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Developing & Implementing The Market Strategy

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organizing focus of six marketing imperatives is a distinctive and powerful integrative tool for communicating
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MANAGING MARKETING
IN THE 21ST CENTURY:
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MANAGING MARKETING
IN THE 21 CENTURY: ST

Developing & Implementing

The Market Strategy

3rd edition

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 Managing Marketing in the 21st Century
SECTION I: MARKETING AND THE FIRM

CHAPTER 1
Introduction to Managing Marketing

CHAPTER 2
The Value of Customers

S E C T I O N I I : F U N D A M E N TA L I N S I G H T S F O R S T R AT E G I C M A R K E T I N G

CHAPTER 3 CHAPTER 4
Market Insight Customer Insight TRANSITION TO
CHAPTER 6
STRATEGIC
Marketing Research MARKETING
CHAPTER 5
Insight about Competitors, Company, and Complementers

S E C T I O N I I I : S T R AT E G I C M A R K E T I N G
I M P E R AT I V E 1
Determine and Recommend Which Markets to Address
CHAPTER 7
Identifying and Choosing Opportunities

I M P E R AT I V E 2
Identify and Target Market Segments
CHAPTER 8
Market Segmentation and Targeting

I M P E R AT I V E 3
Set Strategic Direction and Positioning
CHAPTER 9
CHAPTER 10 CHAPTER 11
Market Strategy: Integrating the
Managing through the Life Cycle Managing Brands
Firm’s Efforts for Marketing Success

S E C T I O N I V: I M P L E M E N T I N G T H E M A R K E T S T R AT E G Y
I M P E R AT I V E 4
Design the Market Offer
PART A: PROVIDING PART B: COMMUNICATING PART C: DELIVERING PART D: GETTING PAID FOR
CUSTOMER VALUE CUSTOMER VALUE CUSTOMER VALUE CUSTOMER VALUE
CHAPTER 15 CHAPTER 19
CHAPTER 12 CHAPTER 18
Integrated Marketing Critical Underpinnings of
Managing the Product Line Distribution Decisions
Communications Pricing Decisions
CHAPTER 13 CHAPTER 16
CHAPTER 20
Managing Services and Mass and Digital
Setting Prices
Customer Service Communication
CHAPTER 17
CHAPTER 14
Directing and Managing
Developing New Products
the Field Sales Effort

I M P E R AT I V E 5
Secure Support from Other Functions
CHAPTER 21
Ensuring the Firm Implements the Market Offer as Planned

I M P E R AT I V E 6
Monitor and Control
CHAPTER 22
Monitoring and Controlling Firm Functioning and Performance

S E C T I O N V: S P E C I A L M A R K E T I N G T O P I C S

CHAPTER 23
International, Regional, and Global Marketing
 v201

CHAPTER 2
THE VALUE
OF CUSTOMERS v201

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Success is getting the right customers … and keeping them.

— Charles Cawley, founder of credit card giant MBNA

LEARNING OBJECTIVES
When you have completed this chapter, you will be able to:
• Identify the critical elements that define customer lifetime value.
• Calculate customer profitability and customer lifetime value.
• Recognize the importance of investing in, and retaining, the right customers.
• Relate delivering customer value to generating long-term customer loyalty.
• Explain the importance of measuring customer profitability.
• Make tough decisions on dealing with unprofitable current customers.
• Make tough decisions about accepting/rejecting potential customers.
• Establish a customer relationship management (CRM) program.
• Design customer loyalty programs.

OPENING CASE: ROYAL BANK OF CANADA

Toronto-based Royal Bank of Canada (RBC) serves over 14 million personal, business, and public-
sector customers via offices in North America and 30 other countries. RBC is Canada’s leading bank,
with more than 1,700 offices and 5,000 banking machines. What sets RBC apart from competitors
is its focus on customer profitability. In RBC’s retail business, 17 percent of customers account for 93
percent of profits — an extreme version of the 80/20 rule at 93/17. RBC concentrates on this 17 per-
cent and discourages, or even discards, its least profitable and loss-making customers.

27
28 SECTION I ! MARKETING AND THE FIRM

RBC calculates economic profit by customer.1 Identifying revenue, product profit margins (spreads),
and invested capital is easy. RBC tracks labor costs via activity-based costing. RBC monitors costs
for back office processing, call centers, serving customers through various channels, and other activ-
ities. RBC calculates labor costs per customer, based on product portfolios and monthly transactions.
Because RBC knows which customers earn it economic profit (loss), it can take actions other firms
cannot. RBC determines the shareholder value each individual customer or segment creates. RBC
also calculates an intrinsic price/earnings (P/E) multiple and compares this P/E ratio to the market
average. Golden customer segments — higher than average P/E ratios — are profitable investment
opportunities. RBC rationalizes, closes, or sells off customer segments with low P/E ratios.
RBC’s retail bank has nine customer segment managers and many product managers. Each segment/
product manager has individual and primary responsibility for strategy and profit and loss (P&L),
for their segment/product. They compete with functional managers — marketing, human resources,
facilities — for bank resources. This matrix organization encourages collaboration; it works because
RBC’s culture has always been customer-centric and consensus driven. Also, senior management has
clearly signaled that managing for team success is important for career advancement.
RBC’S NEW APPROACH. RBC traditionally ran mortgage promotions in the spring home-buying
season, emphasizing RBC’s rates. Competitor banks operated similarly. But Louise Mitchell, RBC’s
leader for the builders and borrowers segment, pursued a different approach — she targeted the life
event of a first home purchase. Mitchell created a value proposition to serve the total needs of first-
time home buyers, and add significant value to RBC’s shareholders:
• First-time home buyers have most of their financial lives ahead of them. Attracting these cus-
tomers promises long-term banking relationships, with significant growth prospects.
• On average, first-time home buyers borrow larger amounts for longer terms than other buyers
and are less sensitive to rates. They promise larger investment opportunities, longer-term rela-
tionships, and higher returns on invested capital than other customers.
RBC distributed (direct mail and e-mail) a freestanding newspaper insert — First Time Home
Buyers’ Guide — full of information and expert advice. RBC’s offer included the mortgage and a
$500 savings deposit and free financial review (annually for the first five years). Customers also
received six months free online banking, one year free Internet service, and a no-fee Visa card.
RBC’s product-centric organization could not have executed this promotion; the promotion required
coordination among managers responsible for mortgages, savings accounts, financial advice, and mar-
keting. As segment leader, Mitchell was a powerful catalyst. She stated: “Looking through the customer
lens,” the promotional ideas “jump right out at you.”
N
U E S T IO
RBC’s customer-focused strategy delivered impressive results: First-time CASE Q
curing
mortgage share grew significantly, particularly in the longest, most
firm s face in se
do g
profitable (for RBC) terms. Although 2008 was difficult, from 1994 to allenges lementin
What ch d d a ta and imp
2010, RBC earned several increases: revenues — $7.39 billion to r-focuse s like RB
C?
$40+ billion; profits — $1.17 billion to $6+ billion; year-end market custome ed s trategie
r-foc us
value — $8.9 billion to $70+ billion; and P/E ratio — 8 to 15. custome
 THE VALUE OF CUSTOMERS ! CHAPTER 2 29

Chapter 1 discusses the critical role customers play for the firm’s well-being. By attracting,
retaining, and growing customers, the firm makes profits today and promises profits tomorrow.
KEY IDEA Profits allow the firm to survive and grow, and enhance shareholder value. Because of these
relationships, customers are the firm’s core assets.2 More precisely, customers are core assets
because of two sides of the concept of value. When the firm creates value for customers, it suc-
" When the firm creates cessfully attracts, retains, and grows those customers. By being attracted, retained, and grown,
value for customers, it customers create value for the firm and its shareholders.3
successfully attracts,
retains, and grows A retained customer returns to buy more products and services. If your local coffee shop pro-
customers. vides good value, like a tasty cup of coffee and a fresh snack for a reasonable price, you will keep
going back, morning after morning. The value you bring to the coffee shop is more than just one
" By being attracted,
morning’s purchases. You make a stream of purchases because the coffee shop gives you value. By
retained, and grown,
delivering customer value, the firm generates customer loyalty. This relationship applies to all
customers create value
customers regardless of product — automobiles, credit cards, haircuts, jet engines, or TVs.
for the firm and its
shareholders. The first part of this chapter moves beyond the customers-as-assets concept to measuring the
value that customers bring to the firm. The critical concept is customer lifetime value (CLV)
— what the customer is worth. CLV is the discounted future stream of profits the customer gen-
erates over the life of its relationship with the firm. CLV is the crucial link between the value the
firm delivers to customers and the value customers deliver to the firm. Increasing CLV enhances
shareholder value. This chapter shows how to use CLV to increase the value customers bring to
KEY IDEA the firm; both current customers and potential new customers. The chapter also identifies the
right customers and shows that some customers are undesirable.
" Customer lifetime value Specifically, we address two questions:
(CLV) is the crucial link
• How can we put a monetary value on the firm’s current customers and on potential
between:
customers it may acquire? This monetary value is CLV.
• Delivering value to
• How can we use the CLV concept to help the firm enhance shareholder value?
customers
• Creating value In the second part of this chapter, we examine practical ways in which firms use the CLV con-
for shareholders cept to bind customers closer to the firm. Specifically, we address customer relationship man-
agement (CRM systems and customer loyalty programs.

THE CHANGING VIEW

O L D W AY N E W W AY
Accept that some customers are difficult to address Strive to give customers consistently good
experiences
Acquiring customers is critical Retaining and growing profitable customers and
acquiring new customers are critical
Customer databases nonexistent Customer databases pivotal
Firm manages products Firm manages customers
Firm should attract, retain, and grow all customers Firm should fire some current customers and be
selective in acquiring new customers
Fragmented information on customers Sophisticated CRM systems and data mining
Measure product profitability Measure customer profitability and customer lifetime
value
Plant and equipment are the firm’s core assets Customers are the firm’s core assets
Product profitability drives incentive systems Customer profitability drives incentive systems
Product and sales territory considerations dominate Customer and customer segment considerations
resource allocation dominate resource allocation
Products are at the heart of firm decision-making Customers are at the heart of firm decision-making
Zero or negative reward for customer loyalty Loyalty incentives very common
30 SECTION I ! MARKETING AND THE FIRM

Why Custome r s Are So

Impor tant for the Fir m
CUSTOMER LIFETIME VALUE (CLV)
Several local, regional, and national electronics retail chains have suffered, giving manufacturers like Sony a serious
problem — a long-term customer could go out of business. Sony uses CLV to decide whether, and how much, to invest
in a troubled retailer. Said a senior Sony executive: “We sometimes invest in these customers to try to help them stay
healthy. We actually hire outside consultants to work with them on process re-engineering. We’re working on adver-
tising productivity. We’re working on supply-chain management. If we invest and that customer somehow turns, we’re
not going to take credit for it, but we certainly didn’t help them go down.”4

When customers purchase the firm’s products and services, the firm earns sales revenues; it also
accrues costs. If sales revenues are greater than costs, the firm earns a profit. The profit earned KEY IDEA
from an individual customer during a single time period (year) is the profit margin — the
annual value the customer brings to the firm.5 " CLV depends
on three factors:
Of course, many customers, both consumers (B2C) and partners, distributors, and resellers
(B2B) often purchase the firm’s products for several successive years. Each year, the firm receives • Profit margin
sales revenues, accrues costs, and earns a profit margin. CLV takes into account profit margins • Retention rate
the firm earns in each of these years by using a discount rate.6 Pharmaceutical firms tradition- • Discount rate
ally focused sales efforts on mature, high-prescribing physicians; some firms now place more
effort on young physicians (currently low prescribers) with many more prescribing years ahead
of them.
Some firm customers this year will not be customers next year. They may defect to competitors,
or stop buying the types of products the firm offers.7 In calculating CLV, we must consider cus-
tomer defection and customer retention. Retention rate is simply the number of customers at Mar ke t ing
the end of the year, divided by the number of customers at the start of the year. If the firm starts Quest ion
the year with 100 customers and ends the year with 80 of these same customers, its retention What question about the
rate is 80 percent. Retention is the inverse of defection or churn. In this illustration, the defec- firm’s customers would you
tion rate is 20 percent (100 percent minus 80 percent).8 Understanding CLV allows the firm to like to ask your favorite
better manage its customer base. CEO? How do you think the
CEO would answer?

CALCULATING CLV
In each year, the firm earns a portion of its CLV. In the first year, it earns CLV (1)9: KEY IDEA
CLV (1) = m x r/(1 + d)
" The margin multiple is a
Restating this simple expression in words, CLV (1) is: handy way to calculate
• The profit margin (m) the firm earns in year 1,10 customer lifetime value.
• Multiplied by the retention rate (r) — the probability that a customer at the start of the MARKETING
year will still be a customer at the end of the year, ENRICHMENT
Derivation of Customer Lifetime
• Discounted back to the start of the year, using the term 1/(1+d). The discount rate (d) is
Value (CLV) Formula me201
the firm’s cost of capital — typically provided by the firm’s chief financial officer (CFO).
To calculate a customer’s total CLV, we simply add up the CLV contributions for each successive me201

year.11 This is complicated mathematically. We simplify the calculation by assuming that each
term — profit margin (m), discount rate (d), retention rate (r) — is constant year to year.
With these assumptions, CLV equals the profit margin (m) multiplied by the margin multiple.
(For interested readers, Marketing Enrichment me201 derives the margin-multiple formula.)
 THE VALUE OF CUSTOMERS ! CHAPTER 2 31

The margin multiple = r/(1 + d – r), so that:

CLV = m x r/(1 + d – r)
Calculating CLV is quite straightforward using this formula.12 Table 2.1 makes it easier by pro-
viding margin multiple values for different retention rates (r) and discount rates (d).

TABLE 2.1 Discount Rate (d)

Retention Rate (r) 8% 12% 16% 20%
THE MARGIN
MULTIPLE = 60% 1.25 1.15 1.07 1.00
r/(1+d–r ) 70% 1.84 1.67 1.52 1.40
80% 2.86 2.50 2.22 2.00
90% 5.00 4.09 3.46 3.00
95% 7.31 5.59 4.52 3.80

Suppose the firm earns an annual profit margin of $500,000, customer retention rate is 70 per-
cent, and the firm’s discount rate is 12 percent. From Table 2.1, the margin multiple is 1.67.
Hence, CLV = $500,000 x 1.67 = $835,000. Of course, we lose some precision with these
assumptions, but, in most cases, putting us in the right ballpark is sufficient.
KEY IDEA Note several things about Table 2.1:
1. The ranges of values for discount rate (d) (8 percent to 20 percent) and retention rate (r)
" Increasing customer (60 percent to 95 percent) are quite large. They cover most cases for most firms — the
retention rate has margin multiple value spans 1.00 to 7.31.
greater leverage on 2. The median value of the margin multiple is around 2.5.
customer lifetime value
3. Improving retention rate (r) has a greater impact on the margin multiple than reducing
than reducing the
discount rate (d):
discount rate.
a. When retention rate (r) is 90 percent, reducing discount rate (d) from 20 percent to 8
percent improves the margin multiple from 3.00 to 5.00 — 67 percent.
b. When discount rate (d) is 12 percent, increasing retention rate (r) from 60 percent to
90 percent increases the margin multiple from 1.15 to 4.09 — well over three times! It
follows that:
4. All things equal, the firm is better off increasing retention rate (r) than reducing discount
rate (d) — cost of capital — by financial engineering. Finance students, please note!
5. Customer retention is a big deal. More on this later.
Here’s how we use the margin multiple to calculate CLV for a FedEx customer:

Example: Lifetime Value of a FedEx Customer

FedEx has identified a market segment — these data apply to FedEx’s customers in that segment:

Assumptions
• Total FedEx letters shipped per month = 2,285
Mar ke t ing • Number of FedEx customers = 140
Quest ion • FedEx profit margin per letter (m) = $8.25
How do you assess CLV • Discount rate (cost of capital) (d) = 12%
for customers of Apple, • Annual retention rate (r) = 90%
Facebook. Google, Hershey,
Nokia, Pfizer, and Walmart? We assume these numbers remain constant year to year.
If CLV is high — why? CONTINUES ON NEXT PAGE
If CLV is low — why?
32 SECTION I ! MARKETING AND THE FIRM

MARKETING
Customer lifetime value calculation: ENRICHMENT
Alternate Way to Calculate CLV
Number of FedEx letters per customer per annum = 2,285 x 12/140 = 195.8 for a FedEx Customer me202
FedEx profit margin per customer per annum = $8.25 x 195.8 = $1,616
Discount rate (d) = 12% me202

Retention rate (r) = 90%

From Table 2.1, the margin multiple = 4.09

CLV = FedEx profit margin per customer per annum x margin multiple = $1,616 x 4.09 = $6,609

Marketing Enrichment me202 shows an alternate way to calculate CLV for FedEx. (CLV can also be
used to calculate shareholder value me203 .)
MARKETING
ENRICHMENT
Customer Lifetime Value (CLV)
INCREASING CUSTOMER LIFETIME VALUE and Shareholder Value me203

We now explore ways to increase CLV. Restating the CLV formula: me203

Increase profit margin, m

CLV = m x r Increase customer retention rate, r

(1 + d – r)

Reduce discount rate, d

Quite simply, the firm has three, and only three, ways to increase CLV:
• Increase profit margin (m) the firm earns from customers
• Increase customer retention rate (r) (reduce customer defection rate)
• Reduce discount rate (d)
If the firm spends resources to increase customer retention (r), it reduces profit margin (m). Or
the firm may increase profit margin (m) by raising prices — but customer retention (r) may fall.
Nonetheless, we consider these approaches separately. The third item — discount rate (d) — is
the firm’s cost of capital, the CFO’s responsibility. As marketers, we encourage CFOs to reduce
the firm’s cost of capital, but marketing can do little to help. Hence, we drop further discussion
of discount rate and focus on increasing profit margin and customer retention.13

INCREASE THE PROFIT MARGIN THE FIRM EARNS

FROM CUSTOMERS
The firm has several options for raising CLV by increasing profit margins from current customers:
• Customer selection. Well-selected current customers provide a base level of profit margin.
• Customer satisfaction and loyalty. Well-served customers increase purchases over time.
Hence, revenues and profit margins increase.14
• Customization. Targeted offers to defined segments provide greater customer value.
• Raise prices. If customer satisfaction is high, the firm may be able to set higher prices.
• Reduce operating costs. As the firm learns to serve customers, it reduces operating costs
and may reap scale economies with individual customers.
 THE VALUE OF CUSTOMERS ! CHAPTER 2 33

In addition, satisfied customers may help the firm to secure revenues from other customers:
• Learning. The firm learns by working closely with customers and becomes better able to
attract new customers.
• Network externalities. In some markets, customers bring value to other customers. The
more sellers eBay attracts, the more valuable is eBay’s service to buyers. The more buyers
eBay attracts, the more valuable it is to sellers. Television, some printed media, and web-
Mar ke t ing sites are free, yet their customer traffic has value to advertisers. Deciding what marketing
Quest ion resources to allocate for securing free customers may be a crucial firm decision.15
Do you tend to increase
• Positive word of mouth and referrals. Satisfied customers generate positive word of
your purchases from firms
mouth and provide referrals to potential customers. Lexus secures more new customers
that treat you well? Have
from referrals than any other source.16
you told others about these • Signals. Securing a high-profile customer may provide the firm with credibility among
experiences? other potential customers.
Figure 2.1 shows annual profit margin per customer in the U.S. credit card industry. In year 1,
by incurring customer acquisition and start-up costs, the average credit card issuer loses $80; in
year 2, the customer earns the firm $40. Profit margin per customer increases steadily with cus-
tomer longevity.17
150
Annual Profit Margin (US$)

FIGURE 2.1 155 161

148
137 142
124 130
PROFIT MARGIN IN 100 111 116 120
106
THE U.S. CREDIT CARD 96 99 103
87 92
INDUSTRY BY LENGTH 79
66 72
50
OF CUSTOMER
40
RELATIONSHIP
0

(50)
(80)

0 2 4 6 8 10 12 14 16 18 20
Length of Customer Relationship (Years)

Figure 2.2 shows how customer retention relates to profit patterns in several other industries.18
Auto Industry Auto Service
FIGURE 2.2 100
50 75 90 88 88
75
PROFIT MARGINS IN
(50) 70
SEVERAL INDUSTRIES BY -50 50
LENGTH OF CUSTOMER
Annual Profit Margin (US$)

-150 25 35
RELATIONSHIP
25
-250 (250) 0
1 2 3 4 5 1 2 3 4 5

Industrial Distribution Life Insurance

200
0 13 3
150 168 (75) (29)
144 (175)
-400
100 121
99
-800
50
35 (1125)
0 -1200
1 2 3 4 5 1 2 3 4 5
Length of Customer Relationship (Years)
34 SECTION I ! MARKETING AND THE FIRM

me204

Increasing the profit margin the firm earns from customers has an important impact on CLV.19
The impact is simply the profit margin multiplied by the margin multiple. Previously, we showed
that the margin multiple with constant profit margin, retention rate, and discount rate was:
CLV = m x r/(1 + d – r)
If profit margin grows at a constant rate (g), then:
CLV = m x r/(1 + d – r [1 + g])
MARKETING
ENRICHMENT
As g increases, r [1 + g] also increases, but the entire denominator (1 + d – r [1 + g]) decreases;
Derivation of Customer
hence CLV increases. Table 2.2 shows the margin multiples for different profit margin growth Lifetime Value (CLV) Formula
rates, assuming a 12 percent discount rate (d). (For formula derivation, see Marketing with Constant Annual
Enrichment me204 .) Profit Margin Growth me204

Profit Margin Growth (g) TABLE 2.2

Retention Rate (r) 0% 2% 4% 6% 8%
THE MARGIN
60% 1.15 1.18 1.21 1.24 1.27 MULTIPLE WITH
70% 1.67 1.72 1.79 1.85 1.92 PROFIT MARGIN
80% 2.50 2.63 2.78 2.94 3.13 GROWTH =
r/(1+d–r [1 + g])
90% 4.09 4.46 4.89 5.42 6.08

Because we selected a 12 percent discount rate, the first column of Table 2.2 is identical to the
“12%” column in Table 2.1. Note two items from Table 2.2: KEY IDEA
• Regardless of retention rate, higher profit margin growth gives higher margin multiples.
For example, when the retention rate is 80 percent: " The profit margin
• At 0 percent profit margin growth, the margin multiple is 2.50. the firm earns from
• At 6 percent profit margin growth, the margin multiple is 2.94. a customer tends to
increase over time.
• As retention rate increases, higher profit margin growth has greater impact:
• At 70 percent retention rate:
• Profit margin growth rate = 0 percent, margin multiple = 1.67
• Profit margin growth rate = 8 percent, margin multiple = 1.92 – 15 percent increase
• At 90 percent retention rate:
• Profit margin growth rate = 0 percent, margin multiple = 4.09
• Profit margin growth rate = 8 percent, margin multiple = 6.08 – 50 percent increase
Of course, this last result is not surprising. Customers with higher retention rates have a longer
time period to provide the firm with higher profit margins.20

INCREASE THE CUSTOMER RETENTION RATE —

REDUCE THE CUSTOMER DEFECTION RATE
Medco Health Solutions (MHS) provides pharmacy services to 60 million Americans. In 2003, MHS secured independ-
ence from Merck with a $12 stock price (adjusted). By 2010, MHS’s retention rate among corporate customers rose to
98 percent; stock price reached $63.

We just showed that a profit margin (m) increase leads to CLV increase. Of course, profit
margin is only relevant if the customer continues to be a customer! Figure 2.3 shows retention/
defection patterns based on customer tenure — for 90 percent and 80 percent retention rates;
of course, defection is greater at 80 percent retention rate than 90 percent. Regardless, the
 THE VALUE OF CUSTOMERS ! CHAPTER 2 35

number of customers defecting is greatest in the first year — as time goes on, fewer customers
Mar ke t ing defect. Assume the firm acquires 1,000 new customers at the beginning of year 1:
Quest ion • 90% retention: Start — 1,000 customers
Suppose you were advising 1st year — Lose 100 customers; 900 remain
a local restaurant located 2nd year — Lose 90 customers; 810 remain
on a busy street. The owner 3rd year — Lose 81 customers; 729 remain
tells you she receives plenty • 80% retention: Start — 1,000 customers
of walk-in traffic but has few 1st year — Lose 200 customers; 800 remain
returning customers. What 2nd year — Lose 160 customers; 640 remain
options can you suggest? 3rd year — Lose 128 customers; 512 remain
These data tell us that customer retention rate has an important impact on CLV. Figure 2.4
shows that a 5 percent increase in customer retention rate enhances customer CLV by over 50
percent in several industries.21 Figures differ by industry because of different profit patterns —
and different retention/defection rates. We discuss customer relationship management (CRM)
and specific programs to encourage customer loyalty later in the chapter.
100%
FIGURE 2.3 90% retention rate
Percent of Starting Customers Remaining

RETENTION/DEFECTION 80% retention rate

by Length of Customer Relationship

PATTERNS — PERCENT OF 80%

STARTING CUSTOMERS
REMAINING BY
LENGTH OF CUSTOMER 60%
RELATIONSHIP —
80% AND 90%
RETENTION RATES 40%

20%

1 2 3 4 5 6 7 8 9 10
Customer Tenure (Year)

100%
FIGURE 2.4 95
90
INCREASE IN CUSTOMER 80 84 85 85
81
LIFETIME VALUE BY
Increase in Customer

75
IMPROVING CUSTOMER
Lifetime Value

60
RETENTION 5% IN
SELECTED INDUSTRIES
50
40 45 45
40
35
20

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36 SECTION I ! MARKETING AND THE FIRM

HOW CUSTOMER RETENTION WORKS

We just saw that customer retention rate is an important CLV driver. We now show how small
differences in customer retention lead, over time, to major differences in sales and market share.
Figure 2.5 shows three hypothetical scenarios — A, B, C — each with two firms, Jane’s Makeup
Emporium and Joe’s Beauty Aids, and two time periods, year 1 and year 2. Each scenario shows
patterns of customer retention (defection), and customer acquisition. To keep things simple, we
assume 1,000 customers in total and that Jane and Joe each start with 500. Our task is to figure
out the number of customers that Jane and Joe eventually secure in each scenario, and their
steady-state market shares.
Scenario A Scenario B Scenario C
FIGURE 2.5
Year 2 Year 2 Year 2
Jane’s Joe’s Jane’s Joe’s Jane’s Joe’s ILLUSTRATIVE
LONG-RUN
Jane’s 80% 20% Jane’s 90% 10% Jane’s 95% 5% MARKET-SHARE
Year 1 Year 1 Year 1 SCENARIOS
Joe’s 20% 80% Joe’s 20% 80% Joe’s 20% 80%

Scenario A. In year 2, Jane retains 80 percent of her year-1 customers and acquires 20 percent of
Mar ke t ing
Joe’s. Joe’s pattern is identical. This scenario is trivial, but it provides a useful baseline. Jane and Quest ion
Joe essentially swap equal numbers of customers back and forth. In year 2, Jane’s 80 percent Suppose a firm’s annual
retention yields her 400 customers — 500 x 80% = 400 — and she acquires 100 customers from revenue growth goal was
Joe — 500 x 20% = 100. Jane ends up with 500 customers (400 + 100), the same number she had 15 percent. Consider two
originally. Joe’s situation is identical. Jane and Joe each earn 50 percent long-run market share. situations:

Scenario B. Jane does better. In year 2, she retains 90 percent of her year-1 customers — versus • Customer retention rate =
80 percent in scenario A — but again, Jane acquires 20 percent of Joe’s customers. Joe’s reten- 80 percent
tion pattern is identical to Scenario A — 80 percent — but he acquires only 10 percent of Jane’s • Customer retention rate =
customers. Jane retains 450 of her original 500 customers — 500 x 90% = 450 — and acquires 95 percent
100 customers from Joe — 500 x 20% = 100. Jane now ends up with 550 customers (450 + 100). What would the firm’s cus-
Joe has 450 customers. tomer acquisition rate have
In year 3, Jane’s starting customer base is higher — 550 versus 500 — so she retains 495 to be in each case? What
customers — 550 x 90% = 495. Joe’s starting base is lower — 450 versus 500 — so Jane only would be the implications
acquires 90 of his customers — 450 x 20% = 90. But the combination of acquisition and reten- for the firm?
tion increases Jane’s customers from 550 to 585 (495 + 90). Joe has 415 customers. These num-
bers converge to a steady state where Jane and Joe have 670 and 330 customers, respectively —
67 percent and 33 percent market shares.

Steady-State TABLE 2.3

Market Shares
ILLUSTRATIVE STEADY-
Jane’s Retention Rate Jane Joe
STATE MARKET SHARES 22
80% 50% 50%
90% 67% 33% MARKETING
ENRICHMENT
95% 80% 20% Derivation of a Formula to
Calculate Steady-State
Scenario C. Jane does even better. In year 2, she retains 95 percent of her year-1 customers and Market Share me205
again acquires 20 percent of Joe’s. Joe’s retention pattern is the same as previously — 80 percent
me205
— but he acquires only 5 percent of Jane’s customers. Using the same process as before, the
steady-state customer numbers are 800 for Jane and 200 for Joe — 80 percent and 20 percent
market shares, respectively — Table 2.3. (You may want to confirm this result for yourself. For
the formula to calculate steady-state market share, see Marketing Enrichment me205 .)
 THE VALUE OF CUSTOMERS ! CHAPTER 2 37
Mar ke t ing
Quest ion
In 2010, Toyota faced serious To summarize:
gas-pedal-related quality • As retention rate increases, steady-state market share increases;
problems. Assume Toyota's • The higher the retention rate, the greater is the impact on market share for a given
retention and acquisition increase in retention rate. For example:
rates fell: retention rate —
60 percent to 50 percent;
• When Jane’s retention rate is 80 percent, a 10 percent increase — to 90 percent —
acquisition rate — 15 per-
increases her market share by 17 points — from 50 percent to 67 percent; but,
cent to 10 percent. What • When Jane’s retention rate is 90 percent, a 5 percent increase — to 95 percent —
would be the effect on increases her market share by 13 points — from 67 percent to 80 percent.
Toyota’s long-run market Of course, it may be more expensive to improve retention rate from 90 percent to 95 percent
share? What action should than from 80 percent to 90 percent!
Toyota take?
This simple exercise demonstrates an important truth — customer retention is a big deal!
Relatively small differences in customer retention lead to large differences in long-run market
share. Table 2.4 shows steady-state market shares for various retention and acquisition rates.

Acquisition Rate (a)

TABLE 2.4
Retention Rate (r) 5 10 15 20 25 30
STEADY-STATE
60 11.1 20.0 27.3 33.3 38.5 42.9
MARKET SHARES
FOR VARIOUS 70 14.2 25.0 33.3 40.0 45.5 50.0
ACQUISITION RATES 80 20.0 33.3 42.9 50.0 55.6 60.0
AND RETENTION RATES
90 33.3 50.0 60.0 66.7 71.4 75.0
95 50.0 66.7 75.0 80.0 83.3 85.7

The key implication of increased retention rate is longer customer tenure — individual cus-
tomers provide sales revenues and profit margins for longer periods.23 Table 2.5 shows this
duration effect. Note that at high retention rates, small retention rate increases have a dispro-
portionate impact on average customer tenure:
• When customer retention rate is 50 percent, a 30-point increase in retention rate — to 80
percent — increases average customer tenure by 3 years — from 2 years to 5 years; but,
• When customer retention rate is 90 percent, a 5-point increase in retention rate — to 95
percent — increases average customer tenure by 10 years — from 10 years to 20 years.
Boeing’s relationship with Southwest Airlines (SWA) is a good example. In the early 1970s, SWA
was a startup airline serving Dallas, Houston, and San Antonio, but later became the U.S.’s
largest domestic airline. Boeing supplied SWA’s original planes — SWA has never purchased
planes from any other supplier!

TABLE 2.5 Customer Retention Rate Average Customer Tenure

50% 2 years
THE DURATION EFFECT:
RETENTION RATE 75% 4 years
AND AVERAGE 80% 5 years
CUSTOMER TENURE 90% 10 years
95% 20 years

PROFIT MARGINS AND CUSTOMER RETENTION

Table 2.6 combines credit card profit margin data — Figure 2.1, with customer retention data —
Figure 2.3, assuming a 10 percent discount rate. We see the effect of increased profit margin over
the length of the customer relationship, based on two different retention rates. Table 2.6 shows:
• When retention rate is 90 percent, total annual profit peaks at $53,460 (year 2), then
declines annually. Ten-year discounted profits are $205,721.
38 SECTION I ! MARKETING AND THE FIRM

• When retention rate is 80 percent, total annual profit also peaks in year 2, but at a lower
figure — $42,240. Ten-year discounted profits are $93,475.
The 90 percent to 80 percent retention rate difference leads to a CLV difference of $112,246
($205,721 – $93,475).

90% Retention Rate 80% Retention Rate

TABLE 2.6
Age of Annual Number of Total Total Number of Total Total
Account Profit Customers Annual Discounted Customers Annual Discounted PROFITS IN THE U.S.
Margin Remaining Customer Annual Remaining Customer Annual CREDIT CARD INDUSTRY
per Profit Customer Profit Customer AT DIFFERENT CUSTOMER
Customer Margin Profit Margin Profit
RETENTION RATES
by Age of by Age of Margin by Age of Margin
Account Account by Age of Account by Age of
Account Account Mar ke t ing
0 –$80 1000 –$80,000 –$80,000 1000 –$80,000 –$80,000 Quest ion
1 $40 900 $36,000 $32,727 800 $32,000 $29,091 Suppose a firm can sustain
a 15 percent customer
2 $66 810 $53,460 $44,182 640 $42,240 $34,910
acquisition rate; its goal is
3 $72 729 $52,488 $39,435 512 $36,864 $27,696 to double the customer base.
4 $79 656 $51,824 $35,396 410 $32,390 $22,123 Consider two situations:
5 $87 590 $51,330 $31,872 328 $28,536 $17,719 • Customer retention rate =
6 $92 531 $48,852 $27,576 262 $24,104 $13,606 90 percent

7 $96 478 $45,888 $23,548 210 $20,160 $10,345 • Customer retention rate =
95 percent
8 $99 430 $42,570 $19,859 168 $16,632 $ 7,759
In each case, how many
9 $103 387 $39,861 $16,905 134 $13,802 $ 5,853
years will it take for the firm
10 $106 348 $36,888 $14,221 107 $11,342 $ 4,373 to reach its goal?
Total CLV $205,721 Total CLV $93,475

Mar ke t ing
Quest ion
ACQUIRING NEW CUSTOMERS What is the source of CLV
So far, we used CLV to focus on the firm’s current customers. We showed that increasing both for: Capital One, Domino’s
profit margin and customer retention rate raises CLV. But what about potential future cus- Pizza, Potemkin automobile
tomers? How valuable are they? We can use the same approach to consider potential customers. dealership, and Rolls-Royce
The biggest difference is that, right now, the firm earns no revenues from these potential cus- aero engines?
tomers and, to attract them, it must incur an acquisition cost (AC). Using the same approach
as before, we include the cost to acquire these new customers:
CLV = m x r/(1 + d – r) – AC
We now have a useful way to think about new customers. All thing equal, the firm should
acquire a customer if the first term in the CLV expression, m x r/(1 + d – r), is greater than the
acquisition cost (AC). If the customer acquisition cost were greater, the firm would lose money.
The actual cost to acquire new customers varies widely by company and industry. Table 2.7
shows public data on company experience in acquiring customers.
Customer acquisition costs in a petroleum industry study varied by acquisition method: per- KEY IDEA
sonal selling — $500, direct mail — $115, telesales — $95, and e-mail and websites — $30.24
The firm should assess acquisition costs for the various ways it secures new customers and " The firm should try to
redesign its processes accordingly. One firm found the typical sales rep’s time allocation was acquire customers
selling — 45 percent, lead qualification — 40 percent, and administration — 15 percent. whose expected CLV
Adding telesales to supplement personal selling lowered the small-customer-acquisition cost.25 is greater than the
acquisition cost.
 THE VALUE OF CUSTOMERS ! CHAPTER 2 39

TABLE 2.7 Industry Firm Acquisition Cost

per Customer
SELECTED DATA Financial Ameritrade $202
ON CUSTOMER
Credit card $25 – $35 (sub-prime)
ACQUISITION COSTS
Credit card $75 – $150 (platinum)
E-Trade $475
Lending Tree $ 28
Mortgage $300 – $700
Satellite/Cable Cable companies $150
Direct satellite broadcasting companies $400
DirecTV $550
$670
$758
$894
XM Satellite Radio $123
Telecom Nextel $430
Sprint $315
Travel Priceline.com $8.66
* Adapted from Table 3.2, pp 54–55, S. Gupta and D.R. Lehmann, Managing Customers as Investments, Philadelphia, PA: Wharton, 2005.

OPTIONS FOR ADDRESSING CUSTOMERS

Much of Managing Marketing in the 21st Century focuses on increasing CLV from current
customers and acquiring profitable new customers. From Chapter 7 on, we elaborate on the six
marketing imperatives that encapsulate approaches for achieving these goals. Here, we identify
a broad set of options for addressing current and potential customers — Figure 2.6.26

FIGURE 2.6 All Customers

APPROACHES
TO IMPROVING
CUSTOMER
Current Potential
LIFETIME VALUE
Customers Customers

Retain Grow Delete Retrieve Acquire Ignore

(Stop Defections)

When asked to divide promotional expenses into two buckets — one for retaining current
customers and one for attracting new customers — most executives report a focus on attracting
new customers. Of course, new customers are critical for firm growth: The issue is one of
balance. Far too often, the firm takes current customers for granted and spends too little on
customer retention. Further, retaining current customers is generally less costly than acquiring
new customers! We do not suggest that current customers are more important than new cus-
tomers. After all, new customers may have greater growth potential. But we do believe the firm
should make customer investment decisions carefully and deliberately.27
British cell phone operator O2 outperformed its peers, and reduced customer churn by half, in part by encouraging
renewals and placing equal effort on retention and acquisition.
40 SECTION I ! MARKETING AND THE FIRM

CURRENT CUSTOMERS
Figure 2.6 shows three firm options for addressing current customers — retain, grow, and Mar ke t ing
delete. Quest ion
RETAIN. The firm’s customer base is like a leaky bucket; the firm should plug its holes. By up- Suppose your research
dating products and services to meet evolving customer needs and taking other actions to bind for the local restaurant
customers more closely, the firm enhances customer satisfaction, increases loyalty, and reduces (Marketing Question, p. 35)
defections.28 Satisfied and delighted customers are more likely to continue buying than dissatis- reveals that customer
fied customers. For its most loyal fans, The Grateful Dead’s telephone hot line provided its tour- retention is suffering
ing schedule before any public announcement, reserved some of the best seats, and distributed because the restaurant is
tickets through a proprietary mail-order house. Wachovia Bank’s (now Wells Fargo) customer too crowded. What options
satisfaction scores improved from 5.5 to 6.5 (1 to 7 scale — Gallup) over a five-year period; would you suggest to
annual customer defection declined from 20 percent to 11 percent. In the insurance and mutual reduce the number of
fund industries, firms try to sell extra products to existing single-product customers; increased walk-in customers?
reliance on the firm creates lock-in.29 Table 2.8 shows that monthly churn for cable firm Cox
Communications is less for multiple-product customers. Some firms conduct lost-customer
research to identify and repair the reasons for defection. Others implement early warning
systems to identify potential defectors:
OfficeMax has a defection detector. Said a senior executive: “We have automatic warning signs that apply to all
major customers, and then for each one there are also special warning signs that we enter manually. Has the
customer gone more than 12 weeks without placing an order? Are orders becoming less frequent? Has the buyer or
purchasing manager changed? Has the content or size of the average order decreased? Has the sales rep changed?
There may be eight warning signs for a customer, and if five of them go off that’s when our CEO gets on the plane and
pays a call to see what’s going on and make sure we don’t lose a valuable account.”30

Number of Products Products Purchased Monthly TABLE 2.8

per Customer Churn Rate
1 Video only 3.0% CHURN RATES
FOR COX
Video plus high-speed Internet 2.3%
COMMUNICATIONS
2 Video plus phone 2.2%
High-speed Internet plus phone 1.9%
3 Video plus high-speed Internet plus phone 1.4%

Some firms budget maintenance expenses as a retention strategy by offering current customers
extra services. Maintenance expenses are not trivial; they reduce the firm’s profit margin from KEY IDEA
current customers. But they are often more cost-effective than having customers defect.
GROW. Satisfied customers may be willing to increase current purchases. Also, by providing " The firm’s options for
good information and employee training, the firm may increase customer revenues by cross- addressing current
selling. Your cable company provides basic channels for a standard fee, but offers higher-value customers are:
channels like HBO and special sports events for extra fees. Amazon is a good Internet example
• Retain
of increasing revenues via cross-selling. Initially, Amazon offered books, then CDs, and now
• Grow
sells a vast array of different products, enabling and personalizing one-stop shopping. Actually,
• Delete
Amazon has two types of marketing effort: Type 1 attracts customers to its website through tar-
geted offerings; type 2 encourages visitors to explore the site for new items, driving multiple
purchases and enhanced customer satisfaction.31
DELETE. Generally, the firm tries to retain and grow current customers so as to increase profit
margins. But some customers are not worth having. Sprint Nextel disconnected 1,000 sub-
scribers who called customer service excessively; Marsh & McLennan (insurance brokers)
terminated thousands of clients; and many local newspapers, like the Atlanta Journal-
 THE VALUE OF CUSTOMERS ! CHAPTER 2 41

Constitution, reduced geographic delivery footprints. Most firms have unprofitable customers
and should seriously evaluate ending these relationships, taking care to avoid potentially nega-
tive word of mouth. We address customer deletion in the next section.

POTENTIAL CUSTOMERS
Potential customers offer an excellent way for the firm to grow. But as we learned earlier, not all
customers are alike. Returning to Figure 2.6, we discuss three broad options for addressing
potential customers — retrieve, acquire, and ignore.
KEY IDEA
RETRIEVE. All firms have customers that defect; the prior relationship makes them winback
opportunities. These customers are a special category because the firm often has more informa-
" The firm’s options for tion about them than about other potential customers. The firm knows (or can find out) what
addressing potential they purchased, what they spent, how they make decisions, why they left, and other data that
customers are: can help the firm serve them again. The video rental firm Netflix has a targeted winback pro-
• Retrieve gram. If the firm understands why customers defect, winbacks can improve.
• Acquire
ACQUIRE. To reach sales and profit goals, most firms must acquire profitable new customers.
• Ignore
Sometimes the firm seeks customers with similar characteristics to current customers — other
times it wants very different customers. Regardless, the firm should be selective in its marketing
efforts so as to acquire the right customers — customers with positive CLV.32
Some firms have well-developed systems for accepting/rejecting customers. In the credit card
and insurance industries, firms use extensive databases on customer demographics and past
behavior to make accept/reject decisions.33 Most venture capital firms conduct extensive analy-
ses of potential investment opportunities, accepting only a small fraction. Flextronics (leading
electronics contract manufacturer) conducts similarly detailed analyses to select the few cus-
tomers it believes will be successful.
Four major approaches for acquiring customers are:
• Independent marketing activities. Most firms use communications to reach potential
Mar ke t ing customers and persuade them to buy products and services. AT&T, GM, P&G, Time
Quest ion Warner, and others spend immense sums on advertising; life insurance firms like AXA
Think of a local business.
and New York Life place major resources into personal selling. So do FedEx, Xerox, and
What approaches does it
many others. We discuss these and other approaches later in the book.
use to acquire customers? • Affiliations. The firm makes formal or informal relationships with individuals or other
What alternative approaches organizations to feed it customers. Informal relationships are very common in the service
could it implement? sector. General medical practitioners feed patients to specialist physicians; specialist con-
sulting firms feed clients to consultants with different specialties. Some firms formalize
this process by paying directly for delivered customers. Amazon has more than one mil-
lion affiliate relationships that send customers to its website.
• Channel strategies. Rather than approach potential customers directly, the firm works
through third parties like agents, brokers, and distributors. In the late 1990s, Cisco made
85 percent of sales direct to customers; today, it makes 85 percent of sales though distrib-
utors and value-added resellers (Opening Case Chapter 18).
• Firm and business-unit acquisitions. Regardless of purpose, whenever the firm completes
a merger or acquisition, it acquires customers. But firms make some acquisitions — like
cable TV franchises and credit card portfolios (Bank of America’s MBNA acquisition) —
for this specific purpose.
IGNORE. The firm must decide on desirable customer characteristics and make investments in
potential customers that bring value. By the same token, it should ignore customers that do not
possess these favorable characteristics. Bottom line: The firm must be selective in making
investments to secure potential customers.
42 SECTION I ! MARKETING AND THE FIRM

BEING SELECTIVE ABOUT CUSTOMERS

Many customers bring value to the firm, but some do not. Quantifying customer value is
important in understanding how to identify customers the firm wants to serve, and develop
options for addressing unwelcome customers.34

CUSTOMER PROFITABILITY
Most firms understand and measure product profitability — revenues minus costs for individ-
ual products. Product profit is a key metric for most product managers. Many firms invest heav-
ily in sophisticated accounting systems and data analysis tools that help answer questions like:
• Are our current products profitable?
• Shall we discontinue this old product and, if so, when?
KEY IDEA
• Shall we introduce a new product?35
" Measuring product
By contrast, few firms can answer equivalent questions about customers. This failure is espe- profitability is insuffi-
cially critical in multi-business and multinational firms. Profitability data typically reside in cient; the firm should
individual businesses and geographies whose systems do not interface with one another. Hence, develop systems for
there is no easy way to extract and integrate sales and profit data for individual customers across measuring customer
businesses and geographies. profitability.
Indeed, several different businesses and/or geographies may have the same customer, but not
know it! Full-line insurance companies are a good example. If you or your parents have auto-
mobile, homeowner’s, and life insurance from the same firm, try getting a single annual bill.
Impossible! Each business typically acts independently and does not share customer data.
Consider the following: A business executive regularly entertained clients at a top-level restau-
rant in his home city. He called the restaurant’s catering division to arrange for his daughter’s
wedding. Catering did not know who he was and gave him no special consideration. Unsur-
prisingly, he started to take his clients elsewhere!
The firm’s inability to measure customer profitability stands in sharp contrast to treating cus-
tomers as assets and CLV. Product profitability is important, but products and services are only
a means to attract, retain, and grow customers. To paraphrase an old management saying: “If
you can’t measure it, you can’t manage it!”

At TreeCo Paper (disguised name) the top ten customers generated 70 percent of revenues. Detailed analysis showed
that three of these customers were unprofitable. At contract renewal time, TreeCo offered sales incentives to lose con-
tracts with these customers. Six months later, senior management said: “Revenues are down, but profits are way up.”36

When customers purchase products and services, the firm earns sales revenues; unfortunately,
most firms have some unprofitable customers. The firm must examine the relevant metrics
across products to assess whether or not customers are profitable. In other words, are revenues
greater than costs?
Firms use a variety of methods to gather and assess data relevant to customer activity and
profitability, notably via CRM systems. We explore CRM later in the chapter.
When firms examine revenues, costs, and profits by customer, they often find an 80:20 rule: 80
percent of revenues come from 20 percent of customers. Of course, this rule is not absolute, but
is a better working hypothesis than assuming all customers have similar revenue/profit relation-
ships. Some firms have even more skewed revenue distributions. A major magazine publisher
found a 90:10 pattern: 90 percent of revenues from 10 percent of customers! We have even seen
95:5 ratios. The firm’s strategic (key) accounts can be very profitable and many firms have
installed account management systems to serve them — Chapter 17. Losing a strategic account
to a competitor or from bankruptcy can be serious. When $9.5 billion hedge fund Amaranth
 THE VALUE OF CUSTOMERS ! CHAPTER 2 43

Demonstrating Customer Profitability

Table 2.9 shows how to convert product profits into customer profits. Suppose the firm’s three
businesses, each with its own sales and service operation, sell three products
(X, Y, and Z) to a large customer:
• Sales revenues. Sales revenues for products X, Y, and Z are respectively $4M, $5M,
and $6M — total sales revenues = $15M.
• Gross margin. The firm makes a positive gross margin of $1.5 million on each product —
total gross margin = $4.5 million.
• Profits. The firm makes profits of $125K and $50K respectively on products Y and Z — it
loses $500K on product X. Overall, the firm loses $325K on this customer, despite $15M sales
revenues.37

TABLE 2.9 Product X Product Y Product Z Total

Sales revenues 4,000 5,000 6,000 15,000
FROM PRODUCT
PROFITS TO CUSTOMER
Cost of goods sold 2,500 3,500 4,500 10,500
PROFITS ($000s) Gross margin 1,500 1,500 1,500 4,500
Selling expenses 750 275 150 1,175
Service expenses 500 600 700 1,800
Additional expenses 750 500 600 1,850
Profit (500) 125 50 (325)

Note that these same products may be more profitable with other customers: Production lot sizes
may be larger, prices may be higher, and selling, service, and/or additional expenses may be lower.

Advisors closed, it voided contracts on 221 Bloomberg terminals, an expensive loss for
Bloomberg.

In the ten years after 1995, Illinois Tool Works (ITW) acquired more than 200 firms. ITW developed and successfully
implemented an 80:20 process — each business-unit manager focused exclusively on the 20 percent of customers
providing 80 percent of revenues. From 2000 to 2005, ITW increased the average operating margin of its acquired
firms from 9 percent to 19 percent; revenue per employee increased 50 percent, and net income doubled.

BrainQUICKEN (online sports-nutrition supplements) sold products through 120 wholesalers. Founder Tim Ferriss
discovered that 5 wholesalers produced more than 90 percent of profits, yet he was spending 90 percent of effort on
the other 115. Ferriss switched effort to his profitable five and added several others with similar profitability profiles.

KEY IDEA Returning to the 80:20 rule, the converse analogue is the 20:80 rule; 20 percent of revenues from
80 percent of customers. This rule raises two critical yet related questions:
" At many firms, 20 • What does it cost the firm to serve these customers?
percent of customers • Is it profitable to serve these customers? If not, what action should the firm take?
provide 80 percent
of revenues and 120 Frequently, firms find that these costs are very high and many customers are unprofitable. Some
percent of profits. firms use extended rules — the 80:20:120 rule and the 20:80:20 rule!
" At these same firms, • 80:20:120 — 80 percent of revenues from 20 percent of customers; these customers pro-
80 percent of cus- vide 120 percent of firm profits.
tomers provide 20 • 20:80:20 — 20 percent of revenues from 80 percent of customers; these customers reduce
percent of revenues firm profits by 20 percent.
and reduce profits by
20 percent.
44 SECTION I ! MARKETING AND THE FIRM

Some examples: In the Opening Case, 17 percent of RBC’s customers accounted for 93 percent
of profits38; at a major media company, 17 of 1,017 advertisers accounted for all profits; a major
software company found only 7 of 307 customers were profitable; and Marsh & McLennan’s
insurance brokerage unit lost money on about a quarter of its clients. One study found similar
CLV distributions for B2B and B2C firms — Figure 2.7.39
B2B Firm B2C Firm
1200 1600 FIGURE 2.7
1056 1435
1400 CUSTOMER LIFETIME
1000
1200 VALUE DISRIBUTIONS FOR
(in thousands of dollars)

800 1000 B2B AND B2C FIRMS BY

CUSTOMER DECILE
Mean CLV

800 739
600
600
400 400
339
200 205
134 86
200 15 9
0 (31) (105) (142)
54 32 25 15 11 9 3 5 -200
0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Customer Decile Customer Decile

We should not forget that unprofitable customers may be small or large. Unprofitable small cus-
tomers typically provide insufficient revenues to offset the costs to serve. By contrast, revenues
from large customers may be high, but they require expensive customization and/or service
support. They may also bargain down prices below sustainable levels.
The firm has two broad options for addressing currently low-profit or unprofitable customers Mar ke t ing
— invest for the future or reduce resource commitment: Quest ion
• Invest for the future. Two types of customer may have significant potential: small organiza- You learn from an internal
tions that may grow — think Google in 1995; and large organizations where the firm is report that 20 percent of
currently unsuccessful. Citicorp consistently targets a few large firms like these; each receives your firm’s customers provide
a structured two-year program for attempted conversion into a profitable customer. 80 percent of profits but that
• Reduce resource commitment. Essentially, the firm has two options: these customers’ retention
• New communications strategy. The firm may switch an on-the-road sales force to rate is slipping. Can you
telesales. In Scandinavia, Reebok made this change to address mom-and-pop shoe develop a list of potential
retailers. Regular contact became weekly (versus monthly); the tele-salesperson was actions to halt these
always available to answer questions; customer satisfaction improved; and Reebok cut defections?
costs. Internet and e-mail approaches also reduce costs, and combination Internet and
telesales that direct website visitors to a salesperson can be especially effective.
• Hand-off to third parties. In many industries, third parties like agents, brokers, contract
sales forces, distributors, and value-added resellers conduct the firm’s selling efforts.
They often have lower fixed costs such that unprofitable customers for the firm
become profitable for third parties. But,
• Customers that object to losing field salespeople may shift business to competitors.
• Over time the firm’s third-party organization may grow customer revenues. The
now-successful customer wants a direct relationship with the firm. Yet this switch
would cut out the third party and negatively affect its relationship with the firm.
• Fire customers. The firm stops selling to loss-making customers with little potential.40
Profitability may increase, but firing customers may generate negative word of mouth.
A critical firm challenge is to correctly identify the right customers. After all, today’s unprof-
itable customers could be tomorrow’s big winners. Also, unprofitable large customers may carry
significant overhead allocations; eliminating them lowers overall profits because the overhead
remains.41
 THE VALUE OF CUSTOMERS ! CHAPTER 2 45

Deciding how to deal with today’s unprofitable and least profitable customers is a tricky matter.
Creative approaches may increase current profits and/or generate profitable future customers.
The following boxed insert and Figure 2.8 show how changes in customer classification helped
a financial services firm to better isolate customer profitability and improve overall profits.42

A Financial Services Firm Classifies Customers by Profitability

Simpson Inc. (fictional financial services firm) traditionally classified customers by account balances and demographic
characteristics. Simpson developed four different customer groups: upscale — age over 45 years, balances more than
$60K; prime — age over 45 years; emergent — balances less than $60K, age under 45 years; and small business.
Simpson based its marketing efforts on these groups.
The incoming marketing director believed that this classification provided few insights into customer buying behavior.
Figure 2.8 shows that each group was profitable, but the director believed that some customers were unprofitable.
The director developed a totally new classification that also contained four groups: heavy hitters — long-term
customers with high balances and high activity; comfortables — long-term customers with high balances and low
activity; growers — newer customers with low activity; and movers — newer customers with high activity. Figure 2.8
shows a markedly different profitability pattern. In particular, movers were unprofitable.
Simpson implemented two key decisions. First, it raised prices for products purchased largely by movers. It reduced
the number of high-activity customers — the remaining movers were profitable. Second, it developed a targeting
scheme to acquire more heavy hitters.

Original Customer Classification New Customer Classification

FIGURE 2.8 Customer Profit Customer Profit
distribution distribution
CUSTOMER 100% distribution distribution 100%
CLASSIFICATION Upscale
Upscale Growers
Growers
Upscale
Upscale
BY A FINANCIAL 20%
20% 20%
20%
25%
25% Movers
Movers
SERVICES FIRM 40%
40%
Prime
Prime Prime
Prime Comfort
Comfortables
20%
20% 10%
10% -ables
25%
25%
KEY IDEA Emergen
Emergent Growers
Growers
t 25%
25% 15%
15%
Emergen
Emergent
" In general, customers t 35%
35% Comfort
Comfortables
-ables
20% Heavy
Heavy
are critical firm assets, 20%
Small
Small Hitters
Hitters
but some customers
Business
Business 55%
55%
may be liabilities and Small
Small Heavy
Heavy
Business
Business 40%
40%
Hitters
Hitters
should be fired.
25%
25% 25%
25%
" The firm may have to 0% 0%
reject some potential Movers
Movers
customers because 20%
20%

of predicted unprof-
itability.

CUSTOMER SUITABILITY
Best Buy (BB) implemented a strategy to avoid several types of undesirable customers. According to CEO Brad
Anderson, BB’s worst customers “can wreak enormous economic havoc.” These customers follow various strategies.
They buy products, apply for rebates, return purchases, and then buy back the products at returned-merchandise
discounts. They purchase large quantities of loss leaders and clearance items, then resell them on eBay. They also
secure the lowest price quotes from websites, then demand that Best Buy honor its lowest-price pledge.43
46 SECTION I ! MARKETING AND THE FIRM

Unprofitable customers do not deliver value. But the firm may cease doing business with a cur-
rent customer or forgo a potential customer for other reasons: Mar ke t ing
• Capacity constraints. The firm may have insufficient ability — expertise, financial re- Quest ion
sources, physical capacity — to serve all its customers. When the Sarbanes-Oxley Act Which companies do you
vastly increased compliance requirements for large public companies, some accounting believe affirmatively seek to
firms dropped many smaller clients.44 Failure to match firm resources to customer needs fire and/or reject customers?
can lead to dissatisfaction, monetary losses, and harmful word of mouth.45 EDS (now part Are they successful in
of HP) had great difficulty performing on an $8.8 billion computer modernization con- pursuing these activities?
tract with the U.S. Navy, resulting in significant losses. What firms inadvertently
• Competition. The customer is a current or potential competitor that could reverse engi- fire and/or reject good
neer the firm’s product, then launch its own. Hi-tech firms often refuse to sell to competi- customers?
tors; they also stop customers from passing on their products.
• Evolving strategy. If the firm shifts direction, drops products, or divests a business, it
sheds customers as a byproduct of strategic change.
• Foreclosing options. The customer prohibits the firm from serving other customers. A
P&G advertising agency is unlikely to work for Colgate or Unilever!46
KEY IDEA
• Impact on the firm’s reputation. A firm/customer relationship negatively affects the firm’s
brand image: Can you find Gucci in Kmart? Or the customer may use the firm’s product " Poor profitability is
inappropriately, leading to aggravation, negative word of mouth, and/or financial loss. not the only reason to
fire current customers
• Impact on the offer. In many service businesses, fellow customers are integral to the offer.
or reject potential
Bad behavior by some customers reduces the value for all customers and can negatively
customers.
affect employee morale. Rowdy sports fans negatively affect the ambiance in expensive
restaurants; college admissions departments screen out many applicants. Specific cus-
tomer profiles the firm should avoid include: cheats — like Best Buy faces (boxed insert);
thieves — like pickpockets and shoplifters who rob other customers or the firm; belliger- Mar ke t ing
ents — like diners who display insufficient patience in waiting for their meals and verbally Quest ion
abuse waiters; family feuders — a sub-category of belligerents who fight among them-
selves; vandals — who destroy equipment; and rule breakers — like unruly airline passen- What economic value
gers who pose a physical danger and affect the service experience for fellow customers. do you offer to your
Customers who behave badly also raise firm costs.47 educational institution?
How might the institution
• Instability. The customer may be profitable but too unstable. People-intensive service enhance this value?
businesses like advertising or PR agencies often add employees to serve new customers. If
those customers left, necessary staff reductions could be very difficult.
• Non-payer. This customer would be profitable if it paid, but it doesn’t! Or it eventually
pays, but the collection costs — money, human resources, aggravation — are too high.
• Potential costs. The future costs of doing business are too high. The customer may require
costly customization, or the firm believes future servicing costs will be prohibitive.

How to Bind Custome r s

Clos e r to the Fir m
CUSTOMER RELATIONSHIP MANAGEMENT
A customer relationship comprises the series of over-time interactions or touch points between
the customer and the firm. Customer relationship management (CRM) (relationship market-
ing) manages these touch points. More precisely, CRM is the ongoing process of identifying and
creating new value with individual customers and sharing these benefits over a lifetime of associa-
tion with them.48 CRM helps the firm know its customers better. In B2C, mom-and-pop stores
often form personal relationships with customers; CRM helps large firms build relationships in
 THE VALUE OF CUSTOMERS ! CHAPTER 2 47

a systematic way. Strong relationships should drive customer purchases over a long time period.
Tesco, the leading British supermarket, has a very successful CRM program:

Tesco has 2,700 stores in Britain (5,400 worldwide) — more than 30 percent market share of retail food sales and 13
percent market share of all retail sales. Tesco lives its catch phrase — “every little helps” — by removing irritants in
the shopping experience. Tesco tackled queues, improved product availability, introduced a Value product line, and
refurbished stores. A critical element in Tesco's success is Clubcard: Tesco collects data on customer purchases, then
makes highly segmented offers based on customer needs. Said Tesco CEO Sir Terry Leahy, “The customers get what
they want, not what some ‘bod’ in head office wants.”49

CRM’s underlying rationale is CLV — forming mutually beneficial relationships is crucial. CRM
systems are only really successful in firms with a true external orientation.50 Unfortunately,
many firms invest millions of dollars in CRM programs but do not realize the promised bene-
KEY IDEA fits. Three issues are crucial for success:
• Objectives. The firm must be clear about CRM system objectives. Without good direction,
" CRM helps the firm the firm cannot select from myriad initiatives, and costs can easily spiral out of control.51
form mutually bene- • Customer benefits. The CRM system must provide benefits and value to customers —
ficial relationships new products and services, attractive offers, high customer service levels — and to the
with customers. firm. Many firms focus on firm value, often by cutting costs, but give short shrift to
" Technology has an customer value. The CRM system must drive mutually beneficial relationships with
important role in CRM, customers.
but CRM is not about • Technology. Many people believe extensive databases and advanced information technol-
technology. ogy underpin CRM systems. Of course, technology, customer databases, and data-mining
often play important roles. But CRM is not about technology. To repeat, CRM is about
forming mutually beneficial relationships with customers.52

DEVELOPING A CRM SYSTEM

Customer databases for effective CRM systems must be accessible, accurate, complete, consis-
tent, current, relevant, secure, and structured. According to one expert, “To implement CRM, a
firm must have an integrated database available at every customer touch point and analyze that
data well. ... [CRM] allows companies to automate the way they interact with their customers
and to communicate with relevant, timely messages.”53 A large firm’s database contains longitu-
dinal (overtime) data, including responses to promotional campaigns, on millions of customers
— even prospective customers. Royal Bank of Canada maintains data on rejected loan appli-
cants, periodically reviews credit status, and offers credit when improvement is significant.
Adding state-of-the-art data-mining technology in the context of a test-and-learn culture
secures and manipulates these data to yield marketing insight. Capital One’s expertise has
shaken up the credit card industry, and Harrah’s (casinos and hotels) has achieved marked suc-
cess. Communications with customers are more personal, and the firm can mass-customize its
offers. Direct marketer Fingerhut maintains 100 pages of data per customer, mostly about
buying habits.54 Customer data is equally important for firms with few customers, like your local
dry cleaner or garage — paper and pencil may be adequate technology.
The firm must identify each customer. In some service industries, customer databases are fun-
damental to formal relationships, like bank accounts, insurance policies, and telephone service.
But these firms often collect and store data by account or policy number, rather than by cus-
tomer. Hence, the best customers — those who buy multiple services — escape firm attention.
Many firms neither collect a full set of customer data nor use it for building long-term relation-
ships. At other firms, marketing data resides in the transactional sales/invoice system, not in a
48 SECTION I ! MARKETING AND THE FIRM

longitudinal and relationship-based form. Many retailers do not know who buys their products
— hence, the introduction of customer value cards:

Smitty’s Super Value (SSV) is a Phoenix-based regional hypermarket chain. SSV offers a full range of grocery, clothing,
electrical, and household goods in a very competitive market. Smitty’s Shoppers Passport is a magnetic card swiped at
checkout. On average, 60 percent of SSV’s 750,000 cardholders use their cards every six weeks, earning points they
can redeem from SSV’s gift catalog. SSV uses Shoppers Passport data to selectively mail customers coupons, maga-
zines, and other information. Families with children under 13 receive coupons for toys, videos, clothes, and cakes
three weeks before the child’s birthday. Customers whose purchases change or decline receive special mailings. The
Shoppers Passport is fully integrated into the business; startup costs were 20 percent of sales, but maintenance costs
are less than 1 percent of sales. Results are spectacular. Cardholders account for 70 percent of sales — purchases
are 50 percent higher than for non-cardholders.55

For suppliers, identifying customers that purchase from intermediaries like distributors or
retailers can be difficult. Indirect methods include customer-get-customer campaigns, customer
value cards, factory warranties, loyalty cards, mail inserts, special events, syndicated question-
naires, telephone help lines, third-party lifestyle databases, and websites — supplemented by
data from marketing information firms. Many firms spend highly to develop customer data-
bases. Table 2.10 identifies the sorts of data required56:
• Customer characteristics. Demographic data independent of the firm: B2C — name,
gender, age, family size (birth dates), address; B2B — sales revenues, number of employ-
ees, age of organization, industry, decision-makers, influencers.
• Customer responses to firm decisions. Purchases following sales promotions, direct mar-
keting offers, price changes — also perceptions and preferences (from research).
• Customer contact history. B2C — phone calls for product information, customer service
requests; B2B — deliveries, sales calls, technical service.
• Customer purchase history. What was purchased — by SKU; when; by what method —
cash or credit; through what intermediary (if any); what price and/or discounts; how and
when delivered. Data should include firm profit margins per purchase.
• Customer value to the firm. Data for assessing CLV, like purchase history.

Customer Customer Customer Customer

TABLE 2.10
Customer Customer Responses to Contact Purchase Value to
Identifier Characteristics Firm Decisions History History the Firm THE CUSTOMER
DATABASE
Jane Doe
John Smith
Name
Name
Name
XYZ Inc. Mar ke t ing
DEF Inc. Quest ion
Company CVS/Caremart (CC) is the
U.S.’s largest single buyer
Company
and dispenser of prescription
Company drugs. What actions could
CC take to help reduce
The database should be sufficiently flexible to follow individuals and track life changes. In B2C, national healthcare costs?
consumers move houses and cities, and change jobs, marital status, names, and family size;
needs also change.57 In B2B, employees change jobs within firms, change firms, and have chang-
 THE VALUE OF CUSTOMERS ! CHAPTER 2 49

ing business and individual needs. Every customer response, contact, and purchase deserves an
entry. But the firm should not limit itself to data on its own customer relationships; it should
also seek data on its customers’ relationships with its competitors. An equipment provider
should know the age and equipment types installed at the customer by all providers. A financial
services firm should collect data on its customers’ relationships with other suppliers. These data
may be available direct from customers or from third-party data providers.

FinSer Inc. (FI) (disguised name) became market leader in cross-selling. FI developed new lead-identification guidelines
for service reps (SR); SRs entered leads into a lead-tracking system that routed them to the appropriate sales reps.
Cell Inc.'s (CI) (disguised name) website received five million unique visitors monthly; 10,000 purchased cell phones,
but 27,000 started a purchase process, then quit. By collecting and passing these data to sales teams, CI secured
8,000 additional subscribers per month. CI also followed up on the 20 percent of visitors who left contact information;
CI added an additional 35,000 new subscribers monthly.

CONTROL OF, AND ACCESS TO, THE CUSTOMER DATABASE

Control of, and access to, the customer database are critical issues. Consider a firm with several
businesses — each product group or business may have its own customer database. When there
KEY IDEA is little customer overlap across product groups/businesses, independent databases work fine.
But when customer overlap is considerable, a corporate-level database that integrates all cus-
" Superior customer tomer information makes more sense. Regardless, individual businesses may not be pleased.
databases are acces- They may fear competition from sister businesses and/or be concerned how other businesses
sible, accurate, com- may use their valuable data: Internecine territorial disputes often impede cross-selling initia-
plete, consistent, tives. Top managers must strongly support the corporate-level database; they must also gain
current, relevant, agreement on use — for sales, customer service, or collections; on control; and on access at the
secure, and structured. appropriately aggregated level.58 If building a corporate-level database is infeasible, the firm
should at least implement processes that cross organizational boundaries.
" The customer database
should distinguish A well-developed customer database is valuable to the firm and others. Many firms earn signifi-
among customers on cant revenues by selling customer data to non-competitors. But privacy is a serious concern:
behavioral measures jetBlue, Northwest, and American Airlines provided passenger records to firms with U.S. gov-
and value to the firm. ernment contracts, causing an outcry of negative publicity. Personal data theft is also an issue:
" Customer databases Sony's PlayStation network suffered an “unauthorized and illegal intrusion,” potentially affect-
are more valuable ing millions of customers.
when they also contain The firm must carefully think through its privacy policy. Some firms like Amazon and UPS
data about relation- absolutely refuse to sell customer data. Said an Amazon spokesperson, “We don’t want to create
ships with competitors. an enormous database that becomes a public relations risk or something that offends our cus-
tomers. We believe that we have done well because of the trust customers have for Amazon and
their belief that our privacy policies are taken very seriously. It’s partly a moral point of view,
but it’s also a sensible business decision.”59

19th-Century National Politics

Foreign Affairs Minister, Austro-Hungarian Empire — Klemens Furst Von Metternich: “I don’t care who the King is as
long as I control the purse strings.”

21st-Century IBM Politics

Senior IBM Executive: “I don’t care who the CEO is, as long as I control the customer databases.”
50 SECTION I ! MARKETING AND THE FIRM

ASSESSING THE VALUE OF CUSTOMERS AND DESIGNING

FIRM ACTIONS
The firm implementing CRM well acts with significantly greater focus. The firm estimates
profitability and CLV by customer, anticipates key customer events, and initiates action. A B2C
firm may send consumers vacation ideas; a B2B firm may alert customers that ordering seasonal
stock can add value. The more comprehensive the customer database, and the more creative the
firm, the more valuable will be its initiatives. The firm can offer new products and services and
give greater customer service to its more valuable and loyal customers. In making offers, the
firm must be concerned about the communications tipping point — the level after which com-
munications create customer resentment. Amazon spends significant effort to identify its tip-
ping point. Figure 2.9 suggests firm objectives and actions, based on customer value and loyalty.

Objective: Switch customers Objective: Customer retention FIGURE 2.9

from competitors to high-value/
high-loyalty group Action: Targeted customer CUSTOMER VALUE
loyalty/reward programs AND LOYALTY
High Action: Sampling and targeted
sales promotion to gain trial,
then loyalty/reward programs

Customer Value
Objective: No special objective Objective: Increase
purchases
Action: No special effort
Action: Cross-sell other
Low products

Low High
Customer Loyalty
High-value, high-loyalty customers are very important, yet some firms offer better service to
low-value customers. Express checkout lanes in supermarkets often reward customers who
make few purchases. The Fairway supermarket on New York’s Upper West Side strives to cut
waiting time for all customers.

EVENT-DRIVEN MARKETING 60
Firms experienced in CRM identify events in their customers’ lives that provide communication
opportunities to enhance the relationship and/or make sales. A simple threefold classification
comprises triggers, scheduled events, and significant events.61
• Triggers. Do not require a customer decision but are often valuable for activating
straightforward business processes, like credit card expiry (send a new card) or reaching
a pre-determined inventory level (reorder).
• Scheduled events. Provide the firm communication opportunities, like the end of a con-
tract (offer/negotiate new contract), birthdays and anniversaries (congratulatory commu-
nications), and graduation. They provide sales opportunities for some firms — Hallmark
develops/maintains birthday/anniversary data for offering customers greeting cards and
e-cards.
• Significant events. Represent significant changes in customer life stage, like marriage,
divorce, first child, first job, first apartment, and relocation. Customers are often respon-
sive to receiving communications when these events occur but firms have difficulty iden-
tifying them.
 THE VALUE OF CUSTOMERS ! CHAPTER 2 51

Austra Bank (disguised name) uses high-powered CRM systems to identify indicators of signifi-
cant events. Twice daily, Austra examines its five-million-consumer database against a set of
predefined criteria like exceptionally large deposits, salary cessation, and criteria combinations.
A four-person call center makes telephone calls to identified customers. Austra claims that over
50 percent of calls lead to sales and that all customers value the personal contact.62 For Bunca
Bank (disguised name), many middle-market firms are potential customers, but they are reluc-
tant to switch banks because of administrative hassle. Bunca identified three events that increase
the probability of a firm switching banks: The current bank merges and the firm anticipates
painful bank integration; the firm has rapid growth and requires new and better services; and a
new leadership team wants to make its mark.63

Centura Banks (Raleigh, NC) rates two million customers on a 1-to-5 profitability scale. High-value customers receive
several service calls annually, plus a happy holidays call from the CEO. In four years, customer attrition dropped 50
percent. Less-valued customers receive less service — unprofitable customers dropped from 27 to 21 percent.

CUSTOMER LOYALTY PROGRAMS

Loyalty is a customer’s sustained commitment to the firm demonstrated by repeat purchase and
positive word of mouth. Loyalty programs, designed to retain customers and improve loyalty,
are a central part of many CRM systems. All loyalty programs have a similar structure: Customers
earn rewards by purchasing goods and services (examples below). Some programs
are simple, like JCPenney’s baker’s dozen: Buy 12 panties, get the 13 th free. Other programs, like air-
line frequent flier and hotel and credit card loyalty, involve complex, multi-tiered incentives;64
higher tiers earn greater rewards, but customer demotion to lower tiers may jeopardize loyalty.65
Complex programs use currencies such as points that customers exchange for various rewards.
Some programs, like AmEx’s Membership Rewards, are well designed; others fail — like an AT&T
points program for consumer long distance — or are too generous.66 Program designers must
consider value both for the customer and the firm to establish successful programs.67

Examples of Loyalty Programs

King Soopers — Consumers automatically earn members-only discounts when they pay with the 1-2-3 Rewards Visa
card. They also earn points towards free groceries.
Recyclebank — Members act green, like pledging to recycle beverage containers and sell or recycle used electronic
products. They receive free offers, and earn points to apply to grocery and entertainment purchases and discounts at
various retailers.
Saks Fifth Avenue’s — SaksFirst. Members earn points for each $1 charged on Saks Fifth Avenue MasterCard at
Saks stores, Folio catalog, and www.saksfifthavenue.com. They earn double points for dining and essentials like
groceries and gasoline, and triple points for purchases at salons and spas.
Tesco — Club Card Loyalty Program. All Internet customers and 90 percent of store customers belong. Tesco uses
13 market segments to tailor store inventory and creates up to eight million coupon variations for Club Card mailings.
United Airlines — MileagePlus Program. Members earn award miles by flying on United and companion airlines,
and by purchasing products and services from partners worldwide. Members use award miles for travel, hotel and car
rental, plus a wide variety of everyday purchases and activities.
52 SECTION I ! MARKETING AND THE FIRM

VALUE OF REWARDS PROGRAMS TO CUSTOMERS

Designing a customer-loyalty program can be complicated. Design considerations include:
• Rate of earning? Should the reward design be equal or accelerated earning? For a vacation
package reward, should the customer earn the same points for each dollar spent? Or
should she earn more points per dollar the closer she is to the goal?
• Aspirational value of the reward. Two rewards can have the same cash value but different
psychological value — like groceries versus vacation travel. Consumers engage in mental
accounting by placing funds and resources in different mental accounts — Chapter 4. Mar ke t ing
AmEx Membership Rewards program offers airline travel, cruises, hotel stays, and many Quest ion
luxury products. Go to www.colloquy.com to
• Cash value of the reward. The reward should offer real economic value. Some programs, learn more about loyalty pro-
like the Discover card, pay cash; airline frequent flier programs provide free travel. grams. You have to register,
• Deterministic or probabilistic rewards. Many reward programs are deterministic — the but it’s free. Which loyalty
customer accumulates points, then collects the reward. In probabilistic programs, the programs are especially good
customer wins a large reward, or nothing. Internet portal iWon used sweepstakes entries. deals for customers? Why?
McDonald’s monopoly game had both reward types. Customers won sweepstakes prizes
but could also exchange Collect & Win Game Stamps for certain rewards.
• Ease of collecting the reward. The customer must be able to redeem the reward. Airlines
face criticism for blocking rewards on some routes. On other routes they offer so few reward Mar ke t ing
seats that large families cannot travel together.
Quest ion
• Length of time to earn the reward. Many consumers engage in hyperbolic discounting —
Many students have low
Chapter 4. The design question for reward programs is: Should the program have smaller
incomes. But your educa-
rewards earned frequently or larger, delayed rewards? Many airlines and AmEx Member-
tional investment may lead
ship Rewards program alleviate the problem by providing data on progress to the reward
to high future income. Which
goal. The firm can also use reminders, or periodically provide small rewards to keep cus-
firms understand that and
tomers engaged.
actively seek your business
• Rewards based on the firm’s product and services, or a broad variety. Some programs with an eye to your future?
reward customers with their own products and services. Buy X, get one free programs are How do they do so? Which
ubiquitous — BestBuy and Subway. Many small firms use these programs, often by firms seem oblivious?
punching out a card with each purchase. The alternative is to partner and offer many dif-
ferent rewards, like AmEx Membership Rewards program.
• Soft versus hard rewards. Hard rewards are denominated in dollars and cents or trans-
latable points. Soft rewards include toll-free information numbers, restaurant seating,
theater ticket availability, and hotel room and airline seat upgrades.
• Type of reward. Should the reward be cash or products and services? The Discover program
now includes frequent flier miles and goods and services. Should entry into the reward
program be free? A fee may discourage entry, but encourage commitment.

VALUE OF THE REWARDS PROGRAM TO THE FIRM

A well-designed loyalty program decreases customer defection, increases customer retention,
and enhances share of wallet. Specific benefits for the firm include:
• Creates barriers for competitors.
• Gains insight into customer behavior.
• Lowers costs to serve loyal customers.
• Makes loyal customers less price sensitive.
• Encourages loyal customers to spend more.
• Stimulates loyal customers to spread positive word of mouth.
• Increases sales via purchase acceleration as customers approach the goal.68
 THE VALUE OF CUSTOMERS ! CHAPTER 2 53

KEY IDEA The firm should assess loyalty programs via hard-nosed financial analysis, but this can be diffi-
cult. First, assessing potential revenues is not simple. Second, some costs — like launching, cre-
ating, and maintaining the database; issuing status reports on earned rewards; and the cost of
" The firm should exam- rewards — are highly visible. But managerial opportunity costs versus other activities are less
ine its privacy policy for easy to identify. Further, the firm should consider both purchase quantity and loyalty: A totally
the impact on customer loyal customer who buys infrequently may not be very valuable. The firm should evaluate loy-
relationships. alty programs against alternative spending like increased advertising, better customer service,
" Customer loyalty and/or lower prices. Loyalty programs have value, but are just one of many revenue-generating
programs have many tools at the firm’s disposal.69
design parameters.

Mar ke t ing KEY MESSAGES

Quest ion • Customer lifetime value (CLV) is the critical link between delivering value to customers and
What other messages did creating value for the firm and its shareholders.
you glean from this chapter? • The firm improves CLV by increasing profit margin (m) and customer retention rate (r), and
decreasing discount rate (d).
• Increasing customer retention rate (r) has greater leverage on CLV than decreasing discount
rate (d).
• The firm has three broad options for addressing current customers — retain, grow, and
delete.
• The firm has three broad options for addressing potential customers — retrieve, acquire,
and ignore.
• The firm should strive to understand the reasons for customer retention and defection and
act accordingly.
• Some of the firm’s current customers are probably unprofitable — but a fraction of these
may present future opportunities.
• The firm may forgo a customer relationship for reasons other than poor profitability.
• A well-designed customer relationship management (CRM) system deepen the firm’s
knowledge about its customers.
• Understanding customer value to the firm and customer loyalty allows the firm to design
effective loyalty programs.
v202

VIDEOS AND AUDIOS

Loyalty Programs v202 Ran Kivetz Columbia Business School
54 SECTION I ! MARKETING AND THE FIRM

QUESTIONS FOR STUDY AND DISCUSSION

Can you answer the questions implied by this chapter’s learning objectives? Check!
1. A cable company spends on average $600 to acquire a customer. Annual maintenance costs
per customer — $45; record-keeping and billing costs — $30 per customer per annum. Price
of a basic service package — $30 per month. Typically, 40 percent of customers buy a premium
package — $50 per month; 10 percent buy the super-premium package — $80 per month.
Over time, 80 percent of customers remain with the company from one year to the next.
• What is the average CLV for all customers?
• What is the CLV of a super-premium customer?
2. Chapter 11 introduces brand equity. What is the relationship between CLV and brand equity?
3. Which firms do a good job of retaining and growing current customers, while simultaneously
acquiring new customers? What has made these firms successful?
4. Sonik CD (disguised name) was a wholesale buying club for classical, jazz, and blues enthusi-
asts — annual membership fee $40. Sonik scoured distributors and independent retailers for
hard-to-get and out-of-print releases. Sonik’s price of $10.95 per CD was lower than average
retail price; average Sonik cost — $10.50 per CD. Shipping and handling price — $4.00 per
package; average cost — $0.50. Subscribers purchased 19.9 CDs annually, mostly at Sonik’s
website; annual retention rate — 90 percent. Sonik fulfilled all orders — annual fixed cost,
$400,000; shipments averaged 3.7 CDs per package. Annual marketing expenses — $230,000;
90 percent for new subscribers, 5 percent for retention. Sonik’s cost of capital was 12 percent.
Three growth options were:
a. Continue niche strategy: Sonik anticipated acquiring 20,000–30,000 new customers
annually for several years without major new investment. Spending $0.5 million annually
would increase customer retention to 95 percent.
b. Mass-market strategy: Abandon the subscription model; add many music genres; build a
mass-market brand. An initial $1 million to $2 million investment would build brand aware-
ness; distribution and warehousing would require $0.5 million annually. Sonik estimated
adding 40,000–50,000 new subscribers per quarter for $12.50 acquisition cost; annual profit
margin — $15; retention rate — 60 percent.
c. Distribution strategy: Sonik also distributed products for other online retailers. AmeriNet
Radio (ANR) operated 43 radio stations (southeast U.S., 25 million listeners); ANR sold CDs
through station websites. ANR asked Sonik for an exclusive arrangement: Sonik would
close retail operations; it would become sole distributor for all ANR CD sales, charging its
normal handling fee. Sonik’s CD price — $13.25; Sonik would pay ANR $1.50 per CD.
Research suggested: 5 percent ANR listeners bought CDs online; 10 percent would buy from
Sonik; a typical customer would buy twice a year, averaging two CDs per order. Sonik’s
additional fixed costs — $0.5 million annually.
Which option should Sonik choose?70
5. Develop a loyalty program for your favorite restaurant. Justify the variables — used/omitted.
6. Select a firm and one of its products. Alternatively, consider this book — Managing Marketing
in the 21st Century. Who are the customers? Use the Figure 2.6 framework to suggest how you
would address customers. Then, design a CRM program.