A Strategic Approach to CRM: The Customer Portfolio

Often, the promise of CRM has not been delivered due to ‘nonstrategic’ initiatives. But it is in the context of smart markets that CRM should be viewed.

'Smart' CRM Strategies

With the strategic objectives in place, how does the organization use its CIF asset to craft a set of actual strategies? Observations of leading best-practice firms have identified a series of generic smart or information-intensive strategies:

  • Mass customization, or personalization, takes advantage of developments in flexible manufacturing and/or operations that enable firms to tailor or customize individual offerings at little additional marginal cost.
  • Yield management, or revenue management, builds on flexible or discriminatory pricing to take advantage of customers' heterogeneous price sensitivity with respect to time (as well as the technical and legal ability to price discriminate) in order to maximize the total return to a fixed asset — particularly where the marginal cost of providing an additional unit is low and the product/service in question is not inventoried.
  • Capture the customer, also known as customer intimacy, affinity marketing, or relationship management, the capture-the-customer strategy is, as its ultimate objective, to realize as high a share as possible of a customer's total (lifetime) purchases in a given (often expanding) set of product categories. Stated another way, its objective is to increase the value of the customer to the enterprise by increasing the value of the enterprise to the customer. The capture-the-customer approach relies heavily on interactive communications and capitalizes on the firm's ability to use the information collected and processed from previous encounters with a customer to influence subsequent encounters and transactions.
  • Event-oriented prospecting, a particular and increasingly important version of the more general capture-the-customer strategy, is the event-oriented prospecting (EOP) approach. EOP is based around a firm's ability to store and process lifecycle-related and other situational information about its customers that might trigger a purchase incident. The goal is to anticipate the customer's lifecycle or other situational needs and to time the interaction in such a way that the firm appears with a solution just when the problem arises — creating the appearance of literally reading the customer's mind.

New Performance Measures for CRM

To maximize the returns to the CIF means that concepts such as profitability or market share per product are replaced with concepts such as profitability per customer. This is increasingly referred to as LTV (the total profits generated over a given customer's life) and the associated concept of customer share.

In a formula, LTV = m(1+d)/(1-d-r)-AC, where m is the margin per customer, d is the discount rate, r is the retention rate, and AC is the initial customer acquisition cost. The challenge for most firms, of course, is to estimate LTV and its components (particularly r and d). In practice, concepts such as recency (of purchase), frequency (of purchase), and average monetary value are used, and these become the basis for computing the LTV metric.

The Future of CRM: The Customer Portfolio

While many firms have made major progress using RFM (recency, frequency, monetary) approaches to estimate LTV, the fundamental problems with the methodology are: (a) that it uses historical purchase behavior — which has been a function of the actions the firm has made to date — as a guide to the future and can thus underestimate the potential changes in purchase behavior that might result from changes in firm actions; and (b) it treats each customer as independent of every other customer. Consequently, the decision as to how to treat that customer — in particular, what level of resources should be devoted to customer retention — is made in isolation and without respect to retention decisions about other customers. The notion of customer retention is becoming the key goal of most organizations; similarly, the notion of customer equity is becoming the new measure of organizational performance.

In this sense, the traditional LTV metric is inefficient and misses the mark. Firms should actually manage a portfolio of customers — i.e., customers should be treated not in isolation but as part of a portfolio, and the value of any one customer should be influenced by that customer's relationship with other customers in the portfolio (hence the decision whether or not to retain that customer).

The notion of a customer as an asset is rooted in the appreciation that a customer can be seen as a stream of revenues and/or profits (e.g., cash flows) through time — i.e., a set of returns. Each customer displays a pattern of such returns, with respect to both the magnitude of the return in each period (captured in the aggregate by the mean return over all periods) and the variance of returns across periods. The concept of a customer as part of a portfolio suggests that the particular mean/variance pattern displayed by any one customer will differ from that displayed by any other customer and that the “value” of that particular customer to the firm will depend on the interdependence with or correlation of the customer’s pattern of returns with the patterns of returns of other customers.

In keeping with the insights of modern financial portfolio theory regarding the value of diversification with respect to the patterns of returns from various assets, the core idea is that the firm may maximize the return to the overall portfolio of its customers if the customer retention decision is approached from a diversification perspective. This is because a customer's LTV is not deterministic (in which case it would make sense, as is now done, to retain only those customers with the highest LTV), but is in fact a "risky" asset — i.e., one characterized by a mean and variance through time. If so, determining which customers to retain should depend on which other customers are retained, where diversification is with respect to the correlation among the patterns of returns across the entire set. The notion leads to an expanded view of LTV — what may be called "risk-adjusted LTV." The objective is for the firm to achieve a higher expected return through diversification.

From a managerial decision-making perspective, the key variable is to determine what is the appropriate measure of risk. The philosophy behind diversification is that, given a portfolio of customers, the appropriate measure of the risk of the customer information file is the contribution of any given customer to the risk of the entire portfolio. This is best measured by the covariance of that particular customer with other customers in the portfolio. The notion is that the benefits of customer diversification come from managing a portfolio of customers in such a way that the combination of individual customers is almost always less risky than that any of the individual customers. (This is possible because customers have variable spending patterns that are not perfectly correlated to each other.)

Customer Beta and the Efficient Customer Portfolio

The fundamental question of interest then becomes: What is the impact of an individual variance in cash flow on the risk of a portfolio? As is the case with portfolio analysis regarding traditional financial assets, a customer beta should be identified — a measure of a given customer's riskiness that is designed to capture the sensitivity or responsiveness of an individual customer's return to that of the overall portfolio or market of customers. This becomes the criterion for whether or not to include any given customer in the portfolio and, depending on the firm's particular capacity to take on risk, the basis for customer investment decisions. For example, choosing which customers to retain, which to divest, and which to acquire — to the extent that the profiles of potential acquisitions are similar to those of existing customers.

Given a desired level of risk, the CM's next task is to construct what is called the "efficient set" of customers. In other words, given the mean and variance of cash flows associated with each customer, the user of a CIF can choose the best combination or portfolio of customers to hold, where the expected return from a portfolio of customers is a weighted average of returns from each customer.

A strategic approach to managing a firm's customer base as an asset (and the framework for an integrated strategic approach to CRM) should be determined by considering which customers to acquire or divest, and what proportion of each segment of customers (based on measures of risk) to target so as to have an efficient portfolio.