The Strategic Value of High-Cost Customers

Abstract

Many firms today manage their existing customers differentially based on profit potential, providing fewer incentives to less profitable customers and firing unprofitable customers. Although researchers and industry experts advocate this practice, results have been mixed. We examine this practice explicitly accounting for competition and find that some conventional prescriptions may not always hold. We analyze a setting where customers differ in their cost to serve. We find that when a firm can discriminate among its customers but the rival cannot, customer base composition influences the rival's poaching behavior. Consequently, even though a low-cost customer is more profitable when viewed in isolation, a high-cost customer may be strategically more valuable by discouraging poaching. Therefore, contrary to conventional advice, it can be profitable for a firm to retain unprofitable customers. Moreover, some customers may become more valuable to retain and receive better incentives when they are less profitable. We further show that, in competitive settings, traditional customer lifetime value metrics may lead to poor retention decisions because they do not account for the competitive externality that actions toward some customers impose on the cash flows from other customers. Our results suggest that firms may need to evolve from a segmentation mindset, which views each customer in isolation, to a customer portfolio mindset, which recognizes that the value of different customers is interlinked. This paper was accepted by J. Miguel Villas-Boas, marketing.