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1.
Introduction
Angel or devil? These are the types of customers the computer electronic retailer
Best Buy deals with. Best Buy's angels are the ideal customers who boost profits by
purchasing premium items like high-definition televisions without waiting for
markdowns or rebates. The devils are the store's worst customer and the company's
nightmare. They wreck economic havoc by purchasing loss-leading products and
returning merchandise. Best Buy estimates that one-fifth of its 500 million yearly
customer visits are undesirable (McWilliams, 2004). The question is what to do with
the unprofitable customer, the so called "bad egg". Most of the current literature
discusses the option of exit management, i.e. simply dissolving the relationship with
an unprofitable customer (Alajoutsijärvi, Möller, & Tähtinen, 2000; Haenlein &
Kaplan, 2009). This phenomenon of simply "firing" the unwanted customers can
also be seen in the real world. The telephone company Sprint Nextel did exactly that.
It sent letters to 1000 high-maintenance customers telling them they would no longer
be receiving service because they complained too much (Mittal, Sarkees, &
Murshed, 2008). However, what about the other option of keeping the customer on
board? From an economic standpoint it wouldn't be worthwhile to maintain the
relationship, if there wasn't a positive trade-off between the costs and benefits.
Yet, there is the possibility of reversing the relationship, "Relationship U-
Turn", and making it profitable. After all, it is cheaper to retain an existing customer
than to acquire a new one (Ryals & McDonald, 2008, p.115). The value of an
unprofitable customer can be increased, so he becomes more profitable for a firm, if
a successful marketing approach is chosen. The main focus shall be on customer
retention and less on acquisition and recovery. The paper is structured as follows:
First, relationship marketing and "Relationship U-Turn" are introduced. Second,
customer value and methods of measuring customer value are discussed. The body
of this paper concentrates on different approaches that try to turn unprofitable
customer relationships into profitable ones. Examples from business-to-business
(B2B) and business-to-consumer (B2C) markets are given for each approach and
discussed.
The paper concludes with ideas for future research and a discussion.
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2.
Relationship Marketing
In the past 10 to 15 years, the focus of marketing thinking has shifted away
from transaction marketing, which emphasized products and one-time exchanges
with customers, to relationship marketing, in order to increase a firm's profits.
Relationship marketing is a marketing approach that focuses on customer retention
and managing customer relationships over a lifetime (Godson, 2009, pp.4). The term
"relationship marketing" was first introduced by Berry (1983, p. 25) as "attracting,
maintaining and ... enhancing customer relationships" with "individual customers"
(Jackson, 1985, p.2). Building on this, the definition has been augmented by
Grönroos (1994, p. 9):
"Relationship Marketing is to identify and establish, maintain and enhance
and when necessary also to terminate relationship with customers and other
stakeholders, at a profit, so the objectives of all parties are met and that this is done
by mutual exchange and fulfillment of promises."
This definition shows relationship marketing is a process between two parties,
most prominently a customer and a firm that moves from customer acquisition to
establishing and maintaining long term relationships. Relationship marketing is
customer focused and does not just emphasize customer acquisition but retention and
recovery as well (Schnettler & Wendt, 2009, p.33). The customer-centric approach of
relationship marketing is interacting with customers, valuing them as assets and
serving them to their satisfaction (Rust, Moorman, & Bhalla, 2010). The relationship
with the customer evolves over a lifetime, which has lead to the establishment of a
customer life cycle. The customer life cycle is understood as a series of transactions
between a firm and a customer over the entire time period the customer remains with
a firm. It varies from customer to customer and in duration length, depending on the
type of business (Jain & Singh, 2002).
Relationship marketing originated in industrial marketing (Jackson, 1985) and
service marketing (Berry, 1983) because here taking care of customers and
interacting with them is important for success. Due to a restriction in partner choice,
firms concentrated more on cooperation, in order to reduce risks and increase
satisfaction (Turnbull, Ford, & Cunningham, 1996).
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In B2B markets relationships are close, last for a considerable amount of time
and have significant value to both parties involved. Industrial companies in business-
to-business markets have few and large customers. The importance of the
relationship for the buyer is due to high switching costs and lack of alternatives. The
relationship becomes intimate for the supplier because each customer can generate a
substantial amount of profit and needs careful attention. Customers need careful
handling because they can make demands that cut margins, knowing that the supplier
is under intense pressure to maintain a relationship with them (Gruen, 1995).
Therefore, customer profitability and maintaining a relationship is crucial for the
success of an industrial company.
In the 1990's business-to-consumer markets also adopted the idea of
building relationships (Gummesson, 2004). Business-to-consumer markets (B2C)
are marked by many customers that lead to the success of a firm, so firms are less
dependent on one single customer. The customer can more easily switch companies
then in B2B markets as alternative options are available. Business-to-consumer
relationships are less intimate and complex than business-to-business ones, but trust
and customer satisfaction are important to maintain a relationship (Gruen, 1995).
Even though the two market types differ, both now focus on sustaining relationships.
The importance of long-term relationships has been described by Reichheld
(1996, p. 39) who lists six different economic benefits for a company, namely:
saving acquisition costs, guaranteed base profits, increased growth in revenue per
customer, reduction in operating costs, price premiums from customers and free
customer referrals.
2.1
Customer Relationship Management (CRM)
Customer relationship management has its roots in relationship marketing. The
bases are relationship orientation, customer retention and achieving a high customer
value created through process management (Ryals & Knox, 2001). CRM is defined
as the "values and strategies of relationship marketing - with particular emphasis on
customer relationships - turned into practical application" (Gummesson, 2002, p.3).
Hereby IT is one key element. A data warehouse, where information about customers
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is stored, enables retailers to collect data, learn about their customers and tailor future
marketing initiatives (Gummesson, 2004).
Thanks to technology, customer management has become an easier task. A
company can now assess a customer's profitability on an individual level (Ryals &
Knox, 2001). Many service companies such as airlines, telecommunication
companies and financial institutions use customer relationship management software
to increase the lifetime value of a customer "by matching products and levels of
service more closely to a customer's expectations" (Peppard, 2000, p.321).
Usually, the usage of CRM systems has lead to firms "cherry-picking only
profitable customers" (Niraj, Gupta, & Narasimhan, 2001, p.15) and concentrating
all their marketing efforts on the most valuable customers. The emphasis has been
on maintaining long-term relationships with these customers. Companies treat
valuable customers like royalty or the cream of the crop and go to great lengths to
retain them. Take for example the airline company Lufthansa. In 2004 travelers, who
collected 600,000 frequent flyer miles over the course of the last two years could join
the HON circle program. These clients enjoy perks such as limousine pick up,
guaranteed booking, and check-in at special first class terminals (Haenlein & Kaplan,
2009).
However, only a small minority of customers are truly profitable. A well
known fact, the Pareto Principle, states that 20 % of the customers are responsible
for 80% of the sales revenue (Schnettler & Wendt, 2009, p.34). Companies in both
B2B and B2C markets have a large base of so called "unprofitable customers". A
company's client is unprofitable if he possess a "negative contribution margin"
which is the generated revenue minus the direct costs and cost-to-serve (Haenlein &
Kaplan, 2009, p.90). This means that an unprofitable customer costs more than he is
worth. A survey conducted in the German mechanical engineering sector showed
that about one fifth of the companies possess a customer portfolio in which more
than half of their customer are unprofitable (Helm, Rolfes, & Günter, 2006). In a
business-to-consumer setting, a German retail bank identified 26.8% of its customers
to be unprofitable (Haenlein, Kaplan, & Beeser, 2007). Yet, management of
unprofitable customers has mainly been reduced to "demarketing" (Kotler & Levy,
1971, p.74) or termination of the relationship (Helm, Rolfes, & Günter, 2006).
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Many authors suggest termination as "the way" to deal with unprofitable
customers (Kotler & Levy, 1971; Zeithaml, Rust, & Lemon, 2001). Termination is
when a company severs ties to a customer. The seller no longer wants to engage in
business with a certain customer because he no longer sees a value in continuing the
relationship (Buttle, 2009, pp.28). It can make sense not to keep customers who don't
pay bills on time, or who constantly call the service hotline. The same would be
industrial firms who change their mind on quantity or quality of deliveries (Zeithaml,
Rust, & Lemon, 2001). Zeithaml and co-authors (2001) see firing customers as a
possibility to increase profitability because a company no longer has to use their
resources to serve these customers and instead can employ them more effectively.
2.1.1
Relationship U-Turn
A "U-Turn" is to reverse things said or done in order to achieve a different
outcome. Relationship U-Turn shall be defined as follows: Managing the relationship
with an unprofitable customer by finding approaches to extract value. The objective
is to bring the scale of profitability back into balance and have the customer
contribute to a firm's profit.
In times of globalization and fierce competition customers are scarce and
every customer becomes an intangible asset that should be valued and managed to
improve firm profitability (Gupta, Lehmann, & Stuart, 2004). Considering
customers as an asset entails that companies should not only focus on the profitable
customers but also try to manage the invaluable customer relationships as well.
These customers have the potential of becoming profitable in the future (Sherrell &
Collier, 2008).
Also maintaining a relationship with an unprofitable customer can create
profit for the firm. Research conducted by Reichheld and Sasser (1990) show a 25 to
85% increase in a company's profit due to a 5% decrease in customer defection.
Also Gupta & Lehmann (2004) come to the conclusion that improving the customer
retention rate by 1% improves the firm's value by 5%. Increasing profits can be
achieved by noticing that different customer segments have different responses to
marketing efforts. The key is not to treat all the customers in the same manner but to
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customize offerings and find ways to match the costs to the revenues in order to meet
the needs of the customer (Zeithaml, Rust, & Lemon, 2001).
The problem is companies have not established a systematic approach on the
operational level for dealing with unprofitable customers. At best, managers use
intuition and guidelines to try and turn the relationship around and only 20% of the
managers have taken approaches to dealing with these customers (Helm, Rolfes, &
Günter, 2006). In order to implement managerial approaches effectively, the seller
needs to know which customer relationship creates the most profit. Valuing a
relationship involves collecting data of customer behavior and analyzing it (Ryals,
2002). In the next chapter customer value is defined and two
methods on how to
measure customer value are discussed.
2.2
Customer Valuation
Customers are seen as assets because a firm derives value from a customer
(Gupta, Lehmann, & Stuart, 2004). In the English literature a host of different terms
are used to describe the value of a customer or customer profitability as perceived by
a firm such as: "customer value" (Sherrell & Collier, 2008, p.40), "value of the
customer" (Gupta, Lehmann, & Stuart, 2004, p.7) or "customer lifetime value"
(Mulhern, 1999, p.26).
In general the value of a customer is seen as the as the monetary and non-
monetary value a customer supplies to the firm in order for the company to achieve
its goals (Cornelsen 2000, p.38). The monetary aspect or economic values, such as
the contribution margin or customer lifetime value, are factors that can be measured.
However, a customer can also provide non-monetary value or "relationship value" in
the form of referrals or be a source of information for the company. These factors are
more difficult to calculate (Ryals, 2002, p.248).
In this paper the terms customer value as well as customer lifetime value and
customer profitability shall be used to mean the value of a relationship from a firm's
perspective. Also, the term "customer equity" is used in this context which is the
"sum of the lifetime values of all customers" (Rust, Moorman, & Bhalla, 2010, p.7).
This metric represents the value of the entire customer base and not just the worth of
one individual customer. It is a good indicator of firm value and therefore underlines
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the importance of customer-orientation and cultivating customers (Rust, Moorman,
& Bhalla, 2010).
The customer-focused marketing approach concentrates on customer value or
customer profitability instead of product profitability. The three major drivers of
customer profitability are: customer acquisition, customer margin and customer
retention. Customer acquisition (acquisition rate and costs) deals with choosing
profitable customers for the firm and increasing the number of customers. Customer
margin (dollar margin and growth) centers on augmenting the profit from existing
customers and customer retention (retention rate and cost) is focused on keeping
customers (Gupta & Lehmann, 2005, pp. 48).
As research has shown that some customers are more profitable than others,
the importance of calculating the value of a customer has emerged (Reinartz &
Kumar, 2003). There are four main methods to measure in what way a customer
contributes to a firm's profits (Lind & Strömsten, 2006). In this paper, two methods
to assess customer profitability will be discussed: customer profitability analysis
(CPA) and customer lifetime value (CLV) calculation.
2.2.1
Customer Profitability Analysis
Customer profitability analysis (CPA) which focuses more on the customer
than the former product orientated ABC analysis is the method used to analyze
historic customer profitability (Boyce, 2000). It measures a customer's contributions
to a firm which is the "difference between the revenues earned and the costs
associated with the customer relationship during a specific period" (Conroy, Haskins,
& Pfeifer, 2005, p.7). Studies revealed that companies have many unprofitable
customers (Kaplan & Narayanan, 2001) because they fail to notice that customers
differ in the costs they cause (Raaij, Vernooij, & Triest, 2003). These costs, also
referred to as "cost-to-serve", are defined as "all costs of the administrative
commercial and logistic activities related to customer service-delivery" and are
linked to customer profitability (Guerreiro, Bio, & Merschmann, 2008, p.392).
Customers can be high-cost-to-serve or low-cost-to-serve. Profitable customers are
low-cost-to serve and unprofitable customers are the ones with high service costs
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(Kaplan & Narayanan, 2001). The behavior each customer type exhibits can be seen
in Table 2.1.
Table 2.1
High and low cost-to-serve behavior. (Kaplan & Cooper, 1998, p.98)
High-Cost-to-Serve Customers
Low-Cost-to-Serve Customers
Order custom Products
Order standard products
Order small quantities
Order large quantities
Unpredictable order arrivals
Predictable order arrivals
Customized delivery
Standard delivery
Frequent changes in delivery requirements
No changes in delivery requirements
Manual processing
Electronic processing (i.e. Zero
defects)
Large amount of presales support
Little to no presales support
(i.e. Marketing, technical and sales
resources)
(i.e. Standard pricing and ordering)
Large amount of postsales support
No postsales support
(i.e. installations, training, warranty)
Require company to hold inventory
Replenish as produced
Pay slowly
Pay on time
To determine customer-specific costs a financial tool known as activity-based
costing (ABC) is used. Activity-based costing looks at the costs of an activity and
how much time is spent supporting a customer with this activity. Managers are then
able to understand which customers demand what activities and how much it costs to
serve them (Ryals, 2002). The outcome of the measurement can be represented is the
whale curve of customer profitability (Kaplan & Narayanan, 2001).
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Figure 2.1
The Whale Curve of Cumulative Profitability.
(Hutt & Speh, 2006, p. 97)
The whale curve, depicted in Figure 2.1, is a graph of cumulative customer
profitability. The x-axis shows the cumulative percentage of customers and the y-
axis the percentage of total customer profit. The customers are sorted in decreasing
order of profitability. The whale curve shows that one-fifth of the customers generate
between 150 to 300 percent of the total profits. These 20 percent of all customers are
a company's most profitable. The middle 70 percent break even and the least
profitable, the bottom 10 percent, cause losses from 50 to 200% of total profits
(Kaplan & Narayanan, 2001).
Distributing costs to customers though activity based costing highlights the
point that not all customers contribute equally and that unprofitable customers have a
big impact on a customer's profits. A company studied, showed that a customer can
generate losses up to two and a-half times the sales revenue (Niraj, Gupta, &
Narasimhan, 2001). Interesting to note is also that large customers can be very
unprofitable because small customers do not make high volume purchases that would
lead to large losses (Kaplan & Narayanan, 2001). Single-period customer
profitability analysis is a good way to measure the current and historic revenues and
9
costs of different customers. However, it doesn't take into account the future
potential of a customer relationship. To be able to estimate future costs and revenue,
customer lifetime value, the retrospective CPA analysis is important and a first step
(Raaij, Vernooij, & Triest, 2003).
2.2.2
Customer Lifetime Value Analysis
The individual prospective approach is customer valuation analysis which
calculates customer lifetime value (CLV) (Lind & Strömsten, 2006). Customer
Lifetime Value (CLV) is defined as the "present value of the future cash flows
attributed to the customer relationship" (Conroy, Haskins, & Pfeifer, 2005, p.10).
The CLV framework is a tool for measuring profitability that looks at all the costs
and benefits over the life span of a customer, including his future potential (Reinartz
& Kumar, 2003). The future potential of a customer is a combination of forecasted
revenue, expected lifetime and favorable behavior regarding service costs (Niraj,
Gupta, & Narasimhan, 2001).
The CLV framework incorporates three basic factors. They are current as well
as future profits (contribution margin), the time value of money which means that
$100 of profits today are worth more than the same amount of profit tomorrow, the
possibility that the customer may leave the business and so terminate the
relationship. The latter is also called retention or defection rate and is how long the
customer will stay with the firm (Gupta & Lehmann, 2005, pp.15). Measuring CLV
is more align with the idea of relationship marketing as it emphasizes that a
customer's value must be measured over a lifetime. However for most applications it
is about three to five years. This time span is as far forward as a relationship can be
projected (Ryals & McDonald, 2008, p.127). Customer lifecycle as well as product
lifecycle and an 80% of profits can be accounted for in this time period (Kumar &
Rajan, 2009).
The CLV analysis differs from other measuring techniques like CPA because it
doesn't use accounting based profits, but projects costs and revenues into the future
and uses "discounted cash flow analysis to derive at a net present value" (Boyce,
2000, p.652). In other words this calculation is based on expected purchases of a
customer and adjusted back to the present day with the help of a discount rate. An
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example of calculating CLV is shown in Table 2.2 (without considering the retention
rate).
Table 2.2
Calculating customer lifetime value. Source: (Ryals, 2002, p.245)
t + 1
t + 2
t + 3
t + 4
Customer Profit
$100
$100
$100
$100
Discount Rate
(%)
10
10
10
10
Discount Factor
0.91
0.83
0.75
0.68
Present Value
$91
$83
$75
$68
CLTV
$317
As Table 2.2 shows the customer is worth $317 today, because it is expected
that he will contribute $100 each year over the next 4 years with a discount rate of
10%. It also demonstrates that the value of a relationship can be enlarged by
increasing profit (increase in revenue or decrease in cost-to-serve) or by extending
the length of the relationship with a customer (Ryals, 2002).
CLV analysis is a complex way of figuring out if a customer provides value
or is profitable to a company. It is seen as the "best metric used to measure customer
profitability" (Kumar & Rajan, 2009, p.2). The CLV framework is mostly used in
B2C markets (Cokins, 2004, p.15). Using the CLV calculation companies have a tool
to measure the future value of a customer and emphasizes the customer relationship
(Gupta, Lehmann, & Stuart, 2004). Kumar et. al (2009) suggest that the CLV of a
customer should be calculated before making other marketing decisions. After
segmenting customers according to their CLV - low, medium, high - appropriate
marketing approaches can be selected. Knowing the customer lifetime value lets
companies make informed marketing decisions. They can decide about product and
service developments and where and how to use their resources in the most efficient
and effective manner (Mulhern, 1999).
In B2B markets it is sometimes sufficient to simply use CPA analysis because
relationships are less volatile than in B2C markets, which means less customer
churn. Therefore past profitability is often, much the same as future profitability, so
CPA is sufficient for decision making (Cokins, 2004, p.15).
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