Elsevier

Long Range Planning

Volume 38, Issue 4, August 2005, Pages 393-410
Long Range Planning

Using Real Options to Help Build the Business Case for CRM Investment

https://doi.org/10.1016/j.lrp.2005.05.002Get rights and content

The long-term benefits of implementing a Customer Relationship Management programme are widely accepted as being: learning from customers, building customer retention, and reduced market uncertainty. Yet high rates of failure in CRM can originate right at the stage where the investment decisions are made. Traditional discounted cashflow analysis alone does not value or focus managerial attention upon the strategic long-term benefits of CRM. Through a simulated case study analysis, this paper illustrates how the addition of Real Options to discounted cashflow can improve CRM investment decision making, encourage managers to verify critical assumptions and reduce both investment and business risk.

Introduction

Customer Relationship Management appears to be a win:win strategy whereby companies secure and learn from their customers who in turn receive customised solutions, reduced costs and superior service. However the difficulty in quantifying the effect of CRM from a financial perspective often results in it floundering at the stage where the investment decisions are made. Perversely, the financial framework most often used in preparing business cases for CRM may inhibit such programmes from achieving their strategic and business objectives. Arguably, the traditional cashflow analyses based upon Discounted Cash Flow (DCF) and Net Present Value (NPV) calculations are too limited a basis on which to make CRM investment decisions. This is because they undervalue returns, and focus management attention on short-term cashflow when, perhaps, the main benefits of customer relationship investments lie in building a strategic customer relationship asset. In other words, the long-term benefits of closer, deeper relationships with selected customers are difficult to quantify in cash terms as they can lead to reductions in the volatility of sales, market uncertainty and business risk. Given that CRM investments are usually strategically significant, with a value in the range of $60m to $200m for a highly complex installation, the risk of business failure needs to be fully quantified.1 In the 1990s, the climate for CRM investment was more favourable and companies invested without fully considering any risks. Research suggests that 55 per cent of all CRM projects have not produced results, and some 20 per cent of users report actual damage to long-standing customer relationships.2

Today, business leaders are demanding a more rigorous approach to developing and presenting the business case for CRM investment. As a consequence, the senior managers involved in delivering the business case, usually a project team drawn from Marketing, Sales, IT and Customer Service, need to address fully the questions: ‘What steps can we take to reduce the uncertainty in the business case for CRM?’ and ‘How do we reduce the risk of business failure if we adopt a more customer-centric approach through CRM?’

In this paper, we first identify the potential benefits of CRM investments both to customers and the company. Then we explore the limitations of DCF and NPV in assessing how the CRM business case is presented. To counter the problems of risk and uncertainty left largely unanswered by a cashflow analysis, we introduce the idea of Real Options as a risk-reduction step to build the business case for CRM investment. This we do through a simulated case study of a telecoms equipment manufacturer considering a CRM investment. Initially, we develop a range of business case scenarios for the company, together with a cashflow calculation for each. These scenarios show wide variability, depending upon the business assumptions made, and we conclude that they significantly undervalue the likely effects of the company's CRM investment and look very high risk indeed.

To help mitigate the uncertainty of such a large-scale investment, we introduce the idea of using Real Options, in conjunction with traditional cashflow analysis, to quantify the effects of trialling CRM as an alternative pathway for building the case for CRM investment. Although Real Options have been used to manage other IT investment risks, as far as we are aware, this is the first time Real Options have been applied in the context of a CRM investment.3

We close the paper by exploring the managerial implications of how this combination of cashflow and Real Options helps reduce uncertainty in the CRM investment and discuss our contribution to the marketing literature.

The promise of customer relationship management is captivating. For customers, CRM offers the potential for customised solutions, superior service and reduced costs over the lifetime of their relationship with the company as shared knowledge of their business strategy, buying preferences and processes can be developed systematically. For the company, the ability to gather customer data swiftly, identify the most valuable customers and increase customer retention is highly desirable as it positively impacts profitability. Reinartz and co-researchers define CRM as ‘a systematic process to manage customer relationship initiation, maintenance and termination across all customer contact points to maximise the value of the relationship portfolio’.4 Thus, CRM offers a potential win:win scenario for both the company and its customers. However, the underlying reasons why both customers and companies choose to restrict the width of their business relationships require a fuller explanation of the mutual benefits that CRM offers.

Economic theory predicts that customers will buy from many suppliers to reduce costs and improve service. In reality, they restrict their choice to a few preferred suppliers or brands with whom they either trust or collaborate closely. While it seems that customers act contrary to their best economic interests, economists acknowledge that perhaps customers are acting rationally and avoiding transaction costs through relationships. Even where transaction costs are not a major consideration, customers may yet calculate that the total lifecycle costs of owning certain assets or procuring services are better managed through relationships.

In some markets, customer retention can be explained through the avoidance of switching costs.5 For example, companies may be reluctant to change software because of the costs of retraining staff, repopulating databases and potential conflicts with other systems. Relationships with companies that listen, learn and respond through effective CRM practices can improve the customer's procurement experience. Where this happens, a virtuous cycle can develop: committed customers invest further in their focal suppliers by increasing their expenditure and suppliers continually invest in process and quality improvements to support such strong and enduring customer relationships.

In summary, many customers prefer to deal with a small core of supplier-partners than to procure important supplies in the open market. Relationships are considered to add value and reduce costs, and buyers demonstrate a preference for building stable relationships over pure market transactions for all but straight commodities or low-risk purchases.

In recent years, businesses have paid increasing attention to the profit impact of customer retention. Reichheld argues that it is more profitable to focus on retaining customers rather than just maximising market share.6 Reichheld also maintains that these effects increase over time, so that the profitability of retained customers grows exponentially. Small changes in customer retention rates create a disproportionate increase in profitability.

It is the incentive of increasing customer retention and profitability through better CRM practices which often drives companies to develop a more customer-centric strategy. However, effective customer retention is contingent upon market segmentation as the starting point for the development of a firm's CRM strategy.7 Research suggests that most firms ‘carry’ many unprofitable customers who don't generate margins commensurate with the cost to serve them. Peppers and Rogers argue that, through market segmentation and CRM, companies will be able to identify unprofitable customers and discontinue subsidising them so that resources can be redirected to attracting and retaining and profitable customers.8 For businesses supporting a large number of unprofitable customers, realigning the asset and cost base towards profitable customers can reduce the total asset base while increasing revenue. The impact upon shareholder value is obvious.

Recent research suggests that retained customers can also increase shareholder value by reducing the volatility of the company's cashflow.9 Serving large numbers of transient customers makes cashflow volatile and creates fluctuations in short-term assets, such as inventory and receivables. Investors demand greater return on investment to compensate for volatile cashflow. In addition, long-term customers may contribute valuable and unique learning to the company. Knowledge gained by a company from its customers through CRM over time can be translated into marketing action tailored to individual customers. Once a customer sees a supplier acting on information it has been given through CRM, there is a strong disincentive to start again with a competitive supplier. Learning from customers is particularly important in developing new products – there will be fewer expensive failures when customers can input early into the product development process.10 This reduced development risk (or improved success of innovation) builds cashflow and reduces overall business risk. Indeed, many CRM advocates say that customers generate much more than cash flow; they ‘teach’ companies how to improve their business.

While the promise of CRM is beguiling, the concomitant benefits of a more customer-centric strategy can only be achieved through investing in technology, people and processes; both these CRM investment costs and the risk of business failure throughout the transition period can be very high.

Next, we explore what the main assumptions are in developing the business case for CRM and how the financial analysis is usually presented.

CRM creates symbiotic value for both customers and the business. The more customers ‘teach’ their suppliers, the more these businesses can support and respond to them. This value exchange process lies behind the most critical assumptions about the CRM business case:

  • 1

    Trust is developed. Research suggests trust is developed through repeated experiences that meet or exceed customer expectations.

  • 2

    The CRM programme has integrity. Customers will continue ‘teaching’ companies about their needs and preferences for as long as they perceive benefit and therefore the CRM business plan must identify how the company will learn and respond.

  • 3

    There is mutual commitment. The business case must identify how and why customer commitment will increase over time, and how this increased commitment results in increased retention and reduced churn. Moreover, commitment can be leveraged commercially through increased sales, referrals and references. Research suggests that committed customers are likely to buy more from their preferred supplier through choice.11

We argue that traditional financial analysis forces marketing and sales management to identify the outcome of the customer learning process at the outset of the CRM business case. So, senior managers write these assumptions into their sales targets, and design customer relationships around what the company wanted to sell to them in the first place. This compromises the win:win scenario that underpins any CRM strategy and, as we highlighted earlier, research suggests that most companies fail to achieve their targeted ROI from CRM investments.12

Most CRM business cases are built upon traditional financial investment analysis tools; Discounted Cash Flow (DCF) and its associated calculation of Net Present Value (NPV). Investment policy in most companies is to create shareholder value by determining whether expected returns on any investment exceed the risk-adjusted cost-of-capital for that type of investment.

In this financial model, CRM represents an investment in technology, people, new processes and marketing aimed at stimulating an increase in cashflow from customers in future years through higher revenues at lower sales and marketing costs. This cashflow is discounted by an appropriate charge for capital to enable managers to compare investment and return on a like-for-like basis; that is, the present value of each. If NPV is positive when cashflows are adjusted for the true cost of capital, then risk-adjusted return exceeds cost of investment. Sophisticated users of DCF estimate a residual value for the asset at the end of the planning period.

NPV is based upon estimated incremental cashflows that are uncertain and there are no guarantees that the business case will be delivered once the programme(s) starts. However, the forecasting process assumes that the business is a portfolio decision maker, making a series of investment decisions based on expected value. This is a risk reduction strategy; the business makes a large number of investments, none of which will expose it to unacceptable risk levels. If each business case is honestly made, then investments that return less than forecast are balanced by those that exceed their estimates. Across a large number of investments, provided the charge for capital is appropriate, the use of DCF and NPV calculations should lead to decisions that increase shareholder value.

A number of critical assumptions made by these modelling techniques are not necessarily true for CRM investment. For instance:

  • 1

    DCF does not encourage measuring or fully valuing the non-cash value of customers, which, consequently, may remain understated. Customers are worth more than cash; CRM should encourage customers to recruit new customers, to act as test markets for new ideas and to teach companies how to continually improve their operations. These customer relationship impacts can be substantial. For instance, the world's first telephone bank, First Direct, claims 33 per cent of new customers are generated from referral.13 Software companies have long valued co-operative product development with leading customers and some companies may reduce prices to prestigious customers who are willing both to improve and endorse their offering.

  • 2

    The portfolio decision maker assumption may also be suspect. If an industry is in flux and there is a clear imperative to move to a more customer-centric business model, the company may not have the luxury of repeated experimentation. When customer-centric change is a ‘bet your business’ initiative, DCF fails to value the consequence of getting it wrong; the greater the volatility (range of possible returns), the greater the option value of trialling, learning and postponing full commitment.14

  • 3

    Where there is great uncertainty around the outcome, a business case that looks at the NPV of a best estimate scenario is not always helpful. When dealing with a very wide range of outcomes, discounting the cashflows of a mid-point estimate may fail to address adequately the variability and risk of the investment and typically ignores the possibility that managers can intervene during projects to add value.15

Real Options have recently been developed as a financial analysis tool to overcome the limitations of traditional financial analysis and the inability of DCF to reflect the value of learning and risk management. An option is the right (not the obligation) to buy or sell an underlying asset, traditionally a financial asset, at some future time. Real Options are so called because the underlying asset is real, not financial. They are useful for valuation in situations in which investment decisions can be deferred, piloted or scaled; this flexibility has value not just because an organisation can earn interest on the capital it retains but also because deferring a decision until the business situation clarifies reduces the uncertainty surrounding that decision.

The Real Options approach modifies DCF to capture the value of flexibility, learning and risk management in a project such as a major IT installation.16 The value of flexibility is the option to scale a project up (or down) as the opportunity and risks become clearer over time. In other words, the total value of the project is the NPV plus the value of the option to scale up, scale down or to pull out (Figure 1).

Proponents of Real Options claim that they offer a superior pricing technique and decision support analysis to NPV alone; they are a particularly useful technique for evaluating major, future investments. Real Options have recently been demonstrated to have applications in marketing and can offer significant benefits to marketers as a quantitative adjunct to scenario planning or as a way of valuing intuitive ideas or breakthrough thinking.17 For instance, by using Real Options, financial numbers can be put on difficult, hard-to-quantify issues, such as the value of learning from customers and risk reduction in business decisions. By adding back the value of learning and by reducing the risk of investment through exercising a Real Option, senior management is more able to demonstrate that apparently unattractive, or marginally attractive, CRM investments can sometimes have merit.

Like other researchers exploring the potential of Real Options in business investments generally and IT in particular, the limitations of traditional financial analysis and the potential contribution of Real Options can be demonstrated through a simulated case study.18 For the purposes of this paper, our simulated case is Westel, a telecoms equipment manufacturer struggling with a CRM business case.

Mary Green, marketing director of Westel, is leading a multi-disciplinary project team tasked with preparing the CRM business case for a programme believed necessary for the company's survival. Westel is a multinational company providing telecoms network hardware. It has an extensive product and service range, and an established reputation in solving complex, demanding problems. Its high-end products form the telecoms backbone of many of its customers and command high margins. Once installed, Westel can confidently expect the lion's share of upgrades, extensions and ancillary services.

Its annual turnover is £500m which is typical of a US-listed, mid-tier telecoms equipment manufacturer such as 3Com, Scientific Atlanta and Extreme Networks. The company achieves a 40 per cent gross margin with a 5 per cent net contribution; selling, general and administration expenses (SG&A) and research and development (R&D) represent 35 per cent of turnover (see Exhibit 1 for a full breakdown of Westel's simulated income statement). Westel is under attack from new competitors who combine solution design with hardware, installation and network management. These companies are disintermediating Westel from its customers and the board is worried that the company will become a low-margin, hardware supplier to these upstarts. Mary is asked to put together a strategic response. How should Westel leverage its undoubted capabilities and extensive offerings to become a broad-based solution provider to its best customers?

The team divides customers into three categories: profitable; marginally profitable with substantial growth potential; and unprofitable with no prospect of becoming profitable. In the first two categories, Westel is only selling one-third of what it ‘should’ be achieving. Each business unit is focusing on its own offerings rather than total customer need. The company is neither maximising opportunities across business units nor matching sales and marketing expenditure to the opportunity. Each business unit pursues its own targets. To address this, Westel needs to change from being product-centric to customer-centric. The team recommends the creation of a key account management function to:

  • 1

    Integrate Westel offerings into bespoke, value-added customer solutions;

  • 2

    Co-ordinate marketing, sales and service expenses, aligning them to priority customers and development programmes;

  • 3

    Exploit the potential for referral. The team knows that its customers' network extensively and that Westel is not actively fostering customer referrals.

This programme requires substantial investment in sales and marketing, training, new technology and considerable reorganisation of the business.

Mary and her team have prepared the business case for CRM investment on the basis of a 10-year DCF analysis, a normal timeframe at Westel for major investment decisions.

Initially, they compared the NPV results of the DCF calculations based on three scenarios:

  • (1)

    Successful result from a large-scale CRM investment;

    ‘Successful CRM’

  • (2)

    No investment in CRM and no change to the business' performance;

    ‘No Change’

  • (3)

    No investment in CRM resulting in a gradual decline in business performance;

    ‘Gradual Decline’

Exhibit 1 summarises the simulated DCF calculations for ‘Successful CRM’ scenario below:

The year one figures are illustrative of a typical income statement for a US-listed, mid-tier telecoms equipment manufacturer. The average gross margin figure for such mid-tier companies exceeds 37 per cent and they spend about 15 per cent of turnover on R&D. SG&A as a percentage of turnover varies for these companies, reflecting the volatility of this market at the time, and range from 4 per cent to 72 per cent; SG&A expenses are usually adjusted to revenue downturns with a time lag. The figure of 20 per cent used here suggests that Westel has managed its costs effectively and makes a net profit contribution of 5 per cent while operating on a 40 per cent gross margin and allowing for 15 per cent R&D costs.

The revenue forecasts are built up from a base case. This base case is the current turnover which remains constant over 10 years and represents the neutral/no growth assumption. In addition to this base case revenue are the revenues derived from realising the benefits of successfully investing in CRM that were identified earlier; increased business from current customers through cross-selling, new customers through referrals and the ability of customers to help Westel develop new businesses. In CRM business cases, these effects are usually estimated to build over time and taper off by the end of the analysis period as an ‘S’ curve. Revenues from each of these accrued CRM benefits are realised with differing time lags; cross-selling is the most immediate, converting referrals to income is next and commercialising new business ideas based upon the goods and services demanded by major customers usually takes the longest.

The ‘Successful CRM’ scenario shows a gradual and consistent improvement in gross margin, reflecting the elimination of non-value added costs and the migration to higher value-added, higher-priced telecom solutions. CRM enables companies to re-engineer their business processes to provide more of what customers value and less of what customers don't value, thus eliminating non-value added activities and costs.

Westel is also embarking upon CRM to migrate from selling hardware to a mix of hardware and premium-priced systems and solutions that, typically, offer higher gross margins. Gross margin increases of this order (from 40 per cent to 44.5 per cent) have been achieved in recent years by other mid-tier telecoms manufacturers, such as Scientific Atlanta and Extreme Networks.

Other costs (R&D, SG&A) rise in absolute terms over the 10 years but not as fast as turnover. Reduced R&D as a percentage of turnover reflects the spending choices companies often make when moving from a product– to customer-orientation.19 SG&A should also increase at a lower rate than turnover because CRM improves sales, marketing and service processes.

A more detailed explanation of these incremental CRM costs is provided in Appendix 1 under ‘Notes for Appendix 1’. In addition, the income statements for the other two scenarios, ‘No Change’ and ‘Gradual Decline’, are illustrated in Appendix 1.

Despite the dramatic difference in the business outcomes generated by the three scenarios, the NPV estimates demonstrate only a small difference between them in value (Figure 2). This is particularly true when comparing the ‘Successful CRM’ and ‘No Change’ scenarios, the comparison most salient to the board.

On an NPV basis alone, one cannot justify the huge investment in CRM that the team believes is necessary for Westel's future prosperity. The problem is that nobody can prove with any credibility how well CRM will work or how much risk the business is at from competition. They have no basis in fact or experience for their estimates of CRM benefits. For example, the team's belief that future product ideas would generate cost savings from better customer engagement is difficult to evaluate using DCF. To make the case for CRM using traditional financial analysis, the team would have to increase the revenue forecasts well beyond levels that Westel's sales and marketing team could reasonably hope to achieve.

The team is convinced that once a more customer-centric organisation was in place, Westel would find opportunities to reduce non-value-adding costs and identify winning new business ideas. Westel would be at the ‘top-table’ with its customers – gaining inside knowledge of their evolving needs and leading through innovative business practices. Without this access, Westel would lose its edge. Moreover, such a transformation takes time; if Westel does not begin implementing CRM soon, it may be too late by the time the business case becomes apparent.

The team ponders what to do. Should they be even more ambitious about the revenue and margin upside even though they had no firm basis? Could they scale down CRM investment and still justify their growth assumptions? Should they try to convince the Board with ‘soft’, unquantifiable benefits? Should they try frightening the board by painting a vision of doom if Westel allowed competitors to consolidate their hold on its best customers?

Westel needs to become customer-centric. But the only way to make a compelling business case based upon NPV is to make heroic assumptions about increased revenue, reduced cost and the risks of ‘do nothing’. Forecasting large increases in revenue, based on beliefs, experts' claims and hard-to-verify estimates of best practice is risky. Moreover, it assumes that you know the outcome of stronger customer relationships before entering into them. Locking Westel into pre-identified, cross-selling programmes and new product launches risks compromising the trust and learning which is at the heart of CRM. Investing more in the current business practices might generate more immediate return. Smaller initial investments giving short-term returns are favoured in NPV calculations because the discount rate – the time value of money – dramatically reduces benefits that are realised only in the long term.

But what will happen to Westel if Mary and the board are right about the increased competitive threat? How should senior managers assess the risk of being too cautious? If they fail to implement CRM now, can they come back later or will they have missed the chance forever?

DCF, not surprisingly, is best used when the situation can be described in cashflow terms. It fails to value what Westel will learn from its customers – a major CRM benefit. It also favours the short over the long term. DCF/NPV is not good at assessing the longer term, and potentially fatal risk facing Westel. If the competitive threat materialises, then DCF will lead Westel to seriously underestimate the benefits of the CRM investment case and by the time this is understood, it may be too late to implement the far-reaching changes needed to respond in a timely fashion.

The team should avoid the use of heroic assumptions in the business. They are likely to be controversial when held up to scrutiny by experienced directors and the sales function. Moreover, if they are accepted, the pressure for immediate sales increases to customers will undermine any serious attempt at learning and responding to customers flexibly. The problem Mary faces is how to present financial data in a manner that promotes an intelligent discussion with the board, identifies the key assumptions and risks of the investment and builds an informed consensus.

Reviewing the project, the team generates a fourth scenario. Rather than an all-or-nothing rollout of CRM, they identify a limited number of key accounts with which CRM will be trialled. The ability to trial CRM indicates that a Real Option on CRM is present. The value of this option is the value of flexibility, which reduces the risks associated with the CRM investment while increasing senior managers' learning about the returns of CRM for the company. The team estimates that it will take three years to implement and ‘read’ the CRM trial after which time, the board can make the decision whether or not to discontinue the trial (or scale it up) according to the firmer evidence provided by the team's analysis of the key accounts involved.

The DCF calculation of this fourth scenario, Trial CRM, is made on the basis of a three-year trial costing £36m in terms of CRM investment (see Appendix 1 for the Trial CRM income statement and notes for the detailed, year-by-year calculations of Trial CRM incremental costs and Net Contribution). If the trial is successful, CRM can then be extended quickly across the business. However, if the trial is unsuccessful, Westel would not extend CRM and the company will have ‘lost’ £36m which puts much less investment at risk than the £129m required for immediate implementation of CRM across the business during the same three-year period.

On a DCF basis alone, this option does not appear to make sense (Figure 3). The impact of the delay is to reduce the overall NPV of the CRM project to £107m; much lower than a possible £133m for the Successful CRM scenario and only marginally better than the Gradual Decline scenario. This perhaps indicates why so many organisations have plunged into full-scale CRM rollout with sometimes-costly results. Conventional DCF approaches understate the true value of trialling because they ignore the option value.

However, the trial scenario buys flexibility for Westel. It allows the company to validate the team's forecast of the impact upon revenue and costs of the CRM programme and be in a position to extend the programme across the business in a timely fashion should these benefits prove real. Flexibility and the attendant risk reduction are not cashflows and, hence, are omitted in a pure DCF comparison of the four scenarios. Mary must work with Finance to value the flexibility contained within the fourth scenario, Trial CRM. First, they need to calculate the numerical values for the five factors that affect the value of this real CRM option. These are shown in Figure 4:

Then, Mary and her finance colleagues use the numbers in Figure 4 to work out the value of Westel's CRM Real Option. Because of the complexity of options valuation models, they decide to calculate an approximate option valuation using look-up tables based on the Black and Scholes equations set out earlier (see Figure 1).

To find the relevant column, the asset value (£107m) must be divided by the present value of the exercise price (£195m discounted at r of 15per cent = £102.2m). This comes to 1.05 (£107m/£102.2m).

To find the relevant row, the volatility of the underlying asset must be multiplied by the square root of the time period for which the option is available (.32 × √3) = 0.554. Applying these numbers to the look-up tables, the team is able to determine that the value of Westel's CRM option is approximately £25m.

Mary's argument to the board is summarised in Figure 5, which shows the NPV of each scenario, including the new scenario four, Trial CRM, which also has an option value. When the value of the flexibility provided by trialling CRM is added to the cash flow generated, the total value of scenario four is very marginally lower than the potentially much higher-risk option, scenario one, of rolling out a full CRM project immediately.

By calculating the value of Westel's CRM option, the team is in a much stronger position to recommend that the company market tests CRM with a limited number of customers over a three-year period in order to validate the business case assumptions about revenue and costs. The company should then be in the position to implement a full-scale CRM programme shortly afterwards. With three years' experience of CRM, Westel will be able to reduce the wide spread in NPV estimates for CRM. In other words, the company will be able to reduce the risk of its CRM investment. This risk will also be reduced through market testing of CRM that will allow Westel to build competencies, resources and a track record of learning relationships with customers.

The discussion of risk in respect of scenario one, Successful CRM, raises an issue about the interest rate used in the calculations. The same interest rate is used in all four scenarios. However, common sense suggests that the Successful CRM scenario is more risky than the others and, as such, it should attract a higher cost of capital (discount rate). This would have the effect of reducing the NPV of Successful CRM while increasing the option value associated with Trial CRM since, as discussed above, the value of a Real Option varies positively with the interest rate. Thus, the approach taken to valuing Westel's CRM option may be slightly conservative.

The identification of a supportable financial value for the factors, which are not captured in the DCF, allows the board to engage in an informed debate and make a rational assessment of the value of CRM. It addresses the finance director's concern about adding such values into a DCF analysis but does not fall into the trap of either ignoring the value or incorporating it in a non-transparent manner through heroic sales growth assumptions.

There are two important implications for CRM project managers concerning how they make the business case for CRM and the way in which they structure and implement subsequent CRM programmes. Many CRM projects fail, indicating that they are risky. In these circumstances, making a case using DCF/NPV will misrepresent the real value of projects that contain options. The greater the uncertainty, the greater the option value. Making a case for CRM based solely on DCF may deter senior managers from investing in CRM because the potential is understated. In conditions of high uncertainty, a lower commitment entry strategy with real options represents the best approach, avoiding high market risk while maintaining the option of greater investment later.20

The Westel example demonstrates the limitations of financial models (DCF/NPV) which senior managers typically use when building the business case for CRM. Faced with the constraints of considering only the immediately identifiable cashflows, companies may tend to underestimate the true value of the benefits derived from CRM, such as learning from key customers and building their trust. This means that business leaders may not invest in such a programme, leaving their companies vulnerable to competitors. Real Options can help demonstrate the true potential of CRM investment.

The CRM business case is a major strategic document and not merely a financial forecasting exercise. It represents a fundamental change to the business and should be evaluated as a strategic, risky and contingent investment in an unknown future. The challenge for senior managers is to promote a discussion that identifies the extent to which their business must move from a traditional ‘make and sell’ model to ‘listen and respond’ in an unknown future and real options thinking can help to generate this discussion.

The second implication concerns the way in which managers structure and implement CRM programmes. The Westel case illustrates the benefits of options thinking and of structuring CRM programmes to create options to defer, pilot or upscale major CRM investments. Without options thinking, companies may fail to build into the programme sufficient flexibility to learn from customers, which could compromise the huge investment that CRM requires. It can, therefore, enable a rational discussion of risk and flexibility in the search to optimise the structuring of CRM investments and the implementation of programmes. Moreover, in the time before the option must be exercised, the three years of the Westel Trial CRM in this case, senior management attention will be focused on validating the key assumptions built into the business case. This will promote a rigorous, fact-based means of quantifying CRM benefits.

This paper contributes to the emerging research agenda that seeks to relate marketing expenditure and investment to financial performance and shareholder value. Researchers have long decried the lack of sound financial analysis applied to marketing investments and recently the Marketing Science Institute in the US has raised the importance of measuring marketing effectiveness to the status of priority research.21 We would suggest, therefore, that finding appropriate tools for assessing CRM investments helps contribute to this research agenda because the development of profitable customer relationships through CRM is central to the role of marketing. Indeed, Doyle argues that successful marketing strategy, and the creation of shareholder value, is dependent upon building relationships with target customers based on satisfying their needs more effectively than competitors.22

In this paper, we illustrate that the most common methods used to evaluate CRM investment, the DCF calculation and NPV, have clear limitations and cannot be regarded as good predictors of the shareholder value created by CRM investment. Previously, Srivastava et al identify real options theory as a potential approach for assessing the value of projected cashflows from such CRM investments.23 However, they do not provide any examples of its use in practice. So, a further contribution our paper makes to the marketing literature is to provide an example of how real options can be deployed in conjunction with DCF and NPV calculations to develop a more thorough and effective method of building the business case for CRM investment.

Section snippets

Acknowledgements

We would like to offer our thanks to the three blind referees who provided valuable feedback during each drafting stage of our paper and to the continued support, advice and enthusiasm of the Editor-in-Chief.

Stan Maklan is a Visiting Fellow at the Cranfield School of Management and a Founding Partner of the Forge, a marketing consultancy. He spent the first 10 years of his career in marketing with Unilever Canada, UK and Sweden, where he was marketing director of its toiletries business. He spent the following 10 years largely in consulting, most recently with Sapient, a leading builder of new economy businesses, as a senior manager specialising in CRM and marketing strategy. E-mail: [email protected]

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    Stan Maklan is a Visiting Fellow at the Cranfield School of Management and a Founding Partner of the Forge, a marketing consultancy. He spent the first 10 years of his career in marketing with Unilever Canada, UK and Sweden, where he was marketing director of its toiletries business. He spent the following 10 years largely in consulting, most recently with Sapient, a leading builder of new economy businesses, as a senior manager specialising in CRM and marketing strategy. E-mail: [email protected]

    Simon Knox is Professor of Brand Marketing at the Cranfield School of Management in the UK and is a consultant to a number of multinational companies including McDonald's, Levi Strauss, DiverseyLever, BT and Exel. He has held a number of senior marketing roles at Unilever, in the detergents and foods businesses. Since joining Cranfield, Simon has published more than 100 papers and books on strategic marketing and branding. E-mail: [email protected]

    Lynette Ryals began her career in the City as a fund manager and stockbroker, trading UK equities, options and futures. She then moved to a marketing company to work on corporate development and acquisitions, subsequently transferring into the consultancy arm of the same business group. Lynette is a Registered Representative of the London Stock Exchange and is a senior lecturer in marketing at Cranfield. E-mail: [email protected]

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