Diversifying Your Customer Portfolio

With increased competition and globally maturing markets, relationship marketing has emerged as the new mantra. Although companies are successfully using customer satisfaction to create closer and more profitable relationships with customers, the myopic pursuit of such relationships often backfires. Consider a U.S.-based catalog retailer that recently embarked on a campaign to build closer relationships with its loyal and most profitable customers, only to find that it was not bringing enough new customers into its portfolio to grow the business over time. Similarly, a European financial services company recently shifted its focus to serving larger retail-banking accounts, but after losing a large share of its smaller accounts in the process, economies of scale and productivity suffered.

A new view of relationship marketing is emerging. Customer portfolio management is a process of creating value across a company’s customer relationships — from arm’s-length transactions to strategic partnerships — with an emphasis on balancing closer customer relationships with weaker ones (Johnson and Selnes, 2004). In an economy where only so many customers will ever be truly loyal, churn customers lower a company’s unit costs and provide a basis for future cash flow. How the various perspectives on relationship marketing have evolved into customer portfolio management reveals some early lessons gained from this view and illustrate how companies are implementing this new marketing philosophy.

The Evolution of Relationship Marketing

The exchange relationship between a customer (or buyer) and a supplier (or seller) is central to any marketing effort. As a mechanism for creating value, exchange relationships vary from simple transactions, such as a stop at a convenience store, to highly collaborative and coordinated partnerships, such as the integrated supply-chain relationship between Procter & Gamble Co. and Wal-Mart Stores Inc. Four distinct perspectives among marketing scholars — economic, sociological, psychological and operational — provide context for understanding when different types of customer or supplier relationships make sense.

Economists have long emphasized the need to form relationships beyond simple transactions when short-term contracts are unsatisfactory, as in ongoing services or in labor relations. In relationship marketing, the economic perspective focuses on whether or not the costs saved and/or revenues generated through one type of relationship or another justify the costs or investment over time. This has proved essential in the study of business-to-business relationships. Ghosh and John (1999) argue that the decision to invest in a relationship depends on four general factors: The costs and risks of exchange (such as P&G’s decision to open a dedicated office near Wal-Mart’s Bentonville, Arkansas, headquarters), the forms of governance or the rules of exchange (such as the contracts or power relationships between buyer and seller), the value proposition or positioning (product, service and price) and the resources, skills or assets that are unique to customer or supplier. For example, Heide (2003) shows how plural governance (or a combination of transactional and more cooperative relationships with suppliers) helps customers to manage differences in power and resources across suppliers. Importantly, the economic perspective has proved essential toward understanding why customers keep some suppliers at arm’s length.

The sociological perspective emphasizes the networks and interdependencies that relationships create over time (Håkansson and Snehota, 1995). Close relationships entail an interdependence that has both positive and negative consequences for customers and suppliers alike. What differentiates the sociological perspective from the economic is that exchange relationships are the culmination of activities and events that create a mutual commitment to maintaining the relationship; in fact, relationship decisions become more than just cost-benefit calculations and contracts. Close relationships take time to develop and often endure past the point of economic sense. A customer’s commitment toward maintaining a relationship with a company involves a set of linked activities, resource ties and personal relationships that prevents the customer from benefiting from the resources or value propositions of other companies.

Central to the sociological perspective is the development of trust and commitment as relationships evolve (Dwyer et al., 1987). In business-to-business relationships, each party adapts over time to the needs and requirements of the other party in order to create higher levels of mutual dependence as well as to signal their commitment. In Morgan and Hunt’s commitment-trust theory (1994), profitable customer relationships require a level of product or service performance that creates trust and commitment. Still, relationship investments require a careful consideration of the relative power balance between customer and supplier. In a field study of industrial customer-supplier relationships, Narayandas and Rangan (2004) demonstrate that weaker firms are more dependent on interpersonal trust and interorganizational commitment to their customers in order to survive. See sidebar

The psychological perspective seeks to understand how customers’ perceptions of quality, perceived value and satisfaction affect exchange relationships or customer loyalty. This research links customer perceptions of perceived value and satisfaction to customer behavior, including product usage (Bolton and Lemon, 1999) and repurchase (Mittal and Kamakura, 2001). An unfortunate byproduct of this research has been the popularity of a singular pursuit of customer loyalty, which often doesn’t take into account that not all customer loyalty is equally profitable. Edvardsson et al. (2000) find that loyalty per se is more profitable for service companies than sellers of physical goods. Whereas loyalty must be earned through perceived value and satisfaction for services, loyalty for goods is often bought through the use of coupons, rebates or other price incentives. As goods can be inventoried and sold later, there are incentives to build those inventories and move them using price mechanisms, which reduces or eliminates profits. In contrast, the seat-miles on an airplane or the room-days in a hotel cannot be stored and moved later at a lower price. Another reason why loyal customers are not necessarily profitable is that they may become acutely aware of their value to a supplier and may then exploit this power to obtain better service or discounts (Reinartz and Kumar, 2003).

Enabled by the development of sophisticated customer information systems, the operational perspective leverages customer relationship marketing systems and database marketing efforts to quantify, or operationalize, the customer lifetime value of particular customers. Using a CLV framework, for example, Anderson and Narus (2003) use a fine-grained knowledge of a customer’s needs and activities to selectively pursue a greater share of the customer’s business, while Thomas et al. (2004) explore pricing strategies for reacquiring lost customers. Reinartz and Kumar (2003) relate CLV to particular customer relationship variables that managers control. Gupta et al. (2004) have even used CLV and discounted future earnings to value companies themselves. The important contribution from this line of research is a better understanding of how to develop marketing tools that optimize resource allocation across a set of heterogeneous customer relationships.

Customer Portfolio Management

Each of these perspectives underscores the potential for creating value through relationship marketing but also recognizes that this should not imply a myopic pursuit of closer customer relationships by any means. From an economic perspective, customers themselves may not allow closer relationships in order to leverage their power and obtain better prices from suppliers. From a sociological perspective, opportunities are lost because relationships create commitment. From a psychological perspective, more profitable relationships should be earned through customer satisfaction and not bought through price mechanisms. And from an operational perspective, pursuing all of a customer’s business simply doesn’t make sense.

Customer portfolio management, which brings these perspectives together, seeks to understand how an organization can manage an entire portfolio of customer relationships — from arm’s-length transactions to strategic partnerships — in order to create value and develop a competitive advantage (Johnson and Selnes, 2004). Customer portfolio management recognizes that building closer relationships with customers is not a panacea and that customer demands should not be blindly obeyed. Rather, customers are a combination of very different assets that should be managed according to their differences.

Customer portfolio management emphasizes the management of an entire portfolio of relationships, rather than individual customers or customer accounts. When analyzing the forest rather than the trees, weaker customer relationships, judged unprofitable on a CLV basis, may, over time, actually create value as part of a broader portfolio. Consider that the impact of a lost customer on long-term profitability depends on both how and when the customer departs (Hogan et al., 2003). A churn customer who departs to a competitor is a likely source of future revenues, whereas one who departs to a new technology is not. Dhar and Glazer (2003) describe the trade-offs between customers who generate considerable revenue and profit in the short run and those who offer a smaller yet steadier cash flow. From a customer portfolio perspective, attracting both types of customers hedges a company’s portfolio and associated risks.

Focusing specifically on the value of close versus weak relationships in a customer portfolio, a model of customer portfolio lifetime value was recently developed. The CPLV model distinguishes acquaintances (weak relationships) from friends (intermediate relationships) and from partners (close relationships). Through a series of simulations, the CPLV model reveals several important insights (Johnson and Selnes, 2004). A key to long-term growth and profitability is having a “large leaky bucket,” or base of weaker customer relationships. These weaker relationships (or churn customers) serve two important purposes: They provide a base from which more profitable, stronger relationships are built and they provide economies of scale or capacity utilization. Another insight is gained from how unexpected costs, as from technology upgrades or changes in exchange rates, affect the value of different relationships. Because the margins on weaker relationships are small, cost shocks can turn a profitable customer portfolio into an unprofitable one very quickly. The profits from stronger customer relationships, where margins tend to be higher, are more insulated from these cost shocks. In a business environment where economies of scale are high yet cost shocks are common, investing in intermediate relationships (friends) hedges the risks associated with these trade-offs.

Balancing Stronger and Weaker Relationships

Companies are discovering ways to create value with the weaker customer relationships in their portfolios. The U.S. domestic airline industry is losing billions of dollars, with legacy carriers bearing the brunt of the losses. In an economy where an airline seat has become a relative commodity, these fundamental industry changes have forced the legacy carriers to revisit their portfolio strategy of relying upon loyal customers for profits. Companies like Continental Airlines Inc. and Northwest Airlines Corp. have developed self-service technologies that are keeping costs low for churn customersand providing better services for loyal customers (such as automatic upgrades).

In some cases, self-service technology is designed to keep customers at arm’s length as the customer portfolio grows. IKEA International A/S, the Sweden-based furniture and housewares retailer, engages its customers directly in the product search, selection, delivery and assembly process, offering minimal services and keeping its costs and prices astonishingly low. However, as its popularity has grown, increasing numbers of customers are entering the IKEA portfolio, and some need more service than others. To accommodate them without raising costs, IKEA has developed an automated customer service representative named Anna, which retrieves relevant information from the IKEA Web site and responds to questions about specific items or company policies. Anna helps IKEA to manage an increasingly heterogeneous portfolio of customers in a cost-effective fashion that is consistent with its strategy.

In a business-to-business context, innovative competitors are developing strategies and processes for creating value with all of the customers in their portfolio. Norway-based Pan Fish ASA, a global player in the farmed salmon industry, manages the uncertainties of supply and demand by cultivating a portfolio of very different customer relationships, including those who choose fish by its size, those who prefer fresh or frozen salmon and those who will buy whatever salmon remains at the right price.

At the moment we are witness to a very interesting and important evolution in marketing thinking — away from the “Customer is king” to the “Customer is cash.” The overall objective of marketing is moving to maximize return on capital through investments in the right types of customer relationships, ones that a company can serve more effectively than its competitors.