A Strategic Approach to CRM: The Customer Portfolio

Excerpted from Defying the Limits: The CRM Project

The field of CRM is at a crossroads. The promise — while still very much alive — has in too many cases not been delivered. Too many projects have been abandoned; too much investment has been written off. While there are many potential reasons for the current state of affairs, one of the most obvious is that, in many organizations, CRM initiatives are often "non strategic." This paper offers a "strategic approach" to thinking about CRM in the hope that it will help firms realize the true benefits of this fundamentally revolutionary and vital business technology.

Smart Markets

Strategy is essentially a matter of aligning business practice and process to the demands of the environment. Perhaps the most important implication of the information age for business is the emergence of information-intensive or "smart" markets, which are markets defined by frequent turnovers in the general stock of knowledge or information embodied in products and services and possessed by firms and consumers. In contrast to traditional "dumb" markets — which are static, fixed, and basically information-poor — smart markets are dynamic, turbulent, and information-rich.

It is in the context of smart markets that CRM should be viewed. Smart markets are based on smart products, which are product and service offerings that have intelligence or computational ability built into them and can adapt or respond to changes in the environment as they interact with customers. Smart markets are also characterized by smart consumers — consumers who, from the standpoint of the firm, are continually "speaking" (they are not mute or "dumb"); and, in so doing, educate or teach the firm about who they are and what they want. In such an environment, competition is less about who has the best products and more about which firm can spend the most time interacting with (and therefore learning from) its customers.

Customers as Assets

The essence of smart markets — and therefore the imperative behind CRM initiatives — is that the customer is the "new asset" of the organization. This approach shifts the focus away from the product and toward the customer as the key asset or source of wealth generation. The company of the future is likely to be organized around customer managers (CM) rather than product managers who will have bottom-line profit-and-loss responsibility for a set of customer targets. In addition, the CM will be charged with developing and delivering a set of offerings to chosen customers. Consistent with this responsibility, the CM will act as a team leader who coordinates the activities of a variety of marketing-mix professionals or specialists (in pricing, advertising, forecasting, etc.) who will be necessary to develop and implement customer plans, which specify specific strategic objectives with respect to designated customer targets.

Identifying the customer as an asset means that the focus of attention shifts away from the offerings and that the customer, not the product, is viewed as the real generator of wealth for the company. The source of competitive advantage is seen less in terms of unique or superior products and more with respect to having special relationships with customers. Consequently, both performance measures and organizational structure become aligned around customers as opposed to particular products or services.

In particular, the current structure of accounting for profit and loss (P&L) by product — the foundation for the product management system — is being replaced by a customer management structure in which P&L is organized by customer. Notions such as profitability or market share per product are being replaced with concepts such as profitability per customer — increasingly referred to as the customer's lifetime value (LTV), which is the total profits generated over a given customer's "life." The associated concept of customer share is the total share of a customer's purchases in a broadly defined product category — such as Visa's "share of wallet," Levi's "share of closet," or Coke's "share of stomach."

The Customer Information File: The Organizing Framework for CRM Decisions

The organizing principle, as well as the raw material from which a firm measures and evaluates its customer assets, is the customer information file (CIF). It is the data collected and processed as part (increasingly) of every customer transaction or interaction. As a practical matter, this is what it means for the customer to be the asset, since the foundation of relationship marketing is continual communication (the exchange of information between a firm and its customers). CRM activities are based on an understanding of both the structure and strategies that are the result of a well-designed CIF.

The CIF can be thought of as a single virtual database that captures all relevant information about a firm's customers. The database is described as virtual since, while operating as though it were an integrated single source housed in one location, it may comprise several isolated databases stored in separate places throughout an organization. As noted in Figure 1, the rows (or records) of the CIF are individual customers — both actual as well as potential — and not segments. The columns are data that have been collected about customers. At least conceptually, these can be organized into three categories:

As noted in Figure 1, there is one additional column of information in the CIF (at the far right), labeled as P*. If Pit is the actual profit realized from customer i in period t, then P*it is the potential profit that could have been realized from customer i had the firm made the optimum use of its information assets. P*-P thus represents foregone or unrealized profits and the new objective function of the firm is to minimize (P*-P) across all customers in all periods; or, equivalently, to maximize P*it — the value of the CIF. This is the strategic objective of CRM activities.

Figure 1

'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:

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.