1.68% $85.5 million 71.0%
ethics
Bread & Circus Loyalty Local market $100,000 .5 rating point 7.04% $87,540 –12.5%
(groceries) programs in two measures
Appendix A J
Principal Components Regression where Yij equals one if customer i chooses brand j and
The independent variables for the principal components equals zero otherwise, the likelihoods on the right side are
analysis are all the drivers and the LAST variable. The vec- the usual 0–1 logit likelihood expressions obtained as in
tor Xijk denotes the original independent variables for each Equation 3, and p*ij is the element of p*i that corresponds to
customer i by previously purchased firm j by next-purchase firm j. The resulting likelihood for the sample is then the
firm k combination. Treating the customer by firm combi- product of the individual likelihoods across the respondents.
nations as replications, we extract the largest principal com- It is easily shown that with this adjustment in the likelihood,
ponents of Xijk and rotate them using varimax rotation to the standard logit regression maximum likelihood algo-
maximize the extent to which the factors load uniquely on rithms can be employed (Greene 1997, p. 916, 1998, pp.
the original independent variables, thereby aiding manager- 520, 524). The same adjustment of the likelihood does not
ial interpretability. The vector Fijk denotes the rotated factor. affect the derivation of the asymptotic distribution of the
These form the independent variables for our logit regres- regression coefficients14 (as is evident in McFadden’s [1974,
sion, which we describe subsequently. pp. 135–38] work), which means that the usual chi-square
Expressing Equation 2 in terms of the underlying factors statistics, as given in standard logit software such as
leads to the following: LIMDEP, can still be employed, even if the p*ij vector is not
all zeroes and ones.
(A1) Uijk = Fijkγ + εi,
From Equation 3, it is easily shown that the partial deriv-
where γ is a vector of coefficients. ative of probability of choice with respect to utility, for
From factor analysis theory, it is known that the factors respondent i and firm k, is15
are linear combinations of the underlying variables Xijk. In (A4) D ik = ∂Pik /∂U ik
other words, there exists a matrix A for which Fijk = XijkA.
However, the idea of the principal components analysis was
to discard the potentially muddling effects of the least
= ∑ exp(U ik* )
[exp(U ik )]
k*
important components. Denoting A* as the subvector of A
∑ exp(U
2
that corresponds to the reduced factor space (discarding the
principal components that do not meet the eigenvalue cutoff)
− [exp(U ik )]2 } ik* )
k*
and γ* as the estimated γ that corresponds to the reduced
space, Equation A1 can be expressed as
= [exp(U ik )]
∑ exp(U
k*
ik* )
(A2) Ûijk = (XijkA*)γ* = Xijk(A*γ*),
where Ûijk is the estimated utility, which means that β* =
× ∑ exp(U ) ∑ exp(U ik ik* )
A*γ* can be the estimated coefficient vector. In other j ≠ k k*
words, the coefficients of Xijk are obtained by multiplying
the regression coefficients obtained from the logit regression
= p* ik ∑ exp(U ij ) – exp(U ik )
on the factors by the factor coefficients that relate the drivers j
to the factors.
Logit Estimation
∑ exp(U
k*
ik* )
Usually in multinomial logit regression, the observed depen- = p* ik (1 – p* ik ).
dent variable values are ones and zeroes, corresponding to
the purchased brand (1 = “brand was purchased,” 0 = “brand Then, from Equation A2 we have
was not purchased”). This will be the case if the next pur-
(A5) ∂Pik/∂Xijk = ∂Pik/∂Uik × ∂Uik/∂Xijk = (A*γ*)Dik
chase is observed from a longitudinal panel or follow-up
survey. However, if purchase intent is used as a proxy for = (A*γ*) p*ik(1 – p*ik).
next purchase, the dependent variable values will be propor-
This equation shows how each customer’s brand-
tions that correspond to the stated (or calibrated) purchase
switching matrix will change given a change in any driver
intention probabilities. This does not create any difficulties.
(or changes in more than one driver). This result is nonlin-
From Equation 9, we have Uijk = Fijkγ* + εi, after discard-
ing the principal components that did not meet the cutoff. 14Actually, convergence is faster, because the probabilities of
Using the laws of conditional probability, we can express next purchase are given directly, so the law of large numbers does
the likelihood of a particular parameter vector γ* given not need to be evoked with respect to the dependent variable.
respondent i’s observed next purchase (or purchase inten- 15For convenience, we suppress the j subscript for D, P, and U,
tion) vector p*i as because for any customer i in the sample, j is fixed.
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