Marketers' Goldilocks Paradox: The Sweet Spot in Service Quality



Published on: 05/01/2014
Posted on: 05/12/2014
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Abstract:
One of the most important measures of company success is its return on investment from marketing. But retaining customers comes at a high cost — that may not be justified by the expected long-term returns in the future. New research by SMU Cox Marketing Professor Michael Braun and co-authors shows how transaction-specific information about customer experiences can help companies assess the effect of service quality on future cash flow. Instead of focusing on the cost to acquire or retain a customer, companies should pay more attention to the value of customers.

One of the most important measures of company success is its return on investment from marketing.  A typical strategy to support marketing investment is to retain as many customers as possible. A focal point could be “delighting” all of its customers by providing exceptional customer services.  But retaining customers comes at a high cost — that may not be justified by the expected long-term returns in the future. New research by SMU Cox Marketing Professor Michael Braun and co-authors shows how transaction-specific information about customer experiences can help companies assess the effect of service quality on future cash flow.

Instead of focusing on the cost to acquire or retain a customer, companies should pay more attention to the value of customers.  “What is the maximum amount of money a firm should spend to keep a customer?” asks Braun.  “It should be the expected increase in discounted cash flow that the firm expects to get from a customer that otherwise would have canceled or defected.  Focusing on overly simplistic metrics like retention rate, or marketing spend per customer, ignores the fact that some customers might cancel service anyway, and others might stick around no matter what."  Instead, firms should invest in retaining only those customers who are both valuable and at risk of defecting.

“This does not mean that we should ignore other customers, " offers Braun.  "We claim only that customer service, return policies, and satisfaction efforts all cost money; limited resources should be spent on retaining those customers who are most likely to be profitable in the future.”  Ultimately resources should be concentrated on customers who are the most profitable.

Observing the customer experience
Braun and his co-authors have developed a prototype mathematical model that could help firms quantify the long-term effect of service quality and other metrics.  “Our model recognizes that different customers buy at different rates, and that customers have different expected lifetimes with the firm.  When a customer defects it is often unobserved; the customer just stops frequenting the store.  If we know something about the quality of his experiences with the company, we can use that information to predict if and when the customer comes back.” 

The analysis draws heavily on probability theory, and avoids many of the biases and errors that are typical of older models of customer lifetime value. “During the last several years, we have learned a lot about how to separate what we know about customer transaction patterns from what we don’t.  Our models take this variation and uncertainty into account.”

Braun suggests that when thinking about marketing return on investment (ROI), "you should try to predict what the effect of that marketing activity will be for future discounted cash flow from that particular customer. The experience at each transaction can affect that measurement." If the customer's expectations are not met, they are more likely to defect, just as they are more apt to remain a customer if their expectations are met.

So what is the impact of giving a customer a poor service or transactional experience? The researchers quantify this through their model. They measured when customers received the service quality they expected and when they missed or exceeded their expectations. They then looked at that difference.

This is where Braun's research works out the important details to determine where to put marketing investment dollars. For example, if a customer purchased recently, and had a past poor service encounter, then it did not make them defect. They purchased recently so you know they are active. If someone has not purchased for a long time, then missing it on quality doesn't matter so much either because they are already 'dead' as a customer. There is this sweet spot in the middle that matters—the patterns about the impact of quality on customer lifetime value.

Braun says that many managers continue to use past transactions as a measure of customer value.  “That is a common mistake.  A manager might say, 'My most valuable customers are those that have purchased in the past.' But what we really care about is what customers do in the future.  Past experiences serve as a useful, but still imperfect, clue.” By incorporating measures of the customer experience,  firms can quantify how a customer’s future transactions increase or decrease because of a mismatch in the quality of a service encounter between what was requested and delivered. Firms can then decide how much to invest in improving the quality of service encounters, say the authors.

What to invest?
So where should companies invest to keep customers?  "To determine where to place those dollars, put that capital toward those customers that would give you the most improvement," Braun explains. Allocating capital in this way can be considered both offensive and defensive maneuvers to keep customers loyal. "Delighting all of your customers is not a very good business strategy because you could be delighting those that will not come back," Braun notes. "You need to target your marketing activity that increases or at least defends the discounted cash flow that you get from customers. If other customers are not as profitable, you do not fire them." You just should not emphasize marketing dollars towards those segments.

The authors' approach offers insights into just how valuable transaction-specific information is in predicting customers’ future activities. They find that the incremental value of knowing the quality of a customer’s last touchpoint with the firm depends on that customer’s transactional history.

The paper, "Customer Base Analysis with Service Quality Data," by Michael Braun of Cox School of Business, Southern Methodist University; David Schweidel of Goizueta Business School, Emory University; and Eli Stein of Harvard College, Harvard University is under review.

Written by Jennifer Warren.

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