Intangible Assets | Customers, Etc.
Not everything of value is on the balance sheet
Where would “remarkable customer experience” show up in a company’s financial statements?
When looking at a company’s income statement, customer support costs are usually included in the cost of goods sold (COGS) number. COGS directly impacts gross profit margin1, so overspending on customer experience could be bad for business. All things being equal, you want to spend enough on customer experience so you retain customers, but not so much that you hurt your gross margins.2
I’m not terribly satisfied with that explanation. “Good enough” is okay for most businesses to be able to retain their customers, but how do you explain a company like Apple, who is able to provide remarkable experiences across multiple products, such that customers implicitly trust their brand even as they introduce brand new products? Surely they’re not just trying to minimize COGS so they can maximize gross margins.
If the line item that would contain customer experience efforts—cost of goods sold—is intended to be minimized, why would we continue to invest in a remarkable customer experience?
Intangible assets
Let’s look at the company’s balance sheet3. The balance sheet should contain the company’s assets (cash, investments, inventories, property, etc.). Assets are what the company plans to use to operate the business, that is, to produce something of value for customers in order to generate revenue.
Balance sheets includes assets that are measurable. However, not everything of value is measurable. Intangible assets can be quite valuable but may not be measurable. Quoting from my accounting textbook4:
Excluded intangible assets often relate to knowledge-based (intellectual) assets, such as a strong management team, a well-designed supply chain, or superior technology. Although these intangible assets confer a competitive advantage to the company and yield above-normal income (and clear economic benefits to those companies), they cannot be reliably measured. This is one reason why companies in knowledge-based industries are so difficult to analyze and value. (p. 2-6)
But how does as intangible asset like a strong brand make its way to the income statement? First, we need to talk about “market value” vs. “book value”.
Stockholders’ equity [also on the balance sheet] is the “value” of the company determined by generally accepted accounting principles (GAAP) and is commonly referred to as the company’s book value [that is, the number on the publicly available balance sheet]. This book value is different from a company’s market value (market capitalization or market cap)…. To compute Apple’s market cap, we multiply the number of outstanding shares at September 29, 2018 (4,754,986,000 shares), by stock price on that date ($225.74). This equals $1,073,391 million, which is considerably larger than Apple’s book value of equity of $107,147 million on that date [a 10x price-to-book ratio]. (p. 2-12)
The book explains one of the differences between market value (what shareholders are willing to pay) and book value (what’s on the balance sheet):
GAAP excludes resources that cannot be reliably measured (due to the absence of a past transaction or event), such as talented management, employee morale, recent innovations, and successful marketing, whereas the market attempts to value these. (p. 2-12)
And finally, we get to the connection between intangible assets and the income statement:
It is important to understand that, eventually, factors determining company market value are reflected in financial statements and book value. Assets are eventually sold, and liabilities settled. Moreover, talented management, employee morale, technological innovations, and successful marketing are eventually recognized in reported profit. The difference between book value and market value is one of timing. (p. 2-12, emphasis mine)
The value of brand
When we talk about where “good customer experience” shows up on the balance sheet, some of it shows up in cost of goods sold. But delivering a good customer experience is also part of building an excellent brand, which an incredibly valuable intangible asset. Even though the value of brand doesn’t show up on the balance sheet, it can potentially show up in the increase in market value over book value. Shareholders expect that companies with strong brands will use their brand power to generate revenue.
Cutting costs sometimes seems like an obvious business strategy, but as long as gross margins are healthy, it may make sense to instead invest in a remarkable customer experience. Shareholders may value the intangible asset of a strong brand over a few percentage points saved in COGS.
Gross profit margin = Net Revenue - Cost of Goods Sold
Another way to think about it, which we’ve explored in this newsletter, is in terms of feedback loops within a system. As I wrote a few months back,
“[T]he act of keeping a customer—retention—exists mostly in a balancing feedback loop.
”While a reinforcing feedback loop wants to grow a stock level, a balancing feedback loop wants to maintain a stock level. In this case, the retention part of the business wants to retain the stock of customers. It does this in a balancing feedback loop. The business sets a target indicator—a desired percentage of customers to retain, in the diagram above—and it invests in retention efforts to maintain the stock of customers in line with that indicator.”
This is why we want to keep cost of goods sold (which includes the support costs of customer experience) down. You want to maintain as much of the stock of net income (revenue) as you can, so you have a balancing loop to minimize COGS and keep gross margins (sales - COGS) high.
Balancing cost control with customer experience is tricky. You might want to try Loyally AI to design loyalty programs that keep customers coming back without overspending. It helped me find a good middle ground that protected margins and built brand trust.