The Customer is Always Right - But are They Always Worth it?
by Lynette Ryals

 

Abstract: This article looks at what we mean when we talk about customer profitability, and examines the idea of ’total customer value’ - how much a customer is worth to the firm. The conclusion is that we cannot form an accurate view of what a customer is worth using a traditional profitability analysis. I argue that a broader approach to the problem of identifying profitable customers is needed if marketers are not inadvertently to destroy shareholder value by favoring costly customers.

Some customers cost us money: It’s a familiar saying that business would be great if we didn’t have to deal with customers. But have you ever stopped to consider that your business might be more profitable without customers - without some of them, at least?

In an article published in the Harvard Business Review, Cooper and Kaplan (1) reported the astonishing case of a heating wire company which analyzed its customer profitability and discovered that the famous 20 - 80 rule, which would suggest that 80% of profits came from 20% of customers, had to be revised:

"A 20 - 225 rule was actually operating: 20% of customers were generating 225% of profits. The middle 70% of customers were hovering around the break-even point, and 10% of customers were losing 125% of profits"

Even more amazing: it was the largest customers who were producing the biggest losses.

Changes in our market places, and better information about the profitability of our customers, are challenging some of our cherished notions about what constitutes a good (and profitable) customer. Large accounts, for example, may carry the prestige but may actually cost us money by demanding exclusive service whilst simultaneously squeezing us on price. Nor are customers who use a portfolio of our products necessarily profitable, as one bank discovered:

"Interestingly, the most profitable 10% and the least profitable 10% have almost identical numbers of products... ‘sell more products, make more money’ just isn’t true."

(Customer Information Manager at a major international bank)

A third category of customers may not be profitable. They are very satisfied with our service but are heavy users of our time, always calling in to our branches or telephoning us with small queries.

A simple customer profitability analysis might suggest that companies should not do business with certain customers. But this could be a dangerous conclusion. Managers need to examine the analysis very carefully, for two reasons:

  • traditional profitability analysis is inadequate
  • there are benefits other than economic ones of dealing with certain customers

Traditional customer profitability accounting is inadequate: Early approaches to understanding customer profitability, as opposed to product profitability, suffered from a number of drawbacks. Sometimes an organization would find that its costing systems simply did not allow it to analyze profitability by customer; others focused on detailed and time consuming arguments about cost allocation. Until the advent of activity based costing (ABC), most organizations wishing to scrutinize customer profitability had to allocate less tangible costs in proportion to sales revenue or volumes. The effect of this was to "penalize" customers who might be more efficient for the firm to deal with (because they buy in larger lot sizes, for example).

More serious, however, are some of the other criticisms of traditional customer profitability accounting:

    • it tends to relate to profitability in a single period only;
    • it takes no account of risk or volatility in returns;
    • therefore it fails to measure the real value of a customer to the firm.

Single period profitability: Marketers have long understood that customers may be unprofitable in one accounting period for reasons which have little to do with their longer term prospects, and the accounting tool for measuring the value of future spending - discounted cash flow (DCF) - has been around for quite some time. The part that has been missing from the picture was a way of forecasting just what those future-spending patterns might be. Businesses needed to know what customers were going to do in the future even though in many cases they were not able to say with any degree of confidence what they had done in the past. All that a business had to go on were the results of market research purporting to indicate customer satisfaction or future purchase intentions. Many a marketing manager found to his or her cost that what customers say and what they do can be very different.

Recently, however, technology has developed to such an extent that we know more - and can predict more - than ever before. Better behavior modeling techniques and more powerful data analysis using new technology based on data warehouses allows us to make more accurate predictions of a customers’ spending patterns over the lifetime of the relationship.

Customer lifetime value calculated in this way gives marketers more useful information about the value of a customer than single-period profitability. It helps to explain why a bank, for example, might be interested in recruiting lots of students as customers; unprofitable in the short term, these students should develop into high earning, highly profitable customers in a few years’ time.

Customer risks and the cost of capital. DCF is a useful tool, but by no means the end of the story, for two reasons:

  • The discount rate may differ from customer to customer (some customers just are more risky than others, they exhibit larger variations in returns).

  • The amount of capital needed to serve a customer may vary.

The concept of economic value added (EVA® ), developed and trademarked by the consulting group Stern Stewart (2), helps us to understand this point. Economic value added is the return earned in a single period after the costs of all capital are taken into account - not just of debt capital, but of equity capital as well. The total economic value of a customer is then the sum of that customer’s EVA® throughout the relationship.

The EVA® approach shows us that firms should only take on high-risk customers where these customers offer a return which compensates for the extra risk. In other words, value is destroyed where return fails to compensate for incremental risk; and it is created where return exceeds incremental risk.

The EVA® approach to value creation seems to offer a real way to understand customer value based on the transactions of that customer. However, I would argue that we need to go deeper than that to understand what a customer is really worth to an organization. There are some aspects of value which are difficult to state in financial terms, but which arise out of the relationship you have with your customers.

The real value of a customer to the firm: In their book on relationship marketing, Payne et al (3) discuss the limitations of the traditional marketing paradigm as follows; "... this short-term transactional focus is inappropriate for industrial and services marketing, where establishing longer-term relationships with customers is critical to organizational success." At the core of relationship marketing is the idea of customer retention and the acceptance that this is no longer achieved purely by managing the customer relationship. Suppliers, alliances, internal markets, referrals and influencers all have a part to play. An increasing body of work around relationship marketing is indicating that these relationships have value over and above the immediate economic value of the transactions involved. Listed below are four relationship effects which are thought to be significant value-adders. These are the four powerful effects of Reference; Referral; Learning; and Innovation.

Reference accounts: Reference accounts are the customers who add prestige to your organization simply because you are known to be one of their suppliers. This is often associated with large and powerful companies with stringent supplier selection and monitoring procedures. Sometimes these customers will permit their names to appear on your literature, will give you a reference, will speak at your conferences or will even allow site visits by other prospective customers. Even if they do not, just being associated with certain companies has a value to you. In the UK, to be a supplier to Marks and Spencer or to Tesco confers a certain standing on the company; in the US, the equivalent might be to be a supplier to Saks or Wal-Mart. The prestige customer acts like a brand name, reducing the psychological risk of dealing with you ("if they supply Wal-Mart, they must be good"). This encourages other buyers and therefore the value to your company of these reference accounts is greater than the value of your transactions with them.

Referral: An insurance company has a small customer who is renowned for being difficult and time-consuming. The insurance company probably makes no profit on its business with that customer whatsoever. Why does this company continue to court this demanding customer? Why doesn’t it discourage him, or refuse to deal with him altogether? The answer to this seeming puzzle is that this individual has a great deal of influence in his local region. He is appreciative of the service that his insurers give him, and he tells everybody about it. In fact, he has recruited a significant number of good, profitable clients for this company over the years; he refers others to his favorite supplier. Referral accounts are customers who refer other customers; they may not be intrinsically profitable in themselves, but the business they help to bring in can be very substantial. After all, who are your best sales people - your sales team, or your satisfied customers?

Learning: Some customers are intrinsically valuable in a way that would be difficult to identify through normal accounting procedures. These are the customers from whom you learn. It is said that Toyota is particularly good to have as a customer because it will help its suppliers to install certain systems and processes. The supplier then reaps the benefit of these processes for the rest of its business. Learning from customers might result in better ways of manufacturing products, or better administration or IT. Sometimes the customer is even prepared to train its suppliers’ staff.

Innovation: Sometimes the learning benefit from a customer is not a transfer of know-how from them to you; sometimes, the process is a shared one of joint learning from which both parties benefit. Jointly funded research and development (R & D) is one of the best known examples; as is the use of certain customers as beta test sites for partially developed products or systems. You get the benefit of feedback about your new products or services in use, but before committing massive sums to the venture by rolling it out on a large scale; and the beta test customers benefit from early delivery of the product and often the chance to influence the final design towards one that fits their needs more precisely. This also results in a more efficient use of information. The customer is likely to be informed about what the market wants; the supplier, about what is possible. Automotive suppliers, for example, are credited with a string of recent product innovations, such as ABS, which have improved sales to both parties. Jeremy and Tony Hope, in their book "Competing in the Third Wave" (4) cite the experience of Chrysler which, in an effort to simplify its production process, offered its suppliers $20 000 for each part they could engineer out of a car. One supplier submitted no fewer than 213 ideas, of which 129 were approved, saving Chrysler $75.5 million. That supplier’s turnover with Chrysler has doubled.

Total Customer Value: The total value of a customer is, therefore, the risk-adjusted economic value plus the relationship value. This model helps us to understand how a customer that looks unprofitable may add value; and how two customers with the same apparent financial profitability may have a very different value to a business.

Implications for managers: We can use this to increase returns to our shareholders. Companies create shareholder value when they recruit and retain customers with a positive total value; they destroy shareholder value when the customers they win have a negative total value.

First, carry out customer profitability analyses based on lifetime value information. Where exceptionally profitable customers are identified, aim to create referrals. Customers will tend to mix with and hence to recruit others like themselves, a point well made by Reichheld (5). All companies have value locked up in their current customer base, the trick is to find ways of releasing it.

Second, gather information about customers, about what they do and what they think; not only will this improve lifetime profitability modeling, it will help to release some of the hidden potential in your customer base.

Third, think about the potential business your customers could bring. Customer potential has two forms; the business customers can bring over a lifetime, and the share of their current business they now give to a competitor. Once this is understood, you have a basis for developing strategies towards these customers. The strategies should address how you keep the business you have for that customers lifetime, and how you increase your share of their spend.

Finally, if you can identify customers who have high economic value (when measured by their net present risk-adjusted value) and high relationship value (when measured by reference and referral, learning and innovation effects), then you should focus on these as your greatest value creators. These are the candidates for the red carpet treatment. Losing one of these customers is a tragedy, gaining one is a cause for celebration.

Competitors who understand real value have an advantage in developing customer strategies: Objectors to the Total Customer Value concept may argue that it is too difficult. But we do need to understand the real value of a customer if we are going to build exceptional shareholder value by identifying, winning and keeping high value customers. Because there are plenty of hungry competitors out there, circling our most valuable customers and waiting to pick them off!

References:

1. 1991 "Profit Priorities from ABC" R. Cooper and R. S. Kaplan Harvard Business Review May-June 1991 Vol. 69 No 3
2. 1991 "The Quest for Value" G. B. Stewart Harper Business
3. 1995 "Relationship Marketing for Competitive Advantage" A. Payne, M. Christopher, M. Clark, H. Peck Butterworth Heinemann
4. 1997 "Competing in the Third Wave" J. Hope & T. Hope Harvard Business School Press
5. 1996 "The Loyalty Effect" F. Reichheld Harvard Business School Press

 


Arthur Middleton Hughes is Vice President of The Database Marketing Institute. Ltd. (Arthur.hughes@dbmarketing.com) which provides strategic advice on relationship marketing. Arthur is also Senior Strategist at e-Dialog.com (ahughes@e-Dialog.com) which provides precision e-mail marketing services for major corporations worldwide. Arthur is the author of Strategic Database Marketing 3rd ed. (McGraw Hill 2006). You may reach Arthur at (954) 767-4558 .


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