An interesting academic paper was published back in 2005 called “Using Real Options to Help Build the Business Case for CRM Investment” (h/t Graham Hill for sharing it with me a few years back). This is seriously cool stuff and I urge you to follow the link and explore the embedded case study. I’m going to summarize the first part of the piece here so you can get a flavor of it. It’s not going to be easy stuff, if you have no background in this kind of analysis. Nevertheless, it’s a pretty fascinating perspective on building business cases and I recommend anyone in the CRM space (or any space for that matter) to read it a couple of times, and let it sink in.
Just so I don’t mess it up, I’m going to quote the abstract verbatim:
“While CRM (Customer Relationship Management) practices are being adopted widely, research suggests that most CRM programmes fail in their dual objective of creating superior customer value and increasing profits for the firm.
This article questions the basis on which the business case for CRM investments is made. It highlights shortcomings with traditional cash-flow analysis (DCF and NPV), how these shortcomings inhibit successful CRM implementation and why senior managers may consider using Real Options thinking to address the limitations of DCF and NPV. A simulated case study illustrates how the use of Real Options in addition to NPV/DCF can impact decision making when preparing the business case for CRM investments. Such complimentary analyses help ensure that senior manages focus on both the activities that generate immediately-identifiable cash as well as the harder-to-quantify strategic aspects of customer relationships that generate longer-term customer value and profits.”
I want to keep this as brief as possible (you can read the article yourself). First, the assumption is that CRM investments are generally made without critical analysis of the assumptions used. We all know the scenario, someone decides to purchase CRM technology and we really don’t question how they will put it to good use (tactical or strategic). We just assume. Not everyone proceeds this way, just most companies – which is just fine with vendors by the way, so the burden is shifted to companies and their consultants to introduce this. The entire point of this approach is to force executives to identify and verify their critical assumptions in order to reduce risk to the project, and their business.
The authors argue that using traditional approaches (which many don’t really use either) can actually prevent CRM initiatives from achieving their objectives because they focus on short term cash flow instead of the longer term value created with customers. It’s difficult to quantify these benefits in terms of cash but there are certainly benefits to long term relationships with profitable customers; we just need a way to understand them. The promise of CRM has allowed the market to continue its spectacular growth; but that promise has not necessarily translated to automatic wild growth for the customers. If you’ve read my blog in the past, you know that I’m searching for the missing link; and this framework is a piece of the puzzle.
Traditional methods for building business cases tend to promote the value of short-term cash flow of the long term value of cash received. Thus we continue to see decisions (along with motivations and measures) slanted toward the short-term; even though we consistently hear executives talk about the long term. Can you really manage the long-term through short-term decision-making? The evidence clearly suggest no; but short-term testing and validation aimed at longer term goals could help you minimize the risk in large investments. Here are the three main points against traditional approaches used for evaluating investment decisions:
- “Discounted Cash Flow (DCF) does not encourage measuring or fully valuing the non-cash value of customers which, consequently, may remain understated.” – The contention is that customers are worth more than cash. Do you agree? If you’re on the word-of mouth, referral value, loyalty bandwagon, you may finally learn how to measure its value.
- “The portfolio decision maker assumption may also be suspect.” – When things are changing quickly around you in the market, you may not have the luxury of getting big bets wrong; even the bet to become more customer-centric. DCF fails to value the consequence of getting the bet wrong. The greater the range of possible returns, the greater the option value because for testing, learning and postponing full commitments.
- “When there is great uncertainty around the outcome, a business case that looks at the NPV (Net Present Value) of a best estimate scenario is not always helpful.” – If there is a wide range of outcomes, selecting the mid-point estimate will not adequately address risk related to variability.
In the investment world, an option is the right to buy or sell a financial asset at some future time. Real Options get their name because the underlying asset is real, not financial. When investing in CRM initiatives and technology, there is always an option to defer the investment, pilot a smaller test or scale a successful test. Having a model for making these decisions has value because an organization can earn interest on retained capital and it also has value because it can eliminate the risk surrounding a particular investment decision. In a nutshell, there is a great deal of value that comes with the ability to scale a project up or down as risks unfold.
“…the total value of the project is the NPV plus the value of the option to scale up, scale down, or to pull out.”
The benefits of using a real options approach to your CRM investment decisions can include:
- Modifies the DCF approach to capture the flexibility, learning and risk management of a project
- The value of flexibility is the option to scale a project up, or down, as the risks become clearer over time
- It offers a superior pricing technique and decision support analysis
- Real options has demonstrated applications to marketing and marketers (e.g. how to value learning from customers)
- The ability to add back the value of learning, which reduces investment risk in a project
Let me know if you use this approach to building business cases; any type of business case.
This post was written as part of the IBM for Midsize Business program, which provides midsize businesses with the tools, expertise and solutions they need to become engines of a smarter planet. I’ve been compensated to contribute to this program, but the opinions expressed in this post are my own and don’t necessarily represent IBM’s positions, strategies or opinions.
