Balance Sheets as of December

31, 2012,and December

31, 2013

2012

2013

Changes

Cash

150,000

125,000

s (25,000)

Accounts receivable

350,000

375,000

25,000

Inventory

475,000

550,000

Total current assets

Gross fixed assets

975,000

Assets

s 2,425,000

Accumulated depreciation

Net fixed assets

TOTAL ASSETS
Debt (Liabilities)and

(1,000,000)

s 1,050,000

$2,750,000
(1,200,000)

s 1,425,000

s 1,550,000

$2,400,000

$2,600,000

Equity

Accounts payable

200,000

Sbort-term notes

150,000
150,000

75,000

75,000

s 325,000

(200,000)

s 125,000

s~200,000
s (50,000)
150,000

s 100,000

200,000

300,000

Long-term debt

600,000

600,000

100,000

Total debt

800,000

900,000

s 100,000

Common stock

900,000

900,000

Retained earnings

700,000

800,000

Total current liabilities

owners' equity

Total owners' equity

$1,600,000

s 1,700,000

TOTAL LIA81LITIES AND

OWNERS' EQUITY

$2,400,000

S2,600,000

Income Statement for the Year Ending January

s 100,000
s~200,000

1 -December 2013

$1,450,000

Sales
Cost of goods sold
Gross profits
Operating expenses
Operating profits

Interest expense

Profits before taxes

(850,000)

s
s

600,000
(240,000)
360,000
(64,000)
296,000
(118,000)

Taxes

Net profits

178,000
178,000

Net profits
Dividends

0
100,000

paid

Increase in retained earnings

(78,000)
100,000

(Go to www.cengagebrain.com and select the Longenecker text to access the answers to these
questions.)

Allayze the linanoa

statements usilg rattos

toseemoredealt)'how
dtcisioosaftectatim~
linandl/.J)<lbrmarre.

10-5 EVALUATING A FIRM'S FINANCIAL

PERFORMANCE

nce a firm's owner understands the content of the accounting statements. she or
he wants to know how management decisions impact the financial situation of
a business. An entrepreneur's decisions play out primarily in four ways when it comes
to finanoes:
Part 3 Developing the New Venture Business Plan

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I. The firm'sability to pay its debt as it comes due. In other words, does the company
have the capacity to meet its short-term (one year or less) debt commitments?
2. The compnny's profitability from assets. ls the business providing a good rate
of return on its assets? There is no more important question when it comes to
determining if a business is strong economically.

3. The t1111fJ1111tof debt the business is using. Using debt increases a firm's risk. but
may also increase the expected rate of return on the owners' equity investment.
4.

The rate of return earned by the <111 11er.\on their equity investment, All deci
sions ultimately affect the rate of return earned by the owners on their equity
investment in the business.
1

Exhibit 10.8 provides a list offinancial ratios as they relate to the four issues just listed.
The name of each ratio is given, along with how it is computed. We illustrate the ratios
by using the 2013 financial data for Houser & Associates, as presented in Exhibit 10.2
(income statement) and Exhibit 10.5 (balance sheets). Finally, the last column shows an
industry average for each ratio, which comes from financial publications, such as Robert
Morris & Associates. Let's look at the ratios as they apply to Houser & Associates.

10-Sa Liquidity (Ability to Pay Its Debt)

A business-or a person, for that matter-that has enough money to pay off any debt
owed is described as being liquid. The liquidity of a business depends on the availability of cash lo meet maturing deb! obligations. The current ratio is traditionatly used lo
measure a company's liquidity, This ratio compares a firm's current assets lo its current
liabilities, as follows:
Curren! ratio

currem assels
curent liabilities

As you can see in Exhibit 10.8, for Houser & Associates the current ratio is 3.50.
compared lo an industry norm of 2.70. In other words, the firm has $3.50 in current

; :z:

liquidity
The degree to which a
firm has working capital
available to meet maturing
debt obligations.
current ratio
A measure of a company's
relative liquidity,
determined by dividing
current assets by current
liabilities.

Financial Ratio Analysis for Houser & Associates, Inc.

Houser &Associates

Rnancial ratios

)(

1. Ability to pay debt as it comes due:

..,

Currentratio = Current assets

Current liabilities
2. Company's profitability on its assets:

$350,000
---=3.50
$100,000

Industry Norm

2.7

Return on assets = Operating profits

~=10.87%
$920,000

13.2%

.
.
Operating profits
Operating profit margin =- -'---''-'---

$100,000 = 11.76%
$850,000

11.0%

Total assets

Sales

Total asset turnover

Sales
Total assets

~=0.92
$920,000

1.2

$300,000
---=32.61%
$920,000

40.0%

~=9.68%
$620,000

12.5%

3. The amount of debt the company uses:

Debt ratio

Total debt

Total assets

4. Rate of return earned bytheowners

J9

Net prof~s
Return
onequity=----Owners' equity

"'

ontheirequityinvestment:

Chapter 10 Understanding a F'irm's F'inancia I Statements

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279

assets for every$ I of short-term debt, compared to an industry average of $2. 70 of current assets for every $1 in short-term debt. Thus, based on the current ratio, Houser &
Associates is more liquid than the average firm in the industry.

10-Sb Profitability on Assets

A vitally important question to a firm's owners is whether a company's operating profits are sufficient relative to the total amount of assets invested in the company. A firm's
assets are invested for the express purpose of producing operating profits. A comparison of operating profits to total assets reveals the rate of return that is being earned on
the firm's total assets, which represent the total amount of investment in the business.
We compute the return on assets as follows:
Operating profits
Return on assets= -'---=-'--Total assets
As shown in Exhibit 10.8, Houser & Associates' return on assets of 10.87 peroent is
less than the industry norm of 13.2 percent, indicating that Houser & Associates is
generating less operating profits on each dollar of assets than its competitors. That
is not good!
To gain more understanding about why Houser & Associates is not doing very well
in generating profits on the firm's assets, you can separate the return on assets into
two components: (I) the operating profit margin and (2) the total asset turnover. The
equation for the return on assets can be restated as follows:

Return on assets=

return on assets
A measure of a firm's
profitability relative to
the amount of its assets,
determined by dividing
operating profits by total
assets.

operating profit margin

A measure of how well a
firm is controlling its cost of
goods sold and operating
expenses relative to sales,
determined by dividing
operating profits by sales.

total asset turnover

A measure of how
efficiently a firm is using
its assets to generate sales,
calculated by dividing sales
~total assets.

Operating profits
Total assets

Operating
Profit Margin
Operating profits
Sales

Total Asset
Turnover
Sales
Total assets

The first component of the expanded equation, the operating profit margin
(operating profits e- sales), shows how well a firm is controlling its cost of goods sold
and operating expenses relative to a dollar of sales. The second component of a firm's
return on assets, the total asset turnover (saes-s total assets), indicates how efficiently
management is using the firm's assets to generate sales.
The operating profit margin and total asset turnover for Houser & Associates,
along with industry averages, are presented in Exhibit I0-8 and shown again below.
You can also see how they relate to Houser & Associates' return on assets, as well as
to the industry:

Return on assetl)Ho~.
Return on assetl)lodus'Y

=
=

Operating Profit
Margin
11.76%
11.00%

Total Asset
Turnover

x
x

0.92
1.20

=
=

Return on
Assets
10.87%
13.20%

Based on the operating profit margin, Houser & Associates is competitive when
it comes to managing its income statement-that is, keeping costs and expenses low
relative to sales. However, Houser & Associates' total asset turnover shows why the
firm is not earning a good return on its assets. The firm is not using its assets efficiently.
The company's problem is that it generates $0.92 in sales per dollar of assets, while the

Part 3 Developing the New Venture Business Plan

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competition produces $1.20 in sales from every dollar in assets. Management needs
10 assess what is causing the problem, looking carefully al how they are managing the
different types of assets, namely, the accounts receivable, inventory. and fixed assets.
The low 101al asset turnover, showing that Houser & Associates is using more assets
per sales dollar than its competitors, possibly indicates one or more of the following
problems:
I. The firm is no! collecting its accounts receivable as quickly as the competition. By collecting its receivables on a more timely basis, ii would release
money that is currently lied up.
2. Given the amount of sales, the owners have 100 much money tied up in
inventory, which suggests 1ha1 some inventory is slow moving or even
obsolete.
3. II is possible that the company has overinvested in fixed assets (such as facilities) compared 10 the compel ii ion.
Clearly, the Houser sisters need 10 investigate why their firm is not competitive when
ii comes 10 managing assets. After all. entrepreneurship is about doing more with less
when ii comes 10 managing resources.

10-Sc Use of Debt Financing

llow much debt, relative 10 the 101al assets, is used 10 finance a business is extremely
important. For one thing, the more deb! a business uses. the more risk ii is rak ing
because tbe debt has 10 be repaid no mailer how much profit the firm earns; ii is a
fixed cost. However, if a company earns a higher return on its investments than the
interest rate being paid on its debt, the owners benefit from using debt
The debt ratio tells us what percentage of the firm's assets is financed by deb! and
is com puled as follows:
Debi ratio=

Total debt
Tola! assets

Refer again 10 Exhibit 10.8, which shows llouser & Associates' debt ratio as
32.61 percent, compared 10 an industry norm of 40.0 percent Since I louser& Associates
uses less deb! than tbe average firm in the industry, ii has less risk. After all, borrowed
money mus! be repaid regardless of how much money the business makes. All is
if
the company prospers and repays the loan. Bui if 1101, watch out!

'"~II

10-Sd Return on Owners'Equity

The last financial ratio considered here is tbe rate of return that the owners are receiving on their equity investment, or the return on equity.his computed as follows:
.
Net profits
Return on equity = ----'----Total owner' equity

debt ratio
A measure of what
percentage of a firm's
assets is financed by debt,
determined by dividing
total debt by total assets.

return on equity
A measure of the rate of

As you can see in Exhibit I0.8. the return on equity for the I louser sisters is
9.68 percent. while the industry average for return on equity is 12.5 percent. Thus, it
appears that the Houser sisters are not receiving a return on their investment equivalent

return thatowners receive

on their equity investment,
cakulated by dividing net
profits by owners' equity.

Chapter 10 Understanding a F'irm's F'inancia I Statements

281

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to that of owners of comparable businesses. Why not? To answer this question, consider the following:
I. A firm with a high (low) return on assets will have a high (low) return on
equity. It simply is not possible to have a good return on equity if you are not

earning a good return on your assets.

2. As the amount of a firm's debt increases, its return on equity will increase.
provided that the return on assets is higher than the interest rate paid 011
any debt.
In the case of Houser & Associates, the firm has a lower return on equity in part
because it has a lower return on assets. It also uses less debt than the average firm in
the industry,causingits return on equity to be lower than that of other firms. However,
using less debt does reduce the firm's risk.
Here's another example: If a business earns a 15 percent return on assets but
only has to pay 6 percent on its bank debt. the owners will receive 15 percent on the
amount of their equity investment plus the 9 percent difference between the return
on assets and what they pay the bank (15% - 6% = 9"/.). The more debt and the less
equity they use, the more the owners' return on equity will be; it's called financial
leverage.
It's very important to understand that the return on equity will be lower if the
return on assets falls below the interest rate on the loan (e.g., if the return on assets is
8 percent, but the interest rate on debt is 10 percent). That is called negative financial
leverage. These relationships will be explained further in Chapter 12, when we discuss
sources of financing.

financial leverage
The impact (positive or
negative) of financing
with debt rather than with
equity.

Our analysis of financial statements is now complete. llopefully, you are now
better prepared to know what financial statements can tell )'OU about a businessknowledge that can be found in no other way than by interpreting the numbers.
In this chapter, we focused on understanding financial statements related to a
firm's historical financial performance. We were essentially looking back to see how a
business performed in a previous time period. In the next chapter, we will continue to
work with financial statements, but this time we will be looking forward. In writing a
business plan, you need to show convincingly how your plans will play out in terms of
the firm's financial future.

Let's Check for Understanding

Understanding How to Evaluate a Firm's F,inancial Performance
let1s return once again to Maness Corporations financial data to illustrate hO'IN to use financial
ratios to evaluate a firm's performance. Using the data for 2013, which are shown below, and the
industry norms, compute the financial ratios thatvvere discussed in this chapter. Once you have
computed the ratios, answer the following questions:
1. Is Maness Corporation more or less liquid than the averagecompany in the industry?
2. Is the company doing a good job of earning a return on its assets? Explain.
3. How does the owner finance the business in terms of debt and equity?
4. Is Maness receiving a good return on equity? Explain.

Part 3 Developing the New Venture Business Plan

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Balance

Sheet as of December 31. 2013

Assets

2013

Cash

12S,OOO

Accounts receivable

37S,OOO

Inventory

S50,000

s 1,050,000

Total current assets

Gross fixed assets

2,750,000

Accumulateddepreciation

(1,200,000)

s 1,S50,000
s 2,600,000

Net fixed assets

TOTALASSETS
Debt (Liabilities) and Equity
Accounts payable

150,000

Short-term notes

1 S0,000

Total current liabilities

300,000

Long~term debt

600,000

Total debt

900,000

Commonstock

900,000
800,000

Retained earnings

s 1,700,000

Total owners' equity

TOTAL LIABILITIES AND OWNERS' EQUITY
Income Statement for the Year ending December 31, 201 3

Sales
Cost of 9oodssold

s 2(>00,000

s 1,450,000
(850,000)

Gross profits

600,000

Operating expenses

(240,000)

Operating profits

360,000

Interest expense

(64,000)

Profits before taxes

296,000

Taxes

(118,000)

Net profits

178,000

Industry norms
Current ratio

3.2S

Return on assets

1S.0%

Operating profit margin

20.0%

Total asset turnover

0.7S

Debt ratio

0.20

Return on equity

9.0%
(Go to www.cengagebrain.com and select the Longenecker text to access the answers to these
questions.}

Chapter 10 Understanding a F'irm's F'inancia I Statements

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283

LO

1111

Understand howtedlnology
can be used to rnplOYe
custOO'l('I teiateonsh.,sand
the techniques used to aeate

a rustunetdaubase.

14-3 USING TECHNOLOGY TO SUPPORT

CUSTOMER RELATIONSHIP MANAGEMENT

hen it comes to analyzing and making use of customer data, a small business
has options. A startup can easily manage the amount of data available, but this
situation changes as the company grows and the contacts and accounts become more
complex. For that reason, it's best to start thinking about available analytical technologies-from basic spreadsheets to very sophisticated CRM software packages-from
the very beginning.
Many small companieskeep track of their CRM numbers in a simple spreadsheet
that can be expanded and updated as the business grows. The next step up would be
to use a database management package like Microsoft Access. This offers greater utility and flexibility, as it can store large amounts of data and match data from multiple
tables. Though not designed specifically for CRM programs. Access can certainly
help you manage the data needed to guide customer care, basic advertising campaigns,
and other marketing-related initiatives.
The most powerful tools available for customer relationship management are
software programs designed specifically for CRM. According to recent research,
42 percent of small businesses have a CRM system already in place, and another
25 percent are planning to deploy such a program in the near future." These packages
allow companies to gather all customer contact information into a single data management program. Web-based marketers, in particular, are attracted to such technology, because it helps to make their complex job far more manageable. Most online
shoppers expect to receiveexcellent customer service, and companies are much better
positioned to give it if they use the options for interaction and personal attention that
are designed into the software. Expertspoint out that customers typically appreciate
the conveniences that are built into many company websites, but they can quickly
become frustrated when the experience does not go exactly as planned. The burden of
coordination is greatly eased when software can be used to help manage it.
Deciding which marketing activity should get initial CRM support is not always
easy. I lowever, the sales department is a popular place to start, because its personnel
nearly always generate the most customer contact. CRM emphasizes such sales activities as filling orders promptly and accurately, managing follow-up contacts to ensure
customer satisfaction, and providing user-friendly call centers to handle all inquiries,
including complaints. It's a complex mix of tasks, but technologies are available to
support all of these activities and many others.
To find the CRM software package that may provide the best fit for you and
your firm. consider the included features, accessibility of buyer data, integrated
sales and marketing tools, ease of use, and the help and support provided by the
manufacturer. It might be wise to narrow down your search from the start by
checking recommendations from the editors of CRM magazine, especially those
specifically for small businesses (see Exhibit 14.5). These experts have declared
Zoho to be the "king of the CRM software hill" because it's highly functional,
cost-effective, easy to use. and expandable to accommodate a growing company."
Niche products that do exactly what you need them to do may also be available. For
example, both CAR-Research XRM and Reynolds and Reynolds provide CRM
software solutions for car dealers, with high-performance features designed specifically for that industry.
Concerns about having ample resources to support CRM technologies have led
some small business owners to outsource certain applications. For example. hosted
call centers, which handle e-mail and other online communications for clients, may
Part 4 F'ocusing on the customer: Marketing Crowth Strategies

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Highly Recommended CRM Software Packages for Small Businesses

CRM Package

Summary Description

ZohoCRM

Webbased, simple to set up and use free for up to three users (small monthly charge for additional
users), no long~tenn contracts. expandable to accommodate business growth, integrates seamlessly
with Google applications and other Zoho programs.

Microsoft Dynamics

Very well supported, popular because of its overall functionality, hosted ("in the cloud"') and on-premise options, interfaces with Microsoft Outlook and 'Web browser. monthly fee based on number of
users.

NetSulte CRM+

Best for larger small businesses, excellent built-in e-commerceapplcetions, more expensive than
other options, additional charges forvarious add-ons.

Salesforce.com

A very popular package, considered a topinnovator by CRM experts, many features and functions,
expandable to accommodate business growth, some find it to be complicated to use.

SugarCRM

Good first CRM package. easy to set up and configure, tutorials available for assistance, basic package
is free,charge for Professional Edition that offers access to many additional tools.

Sout<es: &sec! Oil Edito.s d Ol'M,1he 2012 CflMMarter leaders;'Wfiw.derunatior'lam.cOW

AttideVEditoallMagazftle~nues/The.2012 Cll\hU..arter:-teaders
'83897.a.rf)X.aessed
Howtrber 20.201 i; and JeMyCathy,S4rl !JegoNfiVS,,"The five Best SmalBusanessCAMP>gtaitr'IS,."~ 2" 2012,tmp-J/sdtutcomtun<idtw.11.e..e'oie'M,aessed
HOllembet 20,2012.

be more cost effective than comparable in-house centers. a crucial consideration for
many cash-strapped small businesses. In addition to cost, a lack of internal expertise
can justify using these outside services.
Many companies have decided to control the cost of customer assistance by
using alternatives like automated Web-based self-service systems. sometimes called
customer information 111011age11u~11t systems. When a customer service rep handles
a single telephone call. text chat, or e-mail, it can cost the company an average of
$5 to $7, but self-service inquiries handled on the Internet cost less than 6-0 cents
per contact. One popular self-service option is to post a list of Frequently Asked
Questions (FAQs). and more than 40 percent of organizations have these on their
websites. But even this simple tool is becoming more sophisticated. For example.
a company can buy smart software that recognizes the questions its website visitors are most interested in and places those at the top of the list. Such systems can
cut down the cost of serving customers while taking some of the repetition out of
tending to their needs."
The list of tools supporting CRM grows longer every day, and they are becoming
much more user-friendly as time goes on. Executives and managers in large and small
enterprises are tapping the power of the Internet to support the biogs, wik is, social
networking sites, and other online communities that allow people to build social as
well as business connections, to share information, and to collaborate on projects.
The real power of these Web applications comes in the form of building relationships
with customers.
A leadinggreeting-cardand gi/i company ... is one of 111tu1y that have set up an online
communny-ea site where it con talk to consumers anti the tfJJ1Sr1111ers can talk to each
other. The company solicits opinions on various aspects of greeting-carddesignand 0t1
ideasJi,, gifts and their peicing. It also asks the consumers to talk about their ifestytes
and even upload photos of themselves so that it con better understand its market, 27

Such online communities can provide a rich source of feedback and ideas for product
development, and in a form that is much faster and cheaper to use than the focus groups
and surveys that have been a staple of common marketing practices. But perhaps more
Chapter 14 Building Customer Relationships
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important, Web tools can be used to give customers a sense of connection with the
enterprise, an identity that results from their active participation in the company's
business. For this, there is no substitute.

143a Creating a CRM Database

The best way to stay in touch with customers and to identify their needs is to talk to
them. Such conversations lead to an understanding of each customer and provide a
foundation on which to build a customer database. These databases are essential to a
successful CRM program and typically include the following categories of information, with examples of specific data items provided:"'
Personal information. Name, address, phone number. e-mail address, clothing

sizes, birthday, hobbies, memberships, etc.

Demographics. Background information that can be used for market

segmentation and other data analysis purposes. such as age, marital status,
names and ages of family members, geographic location.
Lifestyleand psychographic data. Homeowner versus renter status, car

ownership (model and year), media preferences, payment methods of choice,

recreational interests. etc.
Internet information. Time spent on the Internet, frequency of visits to the
company's website, and other online habits.
Transaction data. Complete transaction history. including details such as
prices paid, SK Us (which identifies specific products purchased), form of
order (Web, phone, in-store, etc.), mode of payment, and delivery dates.
Prof/le of past responses. Sales calls and service requests-including all
customer- and company-initiated contacts-responses to past product or
servioe promotions, and incentives redeemed.
Complaints. Complete history of complaints regarding past purchases or service.

CRM data can almost always be collected at any touch point, which provides an
occasion for contact between the business and its customers, whether in-person or
online. Touch points can include interactions resulting from a phoned-in request for
product information, completed and returned warranty cards, responses to online
surveys. a visit from a salesperson, orders placed on the company's website-even a
text message from a customer service representative. As indicated previously, some
small companies prefer to collect data and feedback from customers using comment
cards or questionnaires. While these can be effective, contact via the Internet is fast
becoming the touch point of choioe for companies as well as the customers they serve.

customer database
A collection of information
about a customer. including

demographicdata,

attitudes, preferences.
and other behavioral
characteristics, as defined

l>J CRM goals.

touch point
An interaction between a

business and its customers.

Instead of wasting time with phone 11111nbe,.s and mail sun:ey.t. c'>111pt111ie.\are
publici=ing their Websites as thefirst touch pointfor customer interactions. Web
use,.s can evaluate 1111d purchase products, 11111ke reservations. indicatepreferenttat
data. and provide customerfeedback 011 services and products. Data from these
U!eb~b11setlinteractions 11,.e then captured. compiled,111u/usedto segment customers;
refine marketing efforts; develop new products, and deliver a high degree of indivit/1111/customization to i111p,.01:e customer re/at ionships. 29

In a CRM system. a customer's selection of a channel for interaction can be an

important source ofinfonnation in itself For example, if the customer first contacts
the company via e-mail, this provides an insight into his or her preferred method of
communication, and the astute firm will consider that in all of its follow-up efforts.
Part 4 F'ocusing on the customer: Marketing Crowth Strategies

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143b Using a CRM Database

In a nutshell, an effective CRM program will (1) capture relevant customer data on
interactions across important touch points, (2) analyze those data to better understand customers, and (3) use those insights to improve relationships with customers
so that they are satisfied, loyal to the company and its products or services, and more
willing to do business with it. The database for your company shouk:l include information on every customer you have ever had,
as well as others whom you consider to be
high-potential prospects. As time goes on
and your database grows, you may want to
further organize it aocording to region, economic status, customer focus. or any other
variable that makes sense to your business
and its marketing emphases.
The Seattle Mariners baseball organization has used this process to "better understand the fans" and identify ways to boost
attendance at games. The club launched a
loyalty card program to collect data from as
many touch points as possible. Now, every
time a fan uses thecard to snag a hotdogand
a coke at a concession stand, buy a jersey
from the online store, or purchase a bobble- """'m""gfO><b
head of a favorite player at a shop in the ballpark, the club is able to track the fan's attendance. as well as his or her activities and
preferences. From collecting these data, the club knows to send an e-mail message if a
fan is close to reaching "season ticket holder" status (which boosts sales). The loyalty
program is also useful in monitoring complaints that can flag adjustments needed
to boost fan satisfaction. As an e.xample of how specific this can get, the CRM system found that one fan had complained about the smell of garlic fries. Knowing this,
the organization was able to relocate him to a section "where there were no frequent
consumers of garlic fries.":" Such programs send a powerful message to customers,
who are then inclined to do even more business with the company. But it takes a wellconstructed database to get the process started.
On a more general level, you can use these data to set up a customer segmentation
strategy, which involves a process of identifying customers that lit into smaller, more
homogeneous groups. By focusing on those with similar demographic, psychographic,
and lifestyletendencies and soningthem by their previous purchases and payment histories, a marketing appea I can be crafted to meet their specific needs and generate greater
sales. For example, a small real estatecompanycouk:l identify young, tech-comfortable
customers and reach out to them with an online-intensivesales campaign, while trying
to sell upscale homes to older, more affluent prospects using in-person appeals.
There are many other ways through which the data )'OU gather can be used to form
and strengthen relationships with customers and increase sales. One of these builds on
the usefulness of the 80/20 principle, which maintains that 80 percent of a company's
sales will come from 20 percent of its customers. These percentages are not meant to
be exact, but experience has shown that the idea generally holds true for most businesses. If a company has created a customer database and organized its data appropriately, it then becomes possible to identify the 20 percent who are the most loyal
and who also deliver the greatest profitability to the company. Often, these "best customers" can be identified by running a recency-frequency-monetary analysis, which

customer

segmentation strategy
A processof identifying
customers that fit
into smaller, more
homogeneous groups.

80/20 principle
A principle that maintains
that 80 percentof a
company'ssales will come
from 20 percent of its
customers.

recency-frequencymonetary analysis
An analysis that reveals
customers most likely
to buy from a firm in
the future because they
have made purchases
recently, frequently, and in
amounts thatexceed some
established minimum.

Chapter 14 Building Customer Relationships

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379

reveals those who are most likely to buy from you in the future because they have
made purchases recently, frequently, and in amounts that exceed some appropriate
minimum. Whatever method is used to identify them, you should go the extra mile
with these customers to keep them happy and coming back to do more business. This
might include anticipating their needs and tailoring product or servioe offerings to
suit them, providing intensive customer service, or offering loyalty rewards to build
long-term relationships. As for those who require intensive and costly effort but offer
litrle to no potential to generate profits, it is best to find a way to reduce their cost to
the company. perhaps by steering them to low-cost, self-servioe options on line. Some
businesses may even chose to end the relationship altogether.
As indicated in this chapter's Spotlight feature, Chris Zane knows that it is crucial
to estimate the Customer Lifetime Value (CLV) for those who buy from his cycle shop

if he is to create an effective CRM plan. The CLV is the total profit expected from
all future sales to a customer and underscores the long-term value of each customer,
which can then be communicated to others. Losing a sale today might not seem all
that costly-until you factor in the likely loss of all future sales that can result from
one interaction gone wrong. And sinoe it can cost a lot more to acquire a new customer
than to hold on to the ones you have, the loss can be greatly compounded. Everyone
in the company needs to understand this so they will be more com milled to treating
customers well. The CLV can also give sales and service employees a belier idea of
how much they should spend to acquire and retain customers. Let's say you own a pizzaria and one of your loyal diners gets upset over a $12 meal. Before you decide how
to handle the situation, keep in mind that his CLV could be as much as $8.000 (Pizza
Hut's estimated CLV for its best customers). That's why having good data and knowing what to do with them can be so important.

14-3c Data Use and Privacy Concerns

I laving so much data on customers puts considerable power in an entrepreneur's hands,
and it is imperative that it be used responsibly.Customers may not be comfortable with
everything required to gain the depth of insight necessary for sucoessful CRM. For
Customer Ufetlme
example, firms often watch customers' online shopping behavior very closely, taking
value (CLV)
note of the items they look at, for how long. and in what order. Some even analyze what
The total profit expected
customers say through social media. including comments left on biogs, frustrations
from all future sales to a
customer.
expressed via Twitter, and more-private Facebook reflections. And this is just the start.
The number of database-building options
available to firms is great and growing.
There is no question that well-designed
CRM systems provide value to customers
(such as gelling notices on sales that are
both timely and relevant) and companies
(such as predicting and planning for what
Choose your privacy settings
customers will want next and generating
higher response rates to e-mail oilers), but
there is still potential for abuse. To address
privacy concerns. the prooess must be honest and transparent, the company must
Connecting on facebook
comply with applicable information-use
II ese to f
laws. and permission to use personal data
ront1 b
must be requested whenever appropriate.
Because it can be very profitable to sell
customer data to other companies or to

t!...

Part 4 F'ocusing on the customer: Marketing Crowt h Strategies

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purchase data from third parties to fill gaps in any database being built, it can be

quite tempting to misuse the data. But the trust of the customer is at stake, as well as
the reputation of the company, and these must be protected. The long-term success of
a CR M program depends on it.
Privacy concerns have grown tremendously with the rapidly expanding reach of
computer applications and the mind-boggling growth of e-commerce, which make
data collection easy and nearly cost-free. The risks to the customer are considerable,
as some CRM experts have reported:
Online users have compluined of being "spammed," and Web surfers, i11c/11di11g
dutdren, are rout inely asked to divulge personal i11fi>r111'1tion to access certain screens
01 purchase goods or services. Internet users are disturbed by the t11nou111 of information businessescollect 0111he111 ns they visit varioussites iJ1 cyberspace Indeed, 11u111y
u\ers (Ire 111u1wttre of how 1Je1Jo11td informat ion is collect ed, used, and distributed. 11
Because of the sharp escalation in data collection and use, online and offline privacy practices are coming under increasing scrutiny. Though U.S. companies have, for
the most part, been able to get away with self-policing, increased regulatory attention
i~ coming. More than 50 nations now have or are in the process of enacting legislation
designed to safeguard the handling of customer data in firms that do business internationally. Those that do business in the European Union or trade with a European
company, for example, must comply with strict laws regulating these practices. Many
countries are modeling their own systems after the European standard, so the burden
of privacy protection is sure to rise."

14-4 CUSTOMERSAS DECISION MAKERS

xhibit 14.2. on page 369. shows that the second primary building block supporting a successful CRM program involves knowledge of customer behavior. The
three interrelated "materials" that combine to form that particular building block
include the decision-making process, psychological influences, and sociological
influences. Offering an expanded view, Exhibit 14.6 illustrates how consumer decision making flows through four stages: (I) need recognition, (2) information search
and evaluation, (3) the purchase decision, and (4) post-purchase evaluation.
We'll use this widely accepted model to examine decision making among small
business customers.

E)lfari hOW(OOSllTlefS

aredectsioo makefsand

wf thn inp()nant il

understandingrustomer
relatioosh\i<

14-4a Need Recognition

Need recognition (stage I) oocurs when a consumer realizes that her or his current
state of affairs differs significantly from some ideal state. Some needs are routine conditions of depletion, such as a lack of food when lunchtime arrives. Other needs arise
less frequently and may evolve slowly. Recognition of the need to replace the family
dining table, for example, may take years to develop.
A consumer must recognize a need before purchase behavior can begin: thus, the
need-recognition stage cannot be overlooked. Many factors influence consumers' recognition of a need. either by changing the actual state of affairs or by affecting the
desired state. llereare a few examples:
A change in financial status (job promotion with a salary increase)
A change in household characteristics (birth of a baby)
Chapter 14 Building Customer Relationships
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381