Customer Value and Profitability: A Strategic Approach, Exercises of Marketing

Download Customer Value and Profitability: A Strategic Approach and more Exercises Marketing in PDF only on Docsity! C H A P T E R 41 3 CUSTOMER-BASED STRATEGY If you walk into Stew Leonard’s, a unique grocery store on the East Coast of the United States, you will probably notice a sign engraved in stone. This sign, which represents the company’s philosophy and is meant as much for its employees as its customers, highlights two rules. It reads, “Rule # 1: The Customer Is Always Right. Rule # 2: If the Customer Is Ever Wrong, Re-Read Rule # 1.” A focus on customers is not unique to this company. For years, managers all over the world have reiterated the need to focus on customers, provide them good value, and improve customer satisfaction. In fact, metrics such as customer satisfaction and market share have become so predominant that many companies not only track them regularly but also reward their employees based on these measures. However, this kind of customer focus misses one important component—the value of a customer to a company. Effective customer-based strategies take into consideration the two sides of customer value—the value that a firm provides to a customer and the value of a customer to the firm. This approach recognizes that providing value to a customer requires marketing investment and that the firm must recover this investment. In other words, this approach combines the traditional marketing view, where the customer is king, with the finance view, where cash is king. Chapter 3.fm Page 41 Tuesday, December 14, 2004 3:14 PM MANAGING CUSTOMERS AS INVESTMENTS42 This chapter describes how a strategy that focuses on the two sides of customer value differs from traditional marketing strategy. We argue that traditional marketing’s focus on customer satisfaction and market share may be counterproductive at times. We demonstrate that the two approaches use different metrics for measuring success and frequently lead to quite different insights and strategic decisions. Finally, we discuss in detail the three strategic pillars of this new approach—customer acquisition, customer margin, and customer retention. TRADITIONAL MARKETING STRATEGY A longstanding approach to marketing strategy discussed in almost every marketing management textbook and taught in most business schools is depicted in Figure 3.1. This approach can be summed up as consisting of 3 Cs, STP, and 4 Ps. The first component of this framework is the analysis of custom- ers, company, and competition (the 3 Cs) to understand cus- tomer needs, company capabilities, and competitive strength and weaknesses. If a company can fulfill customer needs better than its competitors, it has a market opportunity. The second compo- nent is to formulate the strategy for STP—segmentation, target- CompetitionCompanyCustomer Product Price Promotion Place Targeting PositioningSegmentation Figure 3.1 The framework of a traditional marketing strategy. Chapter 3.fm Page 42 Tuesday, December 14, 2004 3:14 PM CHAPTER 3 • CUSTOMER-BASED STRATEGY 45 higher profitability. A firm would be well-advised to build this type of customer. In contrast, Lost Cause customers do not get much value from the products and services of the firm. Generally these customers are marginal for the firm; their main value, if there are enough of them, is to provide the economies that come with greater sales— e.g., reduced production costs and promotion efficiencies. Absent economies of scale, if the company cannot migrate them to higher levels of profitability, it should consider either reducing its investment on these customers or even “firing” (dropping, shift- ing to other suppliers) them. One cross-sectional study of U.S. banks found that in the early 1990s only 30% of a typical bank’s customers were profitable over the long run. 2 In other words, 70% of customers destroyed value! Some insurance companies found themselves in a similar situa- tion a few years ago when they realized that after several natural disasters in Florida, their zeal to grow and add more customers had led them to acquire a large number of customers in disaster- prone areas. For long-run profitability, it is imperative for these companies to either convert unprofitable customers to a profit- able status or “fire” them. This notion of dropping customers runs counter to the intuition of managers who have been trained to think that adding customers, increasing sales, and gaining mar- ket share are good per se . In many cases, market share and reve- nue growth may be the wrong metrics to gauge success. The other two cases in Figure 3.2 show unbalanced, and hence unstable, relations. Vulnerable Customers provide high value to the firm but do not get a lot of value out of company’s services. These may include newly acquired large customers whose experi- ence is less than stellar and who may be wondering why they chose your product in the first place. These may also be long- standing customers who, largely through inertia, remain loyal. In a sense, they are exploited, much like overworked cows or farmed-out fields. These customers are vulnerable and prone to defect to competitors unless corrective action is taken. Chapter 3.fm Page 45 Tuesday, December 14, 2004 3:14 PM MANAGING CUSTOMERS AS INVESTMENTS46 A company can invest in these customers through better product offerings, additional services, and related activities. These cus- tomers may deserve better service than others. The concept of service discrimination is similar to the idea of price discrimina- tion, where not all customers pay the same price for a product (e.g., an airline ticket). Airlines and casinos have provided prefer- ential treatment for their best customers for many years, and more and more companies are beginning to implement a similar strategy. For example, the call centers of Charles Schwab were configured so that the best customers never waited longer than 15 seconds to get a call answered, while other customers could wait for as long as 10 minutes. 3 Even airlines that pioneered loy- alty programs are now adjusting their frequent flier programs on the basis of ticket price (and hence profitability to the firm) rather than simply the number of miles flown. Although such ser- vice discrimination can generate a backlash from customers, it is also possible that customers will accept the old adage that “you get what you pay for,” especially if the policy is clear and trans- parent. Free Riders are the mirror image of the Vulnerable Customers . These customers get a superior value from using the company’s products and services but are not very valuable to the firm. For whatever reason (e.g., large size, strong competition), these cus- tomers are “exploiting” the relationship with the company, appropriating the lion’s share of value. Consider the case of supermarkets. Every week, supermarkets promote certain products at a low price in order to attract cus- tomers to their store. Several items are treated as “loss leaders.” A supermarket does not expect to make money on these items but hopes that their low prices will attract more customers to the store. Once these customers are in the store, the hope is that they will buy other items that are profitable. However, many cus- tomers are cherry-pickers—i.e., they only buy those few items that are on sale. It is somewhat ironic that supermarkets have a special line for customers who buy a few items while heavy spenders wait in long lines. Doesn’t it make more sense to treat your more profitable customers better by opening a special line Chapter 3.fm Page 46 Tuesday, December 14, 2004 3:14 PM CHAPTER 3 • CUSTOMER-BASED STRATEGY 47 for them? 4 Clearly, care is needed in implementation. In general, however, a firm should either reduce its service level or raise prices for the Free Riders. Although this will reduce the value to customers and risk losing them, it will, if successful, enhance their value to the firm. As someone once said, “The difference between a sales and marketing person is that a good marketing person knows when to walk away from a sale.” In sum, successful customer-based strategies require that a com- pany consider both the value the firm supplies to the customer and the value the customer offers to the firm. KEY MARKETING METRICS How do we “keep score” in marketing? Each of the strategic approaches has its own key metrics. Unsurprisingly, these met- rics drive decisions. They become goals and are stated every- where from annual reports to marketing plans as objectives and measures of success. Traditional Metrics The key metrics in the traditional marketing approach are sales and share. Ancillary metrics may include customer satisfaction and brand image. Profit is typically measured at a product or brand level. As already illustrated, market share or sales may be the wrong metric in many cases. A credit card company may acquire a lot of low-value customers, which will increase its share but not its long-term profitability. Improving customer satisfac- tion is good in principle but the benefit of this improvement has to be weighed against the cost to achieve it. Measuring profit at a product or brand level is useful but incomplete for at least two reasons. First, most firms focus on the short-term or quarter-by- quarter profits of a brand and treat marketing as an expense. This short-term focus is counter to the very concept of marketing as investment. Second, measuring profit at the product level ignores the vast differences in the profitability of customers. A bank may Chapter 3.fm Page 47 Tuesday, December 14, 2004 3:14 PM MANAGING CUSTOMERS AS INVESTMENTS50 As discussed in Chapter 2 and illustrated in Figure 3.4, customer profitability and the value of customers are primarily driven by three major components—customer acquisition (acquisition rate and cost), customer margin (dollar margin and growth), and cus- tomer retention (retention rate and cost). These three factors are the key metrics of the new approach. They not only provide tan- gible and measurable metrics but also make clear the inherent tension between growth and efficiency. For example, it is hard to simultaneously increase customer acquisition and cut total or average acquisition cost. Similarly, increasing the acquisition rate is likely to draw marginal customers and may negatively impact customer retention rates and margin per customer. Such trade- offs are the essence of astute business decisions and the hallmark of profitable growth. Table 3.1 summarizes and contrasts the metrics used by the tra- ditional and the new customer-based approach. Value of a Customer Customer Aquisition Customer Margin Customer Retention Figure 3.4 The drivers of customer profitability. Source: Eugene W. Anderson, Claes Fornell, and Donald R. Lehmann, “Customer Satisfaction, Market Share and Profitability: Findings from Sweden,” Journal of Marketing, 58 (July 1994), pp. 53–66. Reprinted by permission from the American Marketing Association. Chapter 3.fm Page 50 Tuesday, December 14, 2004 3:14 PM CHAPTER 3 • CUSTOMER-BASED STRATEGY 51 TRADITIONAL VS. CUSTOMER-BASED STRATEGY: A CASE STUDY To highlight some of the differences in the strategic insights gleaned from using the traditional versus the new approach, we present a case study for the U.S. automobile industry. The auto- mobile industry is one of the most competitive in the United States, with very heavy marketing expenditure. In 2002, the automobile industry was the world leader in advertising expendi- ture, with over $16 billion in the United States alone. In addition, several billion dollars were spent on discounts in the form of cash rebates and the like. Some reports suggest that in 2003, U.S. automakers spent as much as $3,310 on each vehicle in the form of cash rebates and below-market loans. 6 A recent study examined the U.S. luxury passenger car market to determine how marketing efforts influence sales (the traditional metric) versus customer profitability (the customer metric). 7 The study examined nine brands (Acura, Audi, BMW, Cadillac, Infiniti, Lexus, Lincoln, Mercedes-Benz, and Volvo) from January 1999 to June 2002. The data covered 26 regional submarkets, representing over 70% of the U.S. market. Using rigorous time series models, this study arrived at some star- tling conclusions. It found that all brands’ discounting efforts either increased or maintained sales volume. Therefore, dis- counting may be considered an effective marketing tool by the traditional metric of sales. However, on average, across these nine TABLE 3.1 Traditional and Customer Metrics Traditional Marketing Metrics Customer Metrics Sales/Share, Product profitability Customer profitability Customer acquisition (rate, cost) Customer margin (dollar, growth) Satisfaction Customer retention (rate, cost) Chapter 3.fm Page 51 Tuesday, December 14, 2004 3:14 PM MANAGING CUSTOMERS AS INVESTMENTS52 brands, discounting rarely increased a brand’s customer equity (i.e., profitability of current and future customers) in the long run. The results were even more dramatic in some cases. For example, discounting had a positive effect on Lincoln’s short- term sales, but the brand’s discounting activities hurt its cus- tomer equity in the long run due to the negative long-term impact on its acquisition rate. This is consistent with other studies that find that discounting does not help in the long run, with either customer purchases or the firm’s shareholder value. 8 Results for advertising were also different when viewed from the traditional versus the new lens. For example, while the advertis- ing for BMW had a positive short-term effect on its sales, it did not have any significant impact on its customer equity. Advertis- ing for Acura increased its sales in the long run but not its cus- tomer equity. Only the advertising for Mercedes-Benz had a positive influence on its customer equity. If $16 billion of adver- tising expenditure does not affect the long-term profitability of customers (which, as we will show in Chapter 4, is closely linked to shareholder value), then the industry needs to re-examine its marketing strategy. This study also emphasized the differential impact of marketing instruments on customer acquisition and retention rates. For example, when high-quality brands offer discounts, it affects their customer acquisition rate more than their retention rates. Evi- dently, if customers are satisfied with a high-quality product, their repeat purchase decisions are less likely to be affected by their favorite brand’s price discounting. This suggests that differ- ent brands may need to monitor different metrics (e.g., acquisi- tion or retention) to assess the impact of their marketing investments on customer profitability. This study illustrates the value of understanding how marketing dollars affect customer profitability and why this focus may lead to very different conclusions than those obtained from traditional approaches. Chapter 3.fm Page 52 Tuesday, December 14, 2004 3:14 PM CHAPTER 3 • CUSTOMER-BASED STRATEGY 55 mated the acquisition cost of that type of customer to be about $50, with a lifetime value in the hundreds. In other words, by estimating lifetime value, Stevens made the right choice. It favored a brick strategy over a click deal at the height of the dot- com mania, a prescient decision indeed. 10 Ameritrade. With almost 3 million customers, Ameritrade is a lead- ing online brokerage company. In its attempt to acquire new cus- tomers, Ameritrade has offered many incentives to potential customers, including free trades. Advertising and other marketing expenses added significantly to the total acquisition cost. In Financial TD Waterhouse $175 Comtex, 02/14/01 Ameritrade $202 Q2, 2002 NetBank $108 Q4, 2000 Sales and marketing management, 05/01 Etrade $475 Q2, 2002 American Banker , 07/19/02 Credit Card $75–150 (Platinum) Consultant reports Credit Card $25–35 (Sub Prime) Consultant reports Mortgage $300–700 Consultant reports Lending Tree $28 2001 Company reports Travel Priceline.com $8.66 Q4, 2001 Goldman Sachs Equity Research TABLE 3.2 Reported Customer Acquisition Costs (Continued) Industry Company Acquisition Cost per Customer Time Period Source Chapter 3.fm Page 55 Tuesday, December 14, 2004 3:14 PM MANAGING CUSTOMERS AS INVESTMENTS56 March 2002, its acquisition cost per customer was almost $203. However, its average annual gross margin per customer was $201.56. 11 In other words, Ameritrade recovered almost all its customer acquisition cost within a year. Figure 3.5 shows that the customer retention rate for Ameritrade remained constant at around 95%. Using the lifetime value for- mula from Chapter 2 and a discount rate of 12%, we estimate Ameritrade’s margin multiple as 5.59. Therefore, the lifetime value of an Ameritrade customer is $1,126, significantly above its acquisition cost of $203. Apparently Ameritrade has been making wise choices in its customer acquisition strategy, as confirmed by its stock market performance, which stands in stark contrast to many other online companies. Figure 3.6 provides estimates of customer lifetime value for sev- eral firms. We again used companies’ financial reports and related data to estimate customer acquisition costs, annual margins, and retention rates. (We recognize that these are rough estimates since estimating acquisition costs, margin, and retention rates involves complex and sometime subjective decisions—see Chap- ter 2.) This figure suggests that although there are significant variations in acquisition costs and lifetime value across compa- 80% 85% 90% 95% 100% Mar-00Dec-99 Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 % R et en tio n R at es Quarter Figure 3.5 The retention rate for Ameritrade. Source: Salomon Smith Barney. Chapter 3.fm Page 56 Tuesday, December 14, 2004 3:14 PM CHAPTER 3 • CUSTOMER-BASED STRATEGY 57 nies, all companies in the figure made sensible economic deci- sions for customer acquisition. Unfortunately, this is not always the case as illustrated by the now defunct CDNow. CDNow. Jason and Matthew Olim launched CDNow in 1994 in the basement of their parents’ house in Ambler, Pennsylvania. Within a year, revenues reached $2 million. Like most Web-based startup companies, CDNow focused heavily on acquiring new customers. Its customer acquisition strategy used traditional methods such as television, radio, and print advertising, as well as some innova- tive programs. For example, in 1997 CDNow introduced Cosmic Credit, the Internet’s first affiliate program, where thousands of customers effectively became part of a commissioned sales force for the company. The same year, CDNow agreed to pay $4.5 mil- lion to a large portal to become its exclusive online music retailer. $0 $200 $400 $600 $800 $1,000 $1,200 Amazon Ameritrade Capital One eBay E Trade Acquisition Cost Lifetime Value $8 $26 $11 $43 $391 $962 $203 $75 $173 $1,126 Figure 3.6 Acquisition costs and customer lifetime value (as of March 2002). Source: Company reports and our analysis. Chapter 3.fm Page 57 Tuesday, December 14, 2004 3:14 PM MANAGING CUSTOMERS AS INVESTMENTS60 time, there was a significant slowdown in the visit behavior of past users. Our estimates of acquisition cost ($30–55), annual margin ($10– 20), and retention rate (51–68%) enable us to evaluate the eco- nomics of CDNow’s customer acquisition programs. Even assum- ing a favorable discount rate of 12% (for a risky young firm, the rate is likely to be higher) and a higher than reported retention rate of 70%, the lifetime value of a CDNow customer, based on Table 2.1, is 1.67 times its annual margin, or $16.70–33.40. Only for the most favorable margin and retention rate and the lowest estimate of acquisition costs are the economics profitable, and then just barely. In other words, unless some unknown growth strategy was involved, the business model of CDNow was fatally flawed. Partly due to its expensive customer acquisition strategy, CDNow reported a loss of over $100 million at the end of 1999. In July 2000, CDNow was bought by Bertelsmann. The European Cable Industry. Cable companies in Europe served over 60 million customers and generated more than €10 billion in 25 20 15 10 5 0 M ar gi n pe r C us to m er ( $) Time M a r- 9 8 Ju n -9 8 S e p -9 8 D e c- 9 8 M a r- 9 9 Ju n -9 9 S e p -9 9 D e c- 9 9 M a r- 0 0 Ju n -0 0 Figure 3.9 The margin per customer at CDNow. Source: Company annual reports and 10Q statements. Chapter 3.fm Page 60 Tuesday, December 14, 2004 3:14 PM CHAPTER 3 • CUSTOMER-BASED STRATEGY 61 annual revenues by 2002. These companies borrowed heavily to spend enormous sums of money building networks and acquiring customers in the hope that customers would be quick to adopt digital services. However, analysis for a typical customer shows that the cable operation in Europe had so far been a losing propo- sition (Figure 3.10). The negative value of a typical customer led many of these debt- laden operators to bankruptcy. In May 2002, NTL, a U.S. com- pany and the fourth-largest operator in Europe, declared bank- ruptcy. Europe’s third-largest operator, United Pan-Europe Communications, defaulted on its bond payments and was Figure 3.10 The cash contribution per customer for two cable segments. Source: Wendy M. Becker, Luis Enriquez, and Lila J. Synder, “Reprogramming European Cable,” The McKinsey Quarterly, no.4 (2002). Chapter 3.fm Page 61 Tuesday, December 14, 2004 3:14 PM MANAGING CUSTOMERS AS INVESTMENTS62 delisted from one of the stock exchanges. A German cable opera- tor, Ish, also filed for bankruptcy. A careful customer value analysis would have shown these opera- tors that in order to be profitable, they would need average monthly revenues of €30 to €100 per customer compared to the €9 to €15 they were generating, a large discrepancy. Many of these companies apparently did not recognize that the cost of acquiring and serving (retaining) these digital customers was also too high. For example, setting up a customer with digital services cost almost twice as much as an analog installation. Similarly, call-center costs for these customers are significantly higher due to complex queries. It is possible that over time some of these costs may decrease and revenue per customer increase as cus- tomers become more comfortable with the new technology. How- ever, some experts believe that cable companies need to change their strategy significantly rather than simply hope that consum- ers spend more.12 Acquiring Customers in Emerging Markets. India has a population of over 1 billion with a per capita GDP of less than $2,000. For many years, multinational companies avoided significant investment in India because of its low per capita income. However, with a popu- lation of over a billion people, if even a small fraction of the popu- lation is wealthy, the raw numbers make India a very large and attractive market. Some companies are looking at the even larger market of low-income consumers. One leading financial institution in India is experimenting with a mobile-banking product for low-income people. Accredited bank agents will own a mobile handset that consumers can use with a mobile card they obtain with their bank application. This will allow consumers to perform basic bank transactions. Does it make sense to consider mobile-banking for low-income consum- ers in a developing country or to try to acquire these low-income customers? On the surface, this strategy sounds crazy. However, the cus- tomer economics show that the idea has a large profit potential. Figure 3.11 indicates that the bank expects a value of $6.20 per Chapter 3.fm Page 62 Tuesday, December 14, 2004 3:14 PM CHAPTER 3 • CUSTOMER-BASED STRATEGY 65 profit from each existing customer. In the retailing context, this means increasing same-store sales rather than opening new stores. Growth can be achieved through a variety of methods such as up-selling (e.g., migrating customers to a higher price/ profit product) and cross-selling related products (e.g., providing a credit card to a bank customer). We discuss three specific strat- egies to create growth from current customers. Share of Wallet. When you open your mailbox, you are likely to find a letter from one of the many credit card companies inviting you to become its customer. If you sign up, a smart company may subsequently track your credit card expenditure pattern, proba- bly on a monthly basis, and use it to make special offers to you. However, this data is missing one important component: Most customers carry multiple cards in their wallet. Two customers who spend the same amount of money on a credit card may have vastly different potential for a company depending on how much they spend on other cards. In other words, it is important to know not just the amount of money customers spend with your company but also the “share of wallet” your company has. One company that understands the importance of wallet share is Harrah’s Entertainment, Inc. A few years ago, Harrah’s was get- ting 36 cents of every dollar that its customers spent in casinos. Today, that share is over 42 cents. Since 1998, each percentage point increase in Harrah’s share of its customers’ overall casino spending has resulted in an additional $125 million in share- holder value. Harrah’s achieved this by better understanding their customers through a variety of programs. One such initia- tive involved merging the company’s database of more than 24 million customers across 25 properties and tracking their behav- ior through a Total Gold loyalty program. In 2001, existing cus- tomers increased their year-over-year play by more than $160 million. 16 Disney is another company that successfully increased its cus- tomers’ share of wallet. During the mid-1980s, Disney found that a typical family of four people (two adults and two children) who visited its theme park in Orlando, Florida, spent several thousand Chapter 3.fm Page 65 Tuesday, December 14, 2004 3:14 PM MANAGING CUSTOMERS AS INVESTMENTS66 dollars for their trip. Trip cost included the cost of airfare, the hotel stay, restaurants, and the entrance fee to Disney’s theme park. To many senior managers at Disney, it was both shocking and enlightening to realize that while the Disney brand attracted many of these families to Orlando, it captured only a relatively small fraction of the total money spent by a family. In its effort to increase its share of the consumers’ wallet, Disney literally fol- lowed the money. As a result, they decided to build hotels on Dis- ney property, offer a choice of multiple Disney restaurants, and even have a Disney cruise ship. This investment has led to a sub- stantial increase in Disney’s share of wallet of a typical Disney visitor.17 Yet in spite of its importance, it is disconcerting how many com- panies don’t even know their customers’ share of wallet, let alone design programs to improve it. Ironically, as companies build large customer databases, they focus more and more on what their customers spend with them and not what they spend with competitors. This focus is essentially company-centric. Unfortu- nately, that is not necessarily desirable. Careful examination of share of wallet requires strategic thinking about how to define your market (or wallet) and your competi- tion. For example, should Visa define its competitors as Master Card and American Express? Or should it broaden its competi- tive definition to include cash and checks? While defining compe- tition narrowly leads to larger share values and a sense of pride, it also can lead to missing key trends, new competitors, and emerg- ing opportunities. Defining share of “what” is an art and requires applying the “Goldilocks” principle: not too broad (i.e., total spending), not too narrow (i.e., just your revenues), but “just right.” Cross-selling . It often takes considerable effort to acquire a cus- tomer. Telecommunication firms spend anywhere from $300 to $400 to acquire a customer. Once you establish a relationship with a customer, it makes sense to try to maximize the value of the relationship by selling customers multiple products. In many cases, there is a natural sequence or progression of the products. Chapter 3.fm Page 66 Tuesday, December 14, 2004 3:14 PM CHAPTER 3 • CUSTOMER-BASED STRATEGY 67 For example, bank customers typically start with a checking and savings account and then gradually move to mortgages and investment advice. Detailed customer databases and sophisti- cated predictive modeling can help companies pinpoint the next product to target to a specific customer. In addition to the obvi- ous benefit of a higher margin per customer from selling multiple products, cross-selling also has the potential to improve customer satisfaction and retention. Hence, cross-selling can have a two- part impact on the lifetime value of a customer. Cox Communications, Inc., the fifth largest cable television com- pany in the U.S. in 2003, served over 6 million customers nation- wide. A full-service provider of advanced communications products, Cox offered an array of residential services, including cable, local and long-distance telephone services, Internet access, advanced digital video programming services, and commercial voice and data services. By examining its customer data, Cox found that turnover, or churn, was lower for customers who sub- scribed to multiple products (Figure 3.12).18 Consequently, Cox increased its emphasis on getting subscribers to buy two or more products from the company (Figure 3.13)19—in a sense locking them in, since it is harder to switch multiple services. 3.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0 2.3% 2.2% 1.9% 1.4% Video Only Video & Internet Video & Phone Average Monthly Customer Churn Internet & Phone Video, Internet, & Phone Figure 3.12 The impact of cross-selling on churn at Cox Communications. Source: www.cox.com. Chapter 3.fm Page 67 Tuesday, December 14, 2004 3:14 PM MANAGING CUSTOMERS AS INVESTMENTS70 the same Web site a significant synergy, over time Amazon’s mar- gin per customer improved only slightly, from about $12 in early 1997 to about $15 in early 2002.20 Why does it make sense for 7-Eleven to get into banking, while insurance companies’ attempts seem to draw skepticism? Two factors conspire against successfully expanding business offer- ings to the same customer. The first factor is customer resis- tance. When the products or services seem to have little synergy in production (e.g., making cars and greeting cards share few skills) or image match (e.g., Timex watches and engagement rings), customers are skeptical of such joint offerings (a.k.a. brand extensions). The second factor is company competence, or lack thereof. Even seemingly related products may require different skills to produce and deliver (e.g., fast food restaurants and processed food sold through supermarkets). Moreover, a varied product line can divide a company’s attention so that one or several products may suffer accordingly. Basic moral: Growth is easy to envision but hard to pull off operationally, especially if you ignore customers’ inherent skepticism or companies’ lim- ited competence. Customer Retention In their zeal to grow, many companies focus almost exclusively on entering new markets, introducing new products, and acquir- ing new customers. However, these companies often have a “leaky bucket”—as they add new customers, old ones defect from the firm. Some studies report the average retention rate for U.S. companies is about 80%.21 Put differently, on average, 20% of a company’s customers defect every year. This means that, roughly speaking, the average company loses the equivalent of its entire customer base in about five years. Studies also show that the cost of acquisition is generally much higher than the cost of retaining existing customers. Therefore, it seems obvious that a firm should focus on retaining its existing customers. Unfortunately, many companies don’t even know their customer retention or defection rates. Part of this problem Chapter 3.fm Page 70 Tuesday, December 14, 2004 3:14 PM CHAPTER 3 • CUSTOMER-BASED STRATEGY 71 lies in the lack of appreciation for the importance of customer retention. We now show that customer retention has a dramatic impact on both long-run market share and profits. Impact of Retention on Share. In spite of its many limitations as a goal, market share continues to be a dominant metric that man- agers monitor and manage constantly. Customer retention can have a dramatic impact on the long-run share of a company. Con- sider customers’ retention–defection or switching pattern under the three hypothetical scenarios given in Table 3.3. These scenar- ios represent customers’ switching behavior over time between two competitors in an industry (e.g., Amazon and Barnes and Noble, or GM and Ford).22 In scenario 1, both company A and B have 80% customer retention. For example, 80% of GM customers trade their old GM car or truck to buy another GM vehicle, while 20% switch or defect to Ford. In scenario 2, company A (e.g., GM) improves its customer retention through better products and improved customer service from 80% to 90%. The retention rate for company B (Ford) remains the same. In scenario 3, company A does an even better job of satisfying its customers, improving its retention to 95%, while company B continues to have 80% retention. If both companies start with equal market share, what will be their long-run market share under the three different sce- narios? Scenario 1 is relatively obvious. Since both companies have the same retention and defection rate, they both end up with a long- run share of 50%. Notice this happens even if their initial shares TABLE 3.3 Retention–Defection Tables Scenario 1 Scenario 2 Scenario 2 Purchase at Time T+1 A B A B A B Purchase at Time T A 80% 20% A 90% 10% A 95% 5% B 20% 80% B 20% 80% B 20% 80% Chapter 3.fm Page 71 Tuesday, December 14, 2004 3:14 PM MANAGING CUSTOMERS AS INVESTMENTS72 are quite different (e.g., 90% and 10%), albeit not quite as quickly. The result in scenarios 2 and 3 is less obvious. In both of these, company A should have a share greater than 50% due to its stron- ger retention rate. However, it cannot have a 100% share because each period it also loses some customers to company B. The exact formula, for long-run share is given in Appendix B. Applying that formula in the present case, we find that the long-run share of company A is 66.67% in scenario 2 and 80% in scenario 3. This example illustrates three important points. First, it shows how changes in customer retention affect market share. In our example, improving customer retention from 80% to 90% improved the long-run share of company A from 50% to 66.67%. It is generally fairly easy for a company to assess how much an extra point of market share is worth to them. For example, some studies estimate the new vehicle sales in the United States in 2003 to exceed $400 billion.23 Therefore, one share point is worth $4 billion in revenues. This type of analysis helps a man- ager determine the maximum amount of money worth spending to improve customer retention by a given amount. The general wisdom, which in this case is correct, is that by increasing customer satisfaction, you will increase retention. After making an investment in a customer satisfaction program, a manager should not only monitor satisfaction scores but also link those scores to the purchase behavior to determine how the pro- gram impacted customer retention. This analysis then helps determine whether or not the investment in a customer satisfac- tion program provided an appropriate return. The second key point illustrated by our example is that share increases at a faster rate as retention increases. For example, improving retention by 10 percentage points, from 80% to 90%, helped company A increase its market share from 50% to 66.67%. In contrast, improving its retention rate by only 5 percentage points, from 90% to 95%, increased its share by almost the same amount, from 66.67% to 80%. Figure 3.14 shows the relationship between retention and long-run market share for company A. Chapter 3.fm Page 72 Tuesday, December 14, 2004 3:14 PM CHAPTER 3 • CUSTOMER-BASED STRATEGY 75 Impact of Retention on Profits—the U.S. Wireless Industry. Although mar- ket share is the metric most commonly monitored by marketing managers, retention is at least as critical for long-run profits. This is especially evident in the telecommunication industry. By December 2002, the U.S. wireless industry had more than 140 million subscribers, with over $76.5 billion in annual revenue. New customer annual growth was still 9.7%. Even in the face of falling prices, revenue per customer had remained fairly constant over the last four to five years, as customers increased their usage of cellular phones. In 2002 alone, U.S. consumers used more than 600 billion wireless minutes.25 Yet in spite of impressive growth in the number of subscribers and usage, the wireless industry has been under severe financial pressure. While part of the problem lies in the heavy capital expenditure needed to upgrade systems, another major problem is high customer churn—i.e., defection. Several studies report that the average customer churn in the U.S. wireless industry is 2.5% per month, or approximately 30% per year.26 This means that 42 million customers, nearly one- third of the total, defect from a wireless carrier each year. With an average customer acquisition cost of $300–400 (see Table 3.2), this translates into $12.6 billion to $16.8 billion in cost, or 16– 22% of revenue, just to keep the number of customers constant. Since the average operating margin was 20–30%, this acquisition (or in many cases re-acquisition) cost is almost as large as the entire operating profit of the industry. Some companies actively work to reduce customer churn by pro- viding better customer service, using data-based predictive mod- eling to anticipate which customers are at greatest risk of defection and appointing special representatives to handle poten- tial defectors. Bell Canada has done this quite successfully and managed to keep its monthly churn at 1.5%, the best in North America. If the entire U.S. wireless industry could achieve this, it would add $1.5 billion to $2 billion in operating profit excluding the additional cost of improving retention. Retention Elasticity. To understand the impact of customer retention on profits, it is helpful to assess the percentage change in profits Chapter 3.fm Page 75 Tuesday, December 14, 2004 3:14 PM MANAGING CUSTOMERS AS INVESTMENTS76 for a 1% change in customer retention (economists call this type of measure elasticity). Appendix B shows that retention elasticity turns out to be a very simple formula. Specifically, Retention Elasticity = 1 + Margin Multiple Chapter 2 showed how the margin multiple varies with a firm’s discount rate (or cost of capital) and its customer retention rate. Using a 12% discount rate, Figure 3.15 shows retention elasticity at different levels of customer retention. This figure shows that if a firm has 80% customer retention, improving its retention by 1% will improve its profit (or customer lifetime value) by 1 + 2.5, or 3.5%. Similarly, improving the retention rate from 90% to 90.9% should improve its profit by 1 + 4.09, or 5.09%.27 These profit improvements do not take into account the cost of improving retention. Even so, they provide a useful standard of comparison for evaluating retention programs. Put simply, for a typical company with 80% retention rate, if a retention program costs more than 3.5% of profits for a 1% improvement in reten- tion, it is too expensive. It also shows that there are increasing returns to retention—each percent is worth more than the previ- ous one. However, retention cost is likely to increase dramatically at higher levels of retention. Therefore, the message is that it is generally not optimal for a firm to have 100% retention. 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 7 6 5 4 3 2 1 0 R et en tio n E la st ic ity Retention Rate Figure 3.15 Retention elasticity at various levels of customer retention. Chapter 3.fm Page 76 Tuesday, December 14, 2004 3:14 PM CHAPTER 3 • CUSTOMER-BASED STRATEGY 77 How does this compare with the benefit from increasing margins? Interestingly, improvement in customer margin (from cross-sell- ing, increasing the share of wallet, etc.) generally has a much smaller impact on profitability than improving customer reten- tion. As shown in Appendix B, while retention elasticity is (1 + margin multiple), margin elasticity is usually 1.28 Since the mar- gin multiple is always greater than zero, the retention elasticity is always greater than the margin elasticity. In other words, assum- ing comparable costs, a 1% improvement in retention is usually better for a company than a comparable improvement in margin per customer. What about savings on acquisition costs? Reducing customer acquisition cost, a one-time effect, has less impact on profitability than improving either retention rate or margin, whose impacts occur over multiple periods. Therefore, while short-term finan- cial results may favor cost-cutting (e.g., reducing acquisition cost), real financial value comes from intelligent allocation of resources for improving service to profitable customers. SUMMARY This chapter has demonstrated that effective customer-based strategies should take into consideration the two sides of cus- tomer value—the value a firm provides to a customer and the value of a customer to the firm. This view considers the invest- ment in customers as well as its return. Therefore, it integrates the marketing world, where the customer is king, with the finance world, where cash is king. We also showed that traditional marketing’s focus on customer satisfaction or market share may be misleading at times. We discussed the three key drivers of cus- tomer profitability (acquisition, retention, and margin) and how they affect marketing decision-making. We outlined various strat- egies for customer acquisition, customer retention, and margin growth, and demonstrated how their financial consequences can be considered. Chapter 3.fm Page 77 Tuesday, December 14, 2004 3:14 PM