Chapter 2 - Creating Value for the Organization

This chapter will examine the value-creating process from the perspective of the producer, in which customer needs are seen as the basis of strategy to generate long-term economic value.

Specifically, relationship marketing recognizes the long-term value of customers. It does not concern itself with the profit to be made on an individual sale, except insofar as acknowledging that maximizing short-term profit is to the detriment of the long-term success of the firm. Instead, relationship marketing focuses on customer retention and achieving the greatest lifetime value from them.

Customer Value, Profitability and Market Segments

To be successful, a product must deliver sufficient value to the customer for them to recognize it as a means to achieve their goals. However, we also recognize that markets are not homogeneous in their needs and interests, as well as recognizing that all needs cannot be profitably satisfied. Market segmentation is an attempt to identify and appeal to specific segments in a way that can be profitably leveraged.

It is not surprising that most companies take a profit-first approach to segmentation, placing their interest in earning a profit ahead of their duty to satisfy customer needs in order to earn it. The distinction is more than wordplay when objectives are formulated into a strategy: the profit-first approach will consider the firm's capabilities and expenses and underemphasize, sometimes completely ignoring, the motives for which customers might purchase their wares, which results in failure.

The notion of customer profitability analysis is based on the assumption that various market segments provide different levels of profit by virtue of the revenue they provide and the cost of serving them. The Pareto principle suggests, that 80% of profits come from 20% of all customers, and that 80% of costs are incurred by 20% - but the two populations are not the same. (EN: Nor does the principle hold true in all instances, and is very often used as a substitute for doing proper analysis.)

Ideally, a firm will court those customers who provide the most revenue at the least expense, or will invest on building a relationship with segments that have the potential to do so in future. B2B firms that serve a very small number of large customers often consider revenue and expense on a per-client basis, deciding whom it is worthwhile to serve.

In the mass markets, it is difficult to impossible to accurately identify the true costs and revenues of individual customers. Companies use statistical measures such as the "average" without exploring the issue much further. This is obviously a mistake with potentially devastating consequences.

Why should customers differ in their real profitability?

The primary reason for the differentiation is that customers have different needs and will buy a different products to satisfy them. While advertising can be used to communicate the availability of products to customers, it has little effect on actual needs.

There are also substantial differences in the costs of servicing customers - specifically, costs particular to a specific customer, not costs that do not vary by customer (which are operational efficiencies of the supplier). For example, a customer who places a few orders for many items is cheaper to serve than one who places many orders for a few, even if their annual consumption is the same in aggregate.

Also, any peculiar needs the customer may have will likely increase the cost of serving him. This may be the retail customer who demands additional items be thrown in to the deal, or the wholesale customer who insists on an unusual pallet size to accommodate his warehouse.

Essentially, firms choose the customers they wish to serve, whether this is done actively (choosing to pursue certain customers) or passively (choosing to offer services that are appealing only to certain customers). A "customer profitability study" can be done to consider the revenues and costs of serving individual customers, but is most often done in aggregate ("does it make sense to sell this to customers who reside in Alaska, given the shipping costs?").

The author does a simplistic four-square matrix to sort customers:

Ideally, firms should be able to recognize the classes of customers by consulting their accounting system, which tracks information about orders and costs. However, must accounting systems are developed with an eye toward internal controls and do not consider external factors, so it may be very difficult to extract and repurpose the data toward analyzing customers.

Why relationship development adds value

When markets competitive, firms that take their customers for granted will lose them to others who value their business more, and it becomes an advantage to build a relationship that will keep the same customers coming back as well as referring others. This would seem to be self-evident, but most firms seem indifferent to churn and allocate far more budget in acquiring new customers than to keeping the ones they have.

It's also notable that firms do not seem to distinguish which customers are profitable to serve: "a customer is a customer." As such, the marketing initiatives of firms are very poorly focused and have a very low success rate. Even when they succeed, they attract customers who are not a good fit for their offerings, and experience high churn rates. The author considers the mobile telephony market, in which some firms have a churn rate in excess of 50% per year.

Clearly, firms need to apply different strategies to both new and existing customers - spending their budgets in ways that demonstrate they value existing customers, and better focusing their marketing efforts to attract customers who will buy from them more than just once.

The Relationship Marketing Ladder of Loyalty

The author mentions the "leaky bucket" effect of placing too much emphasis on acquisition and too little on retention. Very often, it is taken for granted that a customer who has purchased once will return again with no further effort from the seller. (EN: research indicating that a significant percentage of customers tend to return to a provider even if they are not satisfied with the experience to avoid having to undertake the effort to identify a new supplier, which to some justifies taking their future business for granted.)

The authors then describe a "ladder of loyalty" that depicts a progression of six phases of customer engagement: prospect, purchaser, client, supporter, advocate, and partner. They suggest that some customers "may not justify the investment needed" to progress them to the top rung. (EN: Which is seems to disregard that no matter how much you are willing to spend, some customers do not wish to have that much of a relationship with every brand they buy.)

The role of advocacy

Much attention has been given to the "advocate" role, because this is the level at which customers not only purchase frequently, but also give referrals that bring additional customers to the brand, and provide word-of-mouth that is the most credible and influential form of promotional messaging.

(EN: more recent studies find that advocacy and loyalty are two different things, and the most loyal customers are not the most vocal advocates of a brand. As such, assuming that loyal customers will advocate is incorrect, and it is often damaging to try to get loyalists to become advocates. Especially for luxury brands, there are many advocates who have never purchased once. So the two are disjointed.)

The authors also suggest that "total or complete customer satisfaction is key to securing customer loyalty. (EN: This is another misconception, because loyalists repurchase in spite of problems with the service they receive as customers. It's not that the two are independent, as disappointment and dissatisfaction harm loyalty, but it is not an exclusive relationship.)

The author lists some companies that, at the time the book was written, had high levels of customer advocacy: Southwest airlines, Dell computers, Lexus motorcars, Nordstrom's retail, Rolex watches. (EN: Most of these are still on the list of most advocated companies today, suggesting the longevity of such brand relationships.)

The author indicates that academic research has not really paid sufficient attention to customer advocacy and few companies have really sought to leverage it. They seem to simply "let referrals happen" rather than developing marketing activities to encourage advocacy. (EN: In this instance, much has changed. Given the explosion of social media and the impact of customer ratings and reviews, customers have developed voices that are heard by more than their circle of acquaintances.)

Customer Acquisition and Its Economics

The appetite for customer acquisition varies considerably according to the situation. New brands focus entirely on acquisition, as they have existing customers. Brands in mature or declining industries tend to be more focused on keeping the customers they have.

In general, acquisition requires taking on additional cost to get new customers. Some seek to appeal to new customers without increasing cost, or at least maintaining it. Some are selective, seeking to gain more profitable costs. Transitioning existing customers to other brands or difference channels is also a form of acquisition.

The steps involved in making customer acquisition cheaper are fairly well known and widely practices: the company determines which media channel historically had the lowest cost per customer acquired, on the assumption that spending more money in that channel will acquire customers at roughly the same rate.

Where firms have a better understanding of their customers, they can consider the results of marketing not just in terms of a raw head-count, but weighted by the kinds of customers each channel traditionally attracts, to consider the most profitable channels.

Customer retention and its economics

The authors indicate "researchers have suggested" that the cost to sell to a new customer is around five times more than the cost to sell to a customer who has purchased in the past.

The author mentions Richheld and Sasser, whose 1990 research paper indicated that even a small increase in customer retention resulted in a dramatic increase in profitability. Specifically, increasing customer retention from 85-90% resulted in profit increases of 35-125% among the businesses they examined. A number of conclusions were drawn:

Relationship marketing - what managers measure

When the economics of acquisition and retention are considered, it should be evident to the majority of businesses that customer relationships are to be valued for the dramatic impact that retention can have on profitability.

(EN: There are likely exceptions for firms that do not get significant repeat business, though even those can be argued: a newsstand in an airport is a convenience that might be used once by most people, but frequent travelers might use it repeatedly - though it would be hard to argue that encouraging repeat business would be profitable.)

The authors refer to research among 200 large British firms that classify firms as acquirers, retainers, and profit maximizers. Acquirers, which the authors sense to be 80% of firms, focus largely on acquisition of new customers. Retainers, guessed to be 10%, seldom seek new business but focus on the customers they have. Profit maximizers, the last 10%, allocate budget "appropriately" according to the profitability of acquisition/retention initiatives.

In terms of budget, the authors look to a similar survey (225 large UK firms) to find that in aggregate, 41% of marketing budget is spent on acquisition, 23% on retention, with the remaining 36% presumably spent on PR and image marketing. In terms of metrics:

Overall, this indicates that organizations have vague sense that retention is important, but they do not measure it accurately, nor does their spending reflect that it is a priority.

Improving Customer Retention

Given the value of retention and the lack of emphasis on it, organizations clearly need to adopt a structured approach to identifying the most profitable customers and taking meaningful actions to retain them. The authors propose a three-step approach:

Step 1: Measuring customer retention

Measuring retention rates is a basic step to gathering the intelligence necessary to measure the success of measures undertaken to improve it.

Firms should not only gauge retention and attempt to segment it, but also consider the cost of serving each segment to prioritize according to profitability, not unit sales or revenue, as serving more unprofitable customers will be detrimental (or devastating) to the success of the firm.

Measuring share-of-wallet is also important to contextualizing the analysis: whether certain segments purchase often, or in quantity, is a significant factor. Also, considering what other suppliers they use, and under what circumstances they use them, can be informative.

Step 2: Identifying causes of defection and key service issues

Customer satisfaction is a key issue in retention. Asking repeat customers why they repurchase is less significant and less reliable than discovering the reasons that customers have chosen to defect.

The authors aver that current methods, namely surveys, leave much to be desired, as they force respondents to choose among pre-determined responses, which may not be accurate. Instead, companies should do more open-ended research to clearly indentify and sufficiently understand the reasons for defection.

Step 3: Taking action to improve retention

The final step is to undertake actions that will address the causes of defection identified in step two, as measured by improvements in the metrics collected in step one. Some actions will require strategic adjustments, others can be handled tactically.

It's suggested that improving customer retention is not necessarily expensive, and some initiatives can be undertaken at little to no cost. Ideally, the costs of doing things that contribute to retention can be offset by discovering things that are being done that can be discontinued because they have no impact, or drive satisfaction of less profitable market segments.

Customer Segment Lifetime Value Analysis

Another key metric for relationship marketing is the customer lifetime value (CLV) - the net present value of future profit flow from a given customer for as long as they continue to do business with the firm.

(EN: It's actually not that straightforward, as some CLV calculations look to the potential lifetime value - that is, the total value of product purchases in the category, rather than from a specific brand - whereas some CLV is based on projected lifetime value of brand only. Also, some CLV calculations consider profit while others consider gross revenue. Finally, some user present-day value and dispense with NPV because to be precise you would have to account for future increases in costs and expenses, in effect increasing the future values and then discounting them back to the present value, which is not only pointless but introduces speculative errors.)

Companies should not seek to acquire and retain as many customers as possible - some cost too much to acquire, such that the CLV does not cover the costs of pursuing and servicing their accounts. So again, the financial performance of the firm depends on its ability to attract and retain customers who contribute the greatest profit margin, and allow the unprofitable customers to give their business to your competition.

Sources of Increased Profitability

The primary way in which relationship marketing drives profitability is increasing share-of-wallet: providing a high level of service captures the sales that the customer may have given to other brands.

Cross-selling is another potential benefit: a customer who is satisfied with a brand is more inclined to purchase other products offered under the same brand. Up-selling involves migrating customers into more expensive models or versions of the same basic product.

Finally, customers who are satisfied with a brand are more inclined to recommend it to others.

Framework for Segmented Service Strategy

The authors describe a(nother) series of steps.

Step 1: Define the market structure

The author considers the practice of "market mapping," which illustrates the chain from suppliers, intermediaries, and customers in a market, to be means to examine its structure, particularly with a view to the direct and indirect relationships between participants.

Market maps can also be supplemented with additional information, to consider the rate of customer turnover for various firms, as well as the amount of profit make by each link in a distribution chain.

Where a firm is involved in multiple channels or chains, it would do well to consider the level of profit it makes in each of them, and determine whether customers can be migrated to the more profitable chains.

It's also noted that customers may interact with multiple channels, and can be encouraged to use the channel that is most efficient for the supplier. (EN: Skipping the rest, because this was a serious disaster for a number of brands: customers choose the channel, and suppliers can choose to be there for them or not - few have the strength to demand customers use their channel of choice.)

Step 2: Segment the customer base and determine segment value

The author suggests using traditional segmentation criteria first, then determine the amount of revenue you can expect, based on their present purchasing behavior (frequency and volume)

(EN: it's been suggested that segmentation should begin with revenue expectations first, then consider traditional segmentation metrics. The problem with the author's approach is that traditional factors such as age, income, location, race, etc. are entirely arbitrary. So rather than identifying all "urban white single female protestant cat-owning" customers and seeing if they happen to profitable to serve, identify the heavy customers and see if they have demographic characteristics in common. This seems a more sensible approach, and less prone to overlook or ignore profitable customers who don't match a priori expectations.)

Step 3: Identify segments' service needs

The next step is to consider the amount that will need to be spent per segment on expenses required to sell, deliver, and service products to them.

This information may be difficult to gather because traditional cost metrics do not consider market factors and can only provide an aggregated average, but more detailed analysis of the data, case studies, or interviews may help.

Such research also has the potential to assess the difference between the customer's desired level of service and that which they are presently receiving (what companies do, what they don't, and what the customer feels is important). If you are able to collect information about the level of service competitors are providing, it will also help overcome the assumption that he existing level of service is adequate to retain the customers and indentify ways in which revenue can be increased by improving service.

Step 4: Implement segmented service strategy

The authors' final step consists of three steps.

First, review existing segment performance to identify areas of over performance (the company is needlessly spending money on things customers don't value) and underperformance (where additional service would result in increased revenues) to arrive at a state the authors call the "service target corridor" of things that are important to the customer and profitable for the firm.

Second, identify the costs of improving service levels, and consider for each market segment whether implementing changes is likely to increase revenue. Some segments are already profitable at current levels of service, some could become profitable if service were improved, and others will remain unprofitable even if service were improved. Ultimately, the goal is to identify segments in which the increase in revenue is greatest in relation to the cost.

Third, develop a plan of execution based on the choices, which indicates specific initiatives, the segments they seek to emphasize, the improvement to CLV expected, and the metrics used to track performance.