Hanken Svenska handelshögskolan / Hanken School of Economics www.hanken.fi

Customer Portfolios

Customer EquityHelsinki Summer School 2009, Hanken

Andreas Persson

This morning’s agenda

» EVA / economic profit

» Different types of customer portfolios

» The customer base seen as a customer portfolio

» Issues/problems related to viewing the customer base as a portfolio

Economic Value Added (EVA)

Net operating profit minus an appropriate charge for the opportunity cost of all capital employed in an enterprise (also called economic profit)

The BCG-matrix

Typical investment decisions in customers

» Joint projects with the customer

» Financing of inventory or a distribution channel

» Joint R&D projects

» Business process alignment initiatives

» Discounting schemes for specific customers

» Any type of adaptation made to products and services in order to better fit the customer’s situation

Invest in Renewal and Growth

» Finding new sources of future revenue

» Align with customers that demand change and are willing to engage in a mutually rewarding exchange

» Look for completely new ways to satisfy needs through radical innovation and creating new markets and revenue streams

»invest in new competence

Invest in Renewal and Growth

» Move from increasing share of the customer’s wallet to growing the customer’s wallet

» Renewal and innovation require that a company become a part of its customers’ strategy formulation process

» Duration is achieved by creating offerings that are valuable to customers and difficult for competitors to imitate

Invest in Cash Flow Maintenance

» Firms must maintain cash flow as long as possible with customers that currently create the majority of the firm’s economic profit, but that may not have future potential

» Understanding how to keep up duration by decreasing cost in an intelligent and sustainable way and running the existing business operation in a more efficient way

Invest in Capacity Optimization

» Seek lower average cost (achieving economies of scale)

» Firms must calculate how much they are willing to “lose” in this portfolio in order to be able to lower the total average COGS that can be used to maximize spread in other portfolios

» Major risk is growing the portfolio until it is too large

Divestment

» “Deselecting” certain customers already in the customer base

» Customer portfolios showing low or negative spread as well as short duration should be divested

» AOL has had a strategy of identifying and removing non-paying members of its customer base

From financial portfolios to customer portfolios

» If the customer base is viewed as a portfolio of assets, it is not sufficient for firms to consistently allocate resources towards acquiring customers with lifetime values that are expected to exceed acquisition costs

»a customer base comprised of too many high lifetime value customers may burden the company with an unacceptable degree of risk

The customer base seen as a customer portfolio

» Large cash flows from customer relationships are naturally attractive, but if they are highly volatile, it makes sense to balance them with less volatile cash flows

»The aim, as when an investment portfolio is constructed of for example stocks and bonds, is to reach a point on the so-called efficient frontier, where the greatest possible return on investments in customer relationships is achieved, corresponding to a particular level of risk

»The risk of a customer relationship can be expressed in the form of a customer beta, reflecting the correlation of a customer’s returns to that of the overall customer portfolio

Differences between investment instruments

and customer relationships as

investment targets…

Source: Nenonen, 2009

Interconnectedness

» Investment instruments

» Investment instruments are independent from each other and the actions of the investor

» Customer relationships

» Customer relationships are often interconnected to each other and are affected by the actions of the firm

Risk

» Investment instruments

» Diversification leads to

reduced variance: specific

risk can be diversified away

» Systematic market risk is

enough for calculations

» Risk is stable over time and

indifferent to varying

investment amounts

» Universal definition of risk

» Customer relationships

» Customers are interconnected:

specific risks cannot be diversified

away

» Systematic market risk is not

enough for calculations as specific

risks cannot be diversified away

» Risk can vary over time and based

on investment level variations

» Multiple definitions of risk

Return

» Investment instruments

» Expected return can be forecasted by market-wide historical data

» Transaction costs should be considered in return calculations

» Customer relationships

» Firm-specific historical data might not be enough to forecast expected return, return potential has also to be considered

» In addition to transaction costs, also non-direct and capital costs should be considered in return calculations

Risk-return ratio

» Investment instruments

» Risk and return have a positive correlation: existence of efficient portfolios and capital market line

» It is impossible to create a portfolio with a risk-return rate above the capital market line

» Risk-return ratio is independent from the acts of the investor

» Customer relationships

» Risk and return do not necessarily have a positive correlation: no efficient portfolios or capital market line

» Possibility of customer relationship with abnormal returns

» Risk-return ratio can be affected by the firm

Resource allocation

» Investment instruments

» Risk and return are known prior

to making investment decisions

» Resources can be allocated

freely (both investment &

divestment)

» Resource allocation volume can

be decided freely

» Return optimization at a given

risk level is investor’s only

objective

» Customer relationships

» Risk and return are seldom known

prior to initiating a relationship

» Challenges in reallocating customer-

specific resources & in ending

customer relationships

» Customers are active participants in

deciding the volume of customer

relationship

» Firms may have other objectives in

addition to return optimization