How Great Managers Capture Profit Pools -- and Anticipate or Precipitate Shifts

An important source of shifts in profit pools, we said, is everyday changes in the preferences and behaviors of customers. Most of the tools we will discuss here are designed to help you anticipate and respond to such changes.

Customer segmentation. Customer segmentation is an indispensable tool for performance improvement, because it answers fundamental questions any company must face. Are we selling to the right customers? Which segments should be the primary target of our product-development efforts, and of our sales and marketing activities? In which regions and countries should we be competing? In which markets can we create differential value? How should we differentially allocate our sales and marketing resources to various segments? To answer such questions, a management team must understand which customer segments are most attractive in terms of size, profitability, and growth. They must also make an honest assessment of their company’s capabilities to meet each segment’s needs relative to the competition. Some segments “fit” a company better than others -- that is, the company has greater ability to serve these segments in a way that is differentiated from competitors. Some segments are more profitable, either because they generate higher revenues, because they can be served at lower cost, or both. And some segments are growing faster. Segments with high growth, high profitability, and sufficiently large revenue potential are a company’s natural focus. But the company may also be able to adjust its value proposition to serve high-growth customers that are not currently very profitable.

Remember FitEquipCo’s profit-pool map, mentioned earlier in the chapter? The analysis revealed that the company’s share of revenue was less than its share of units sold, and its share of profits was less than its share of revenue. So FitEquipCo’s management team concluded they needed to refocus the company on winning more customers in higher-spending segments. To do this, they worked to gain a deeper understanding of those customers’ needs and how they differed from the needs of other segments. They then invested in product development, sales resources, and service approaches designed to meet those needs better than the competition.

Effective segmentation can also reveal underexploited opportunities within your customer base. By “de-averaging” your customers and prospects, you can often find hidden pools of profit that could be more fully exploited. A great starting point for this sort of analysis is to identify segments that are willing to choose your product over others, or that are willing to pay more for the bundle of needs and wants that your product represents. Have you fully penetrated all the customers in the market who have similar characteristics? Among those you have penetrated, have you earned and captured 100 percent of their purchases?

We discussed a simple scheme that divided customers into three camps: those who buy primarily on price, those who are looking for some combination of quality and service, and those who are looking for some form of prestige through buying a particular brand. Of course, much more complicated segmentation schemes can be developed, but this simple one can be powerful.

Dow Corning is a good example. Dow Corning makes silicone-based products that are used as a raw material in many different industries, from cosmetics to electronics to food and beverages. In 2001, the company was facing a series of challenges. Its revenue growth had been flat for several years, and its profits were below expectations.

As it turned out, Dow Corning had attempted to differentiate its products over time by adding more and more value-added services, pushing up costs and prices. But in talking to customers, Dow Corning managers discovered that some large customers didn’t need those services; they understood the product, used it effectively themselves, and really just wanted the best possible price. In response, Dow Corning developed a line known as Xiameter -- standard silicone products that could be ordered over the Internet without traditional customer service, marketing and sales support, or application and engineering support. This move allowed the company to take a significant amount of cost out and reduce lead times. In fact, Dow Corning could offer these plain-vanilla products at a lower price than anyone in the market, and gained share as a result.

Of course, many of the company’s customers wanted and needed technical support or other services. So Dow Corning began offering these services à la carte, at prices that would cover its costs. This two-brand strategy enabled the company to be clearer internally about the needs of its customers, both the “price-seekers” group and the “custom-solution” group. Both groups turned out to be more satisfied with what they received from the company. The results were remarkable. By 2006, Dow Corning had grown by more than 60 percent and multiplied its profits. In 2005 the research firm Frost & Sullivan named Dow Corning the specialty chemicals company of the year.

Segment Needs and Performance (SNAP) charts. Different customer segments will have different wants and needs. If you compare your offerings for particular segments with those of your competitors and substitute products as they are viewed by these customers, you are likely to glimpse what will happen to your profit pools and relative market shares down the road.

How to assess the needs of different segments over time? One simple tool -- we call it a “SNAP chart” -- can often get you 80 percent of the answer. First, you define the specific attributes of the products or services you offer that might be important to the customer segments you want to target. Second, you conduct research aimed at determining how important each of these actually is to these customers. A bank, for instance, might study everything from its hours of business or its loan rates to the quality of the advice it offers and the ease of access to its ATMs. Third, you assess your performance on each attribute as viewed by the customers and where each of your competitors performs on these dimensions as well.

The resulting chart shows how you measure up to the competition in the eyes of your key customer segments. You can use it to identify which gaps are most important to close (if you’re behind) or widen (if you’re ahead). You can also see where you might be overshooting the mark. The company exceeds customers’ requirements on innovation and assortment, two attributes that rank number four and number six in importance to the customer. It is thus incurring costs that may not earn a return in the marketplace. Meanwhile, it is slightly underperforming competitors on quality, which is number one in importance, and significantly underperforming on customer service, which is number three. It probably needs to take action to close those gaps.

SNAP charts, incidentally, underscore the importance of an effective segmentation strategy. To oversimplify only a little: if you have only one undifferentiated offering, you are unlikely to meet the needs of your customers as well as competitors that have offerings tailored to each significant segment. You will also probably incur unnecessary costs in over-serving needs that are not highly valued by some customers.

Customer ethnographic research. Traditional quantitative and qualitative research techniques can help identify and size customer segments and characterize their needs. But in fast-changing markets, or in situations where innovation is required, customers often have trouble articulating or even recognizing their own needs. Consumer-products and technology companies have pioneered the use of a tool known as customer ethnographic research to address this kind of situation. It’s a way of identifying unmet needs that customers might not be wholly aware of. Researchers spend time with customers in their homes, backyards, or cars. They watch what customers do -- the frustrations they encounter, the jury-rigged devices they come up with to solve their problems. That helps the companies develop products that customers wouldn’t necessarily have been able to describe.

Executives at Procter & Gamble, for example, knew they wanted a product that could clean carpets the way the company’s Swiffer cleaned floors. In 2003, chemist Bob Godfroid led a team into homes, where they took pictures and talked to people about how they cleaned their carpets. A young mother said the vacuum cleaner’s noise scared her child. An older woman had to have two vacuums, a heavy one for regular cleaning (once a week, when she could take painkillers for a sore knee) and a lighter one for spot cleaning. Nobody liked carpet sweepers -- too cumbersome, too ineffective. Focusing on the needs they had uncovered, Godfroid and his team experimented with dozens of possibilities, eventually coming up with a lightweight device that caused dirt particles to spring off the carpet like Tiddlywinks and then trapped the dirt behind a removable element. Further laboratory and consumer testing led the team to add a sticky layer to the element, to catch hair or lint that didn’t flick up. The P&G Carpet-Flick was an immediate hit, generating an estimated $750 million in revenues by 2005.

The revenue sieve. Once you know more about your customers, you need to figure out the appropriate actions. One tool that can help you capture more value from your segmentation is known as the “revenue sieve.”

The revenue sieve starts by asking the question: what customers represent 100 percent of the market we could serve, and why do we not have all of it? This technique breaks down the difference between the full addressable market and a company’s current sales. The concept can best be illustrated through the story of Grainger, the industrial-goods distributor.

Distributors of industrial goods were mostly mom-and-pop operations for much of the twentieth century. By the 1980s, however, Grainger had emerged as a strong national leader in maintenance, repair, and operating (MRO) supplies. The company had 200 branches selling 30,000 products, many of them aimed at the contractor market. But in the mid 1980s, it seemed to be hitting a plateau. Sales growth in the 1970s had averaged 12 percent a year. From 1979 to 1986, as the economy turned down, growth averaged less than 1 percent a year. Grainger at the time had a sizable share of what seemed to be a $3 billion market, and some managers weren’t sure they could increase that share.

At this point, the company took a fresh and detailed look at the addressable market and applied the revenue sieve. It first noticed that MRO products were being purchased by a far broader range of customers than just contractors. Manufacturers, wholesalers, and institutional and commercial organizations all bought MRO supplies, though Grainger had not been targeting these customers. In fact, the total market for the products Grainger distributed was $40 billion, eight times the size of the market that the company had traditionally addressed. Starting with that $40 billion total market, Grainger could identify the points of leakage between that and its current sales.

As Grainger managers analyzed the full-potential set of customers and their buying patterns, they discovered that the various customer segments had different needs. But all had one thing in common: a lot of unplanned purchases. They would suddenly discover they needed something, and would then look for the most convenient location to buy the products. The distances customers were willing to drive, however, was generally limited.

So Grainger took a number of actions to address the full-potential market. It dramatically increased the number of branches, so that more were within a thirty-minute drive from concentrations of customers. It refocused its product lines onto the convenience items that were most often the object of unplanned purchases. It restructured the salesforce and applied best practices for each type of customer. It improved customer service and streamlined its ordering procedures.

The result was a rekindling of growth: through the 1990s, Grainger was able to grow at an average annual rate of more than 7 percent a year, or about twice the underlying industry growth rate for Grainger’s basic products. By understanding the leakage between full potential and current sales, the company could take concrete actions to grow when the conventional wisdom suggested it was doing as well as it could.

Loyalty and retention. Our colleague Fred Reichheld is well known for showing that customer retention and loyalty can be enormous boons to growth and profitability. Think about how rapidly your company grew last year. How much of the growth came from new customers, and how much did you lose from customers who left you for a competitor? Most companies’ revenues are like a leaky bucket. As you add revenue in the top, you lose it out the bottom. This happens for a variety of reasons. Some of your customers have bad experiences and move to someone else. Some enter a new phase in their life cycle and now find your offerings less attractive than those of a competitor. Others experiment with the innovations offered by competitors. In many industries, increasing customer retention can be the biggest single driver of profitability. In credit cards and some other financial-services businesses, for example, increasing retention by as little as 5 percent can double profits.

An obvious starting point, of course, is to measure accurately how well you retain your customers and what share of their purchases you have earned. Understanding customer retention in each segment of customers, and mapping the differences in retention rates among customers acquired through different channels, on different products, pricing or service plans, and with different customer experiences can help locate “hot spots” for focus. But while this is an important technique for figuring out what has happened in the past, managers have long struggled to find a way to anticipate future issues. Traditional measures of customer satisfaction have failed to gain the trust of management teams for a variety of reasons. The measures often rely on complicated, hard-to-understand indices. They are often based on small samples of customers, and they may become available only after a long lag time because they require months of data collection and analysis. The measures may also fail to explain and predict variations in customer behavior and profitability.

In recent years Reichheld and others developed a metric and approach known as Net Promoter® Score (NPS), which measures loyalty and can help predict customer retention and share of wallet. One of the simplest, most practical, and most powerful approaches to customer metrics, NPS is derived from asking your customers just one question: how likely they would be (on a zero-to-ten scale) to recommend your company, product, or service to a friend or colleague. Typically, companies using the NPS approach follow up with only one to five additional questions. That keeps the survey short and respectful of a customer’s time. Speeding up the feedback enables the metric to become an embedded operational process rather than remaining an isolated piece of research. Used wisely and in the right circumstances, NPS can supplement or even replace some of the more complicated customer-feedback approaches companies have traditionally used.

Looking at your Net Promoter Score over time is the best way we have found to assess and predict customer loyalty, and greater loyalty is the best way of plugging the leaky bucket. You can calculate your NPS by customer segment, and you can compare your scores with those of your competitors simply by surveying customers of all the relevant companies. Average scores naturally vary by industry, but the leading companies in many industries are likely to have an NPS greater than 50 to 60 percent. If you are ten percentage points below the best competitor in your industry, you may have an opportunity to improve performance through a strategy designed to increase customer loyalty.

If you find that your NPS is declining over time, additional research into your customers’ experience may reveal the reasons and may help show how to improve things. In businesses with many customer touch points this can be challenging, but the reward is worth it. St. George Bank in Australia, for instance, discovered that its promoters -- those who said they would definitely recommend it to a friend or colleague -- were twice as profitable as an average customer: they used more of the bank’s products, on average, and gave it a greater share of wallet. But the bank’s retention rates for promoters were not as high as they should have been. Root-cause analysis showed that poor service was the major cause of defection. So managers attacked service issues aggressively, focusing on touch points likely to have the greatest effect. They used best-practice examples to set goals and develop initiatives. They developed detailed implementation plans, including training and recognition-and-rewards programs. They created a dashboard of measures so that they could monitor their progress. Three years later the bank’s NPS had risen, and its stock price had outperformed a peer index by a factor of 1.4.

In all such cases, the key to success is identifying the factors that are most important to the customer. Analyzing why customers defect can be an effective way to learn exactly what is most important. Customer satisfaction is usually a combination of many complex factors that are difficult for a customer to articulate and prioritize -- but when customers decide to leave you, they can usually tell you exactly why. So focusing on identifying and eliminating the root causes of defection is a powerful tool.

You can supplement your NPS analysis with a host of diagnostic tools related to loyalty: share-of-wallet analysis, analysis of the lifetime value of a customer, customer migration analysis, and so on. There are also many other sophisticated tools for learning about your customers these days -- tools such as the S curve, cluster analysis, perceptual mapping, CHAID (chi-squared automatic interaction detection, a method of answering questions such as which factors best explain the behavior of a given variable), and discrete choice. Depending on your situation, you will want to use a variety of tools to understand your customers in depth. It’s a key to both diagnosing your current performance and evaluating opportunities for the future.

Segmentation and retention efforts are at the ends of a six-link chain of activity that enables a company to earn more profits per customer than its competitors, and then to out invest the competitors to generate greater growth. The first links are 1. to identify the most attractive target segments and 2. to design the best value propositions to meet their needs. The next steps are 3. to acquire more of the target segment and 4. to deliver a superior customer experience. That enables the company 5. to grow its share of wallet, and finally 6. to drive loyalty and retention, with more promoters and fewer detractors.