Instead of just being miffed, this customer called the manager of the branch where he has his account—a manager who knew just how valuable this guy was. Then he patched in a manager from the bank’s mortgage department. These two managers had never spoken to each other before. Didn’t it make sense, asked the customer, for him to get his mortgage and get it at advantageous rates in light of his long history and high profitability with the bank? If he didn’t, he’d certainly see if some other bank could be more accommodating. “Sorry,” said the mortgage manager, who explained that his hands were tied. This bank, like most major banks today, is the product of several mergers, and after the last big one all mortgage managers were put on a very short leash until the integration got worked through. He was strictly forbidden to do anything special for this or any other customer. “Wait!,” said the branch manager, now pleading with the mortgage manager in an effort to keep this customer. “I’ll pay you the first-year costs of giving this customer a better mortgage deal—just give it to him! Make him happy! We make loads of money with this guy!” “Sorry,” said the mortgage manager. “I’m not allowed.”

The customer got his mortgage someplace else, at an institution that could see what he was worth and was hungry for the business. He gradually began shifting his trading from the Bank of Outer Mongolia to the new institution as well. So the bank not only blew a great opportunity to deepen its relationship with this highly profitable customer, it let a direct competitor take a significant piece of the customer’s business. And it made the customer angry—a lose-lose deal. Bottom line: a complete disaster for the bank. It’s no surprise to find that this bank’s financial performance is lousy. Its ROE (return on equity)1 is a dismal 10 percent and falling; profits and its stock price have been plunging, and its P/E (price-earnings) multiple is much worse than mediocre, about half the average P/E for the S&P 500. As we write this, the newspapers are full of rumors that the CEO’s days are numbered.

Sound like any bank you’ve done business with?
Now suppose that instead of this ludicrous, frustrating experience, the customer had encountered something different. Suppose the manager he spoke to wasn’t in charge of mortgages or a branch but was in charge of him and customers like him. The manager knew everything about the customer’s relationship with every part of the bank and exactly how profitable he was because this information was available on a computer screen at any time. More important, this manager was accountable for the profitability of this customer and others like him. A few layers up in the organization was an executive whose entire job was to manage the customer segment to which this customer belonged (the bank might call the segment something like “wealth builders”). Other parts of the bank—mortgages, deposit accounts, brokerage services, branches—functioned as internal suppliers of products, services, and distribution to this executive and the handful of other executives who were in charge of other customer segments.

Does this sound crazy? Let’s get really radical: Suppose these segment executives had profit-and-loss responsibility. Suppose the bank could calculate the profitability of each individual customer or customer segment, and these executives were on the hook to deliver specific, budgeted improvements in their segment’s profit each quarter.

In this kind of organization, what kind of experience would our bank customer have had? Most likely one that was markedly better—for him and for the bank.

This fantasy bank is no fantasy. It’s Toronto–based Royal Bank, which has reorganized its huge Personal and Commercial division in exactly this way. The results have been astonishing. The division has reduced expenses by $1 billion, in part because those product areas—mortgages, deposit accounts, etc.—are no longer fiefdoms with their own separate administrative infrastructures and their own marketing efforts, which were often aimed in an uncoordinated way at the same customers; everyone in the bank realized that loads of money was being wasted as a result, yet it was virtually impossible to do anything about it. At the same time, the division is ahead of schedule in increasing revenues by $1 billion, a natural result of trying to meet customers’ total needs rather than trying to sell individual products and services. That’s a $2 billion swing, which the bank is sure resulted from its new approach to business. Because of the bank’s high fixed-cost structure, most of that money fell to the bottom line. By contrast with the financial performance of the Bank of Outer Mongolia, Royal Bank’s Personal and Commercial division earns a return on equity of about 25 percent. If the division was a freestanding business, we calculate that its excellent profitability and growth prospects would win it a P/E greater than the S&P 500 average—even though most banks’ P/E multiples are way below the average. And the stock of the corporation has outperformed that of most North American financial institutions over the period.

Other than these radically different financial results, what’s the difference between Royal Bank and the bank that failed so dismally in dealing with our unhappy customer? Not much, by most criteria. They’re both giant, long-established banks offering a full line of financial services to millions of customers. Both have computers loaded with stunning amounts of potentially useful data about those customers. The most important difference between them is much deeper than matters of size, products, or even the business they’re in. It is that these banks conceive of the way they do business in profoundly different ways. Specifically, one of them, Royal Bank, has put customers at the center.

Do You Have Any Unprofitable Customers?
Maybe you’re thinking, “That’s fine for a bank, but my business is very different.” That’s just not the case. No matter what business you’re in, the principles we’re talking about apply to you. We believe that virtually every company in every industry will soon have to reconceive its way of doing business along these lines, with customers at the center. Why? Because the evidence is overwhelming that this is every company’s number-one opportunity to create new shareowner wealth, which is something all companies desperately need to do. Consider: Even when the U.S. economy was booming from 1995 to 2000, most of the biggest companies either failed the most basic test of business—they didn’t earn their cost of capital—or they passed by the slimmest of margins.

We know for sure that companies did much worse through the slowdown that followed the stock market bust in 2000, despite heavy layoffs, divestitures, and other heroic cost cutting. To put this in the starkest terms: Most companies are failing to achieve what they must achieve to make their share prices rise.

That’s a big problem. In trying to solve it, the typical executive looks for troubles in the company’s products or business units or territories, which sounds sensible. But that kind of conventional analysis is no longer good enough because it’s typically applied to all customers, profitable or not, high potential or low, in the same way. Ever more brutal competition, combined with demanding capital markets and suspicious investors, is challenging managers to rethink their businesses in a fundamentally new way. A number of companies are beginning to do so, using a crucial new insight: If a company’s return on capital2 isn’t much better than its cost of capital, then its trouble is even deeper than bad products or business units or territories. By definition the company must have a boatload of unprofitable customers.

This is a huge idea: A company consists of both profitable and unprofitable customers— angels and potential demons. Some customers are making your company more valuable while some are draining value from it. Not that the demons are bad individuals; frequently they’re unprofitable simply because the company doesn’t know who they are and is failing to offer them the right value proposition. Similarly, managers may be blissfully unaware of which customers are the all-important angels. Combined, your angels and demons determine your company’s value. This doesn’t fit the way most managers run and measure—and thus think about—their businesses. Yet it’s obvious that all the profits and value of a company come from its profitable, high-potential customers. If your company has a market capitalization of $20 billion, that value depends entirely on the future profitability of your existing customers and your ability to attract and retain profitable new customers in the future. Thus the first of the three most important principles that emerge from our work and that we will come back to again and again: ,Principle No. 1: Think of your company not as a group of products or services or functions or territories, but as a portfolio of customers.

We will see in almost endless ways why this perspective is so extraordinarily valuable, but to get a basic sense of it, just answer this question: Does your company have any unprofitable customers?

We recently asked that question of the top executives at one of America’s major retailers. (By unprofitable, we meant failing to earn the cost of capital.) Your answer may well be the same as theirs: No. Amazingly, these executives were quite confident they had no unprofitable customers, even though their business overall was failing to earn its cost of capital. If you’re baffled by the apparent illogic of this position, well, so were we. Yet this company’s leaders insisted that through some dark financial voodoo, millions of profitable customers somehow added up to an unprofitable company.

Our analysis of customer profitability—an exercise they had never conducted and weren’t even sure quite how to conduct—showed them they were wrong. The truth, which shocked them, was that some of their customers were deeply unprofitable. Understand the importance of what this meant: Doing business with these customers on current terms was reducing the firm’s market capitalization by hundreds or thousands of dollars per customer. Since the company didn’t understand these facts, it was aiming marketing efforts at these customers and others like them. So here’s how absurd the situation was: This company was actually spending money to bring in customers that were reducing the value of the firm.

If you believe your company has no unprofitable customers, we hope you’re right. But experience has shown us that, like the executives of this retailer, you’re probably fooling yourself. We’ve found that most companies have some very unprofitable customers—as well as hugely profitable customers—but managers rarely believe it or know who they are. In fact, as we’ll see in later chapters, the bottom 20 percent of customers by profitability can generate losses equal to more than 100 percent of total company profits. Even if you know you have unprofitable customers, you may be clueless what to do about it. (“We can’t fire customers, can we?” some managers ask; the answer is that in some cases you can, as we shall explain, though there’s almost always a better alternative. Those demons can often be exorcised.) Yet if a company can’t figure out a way to earn at least its cost of capital with individual customers or customer segments, it’s just a matter of time until its share price gets crushed. These days that’s something no company can afford to risk.

But suppose your company is fabulously profitable already. Are you immune to unprofitable customers? We doubt it. We have examined the customer profitability of two of the most profitable companies in North America and found that 10 percent to 15 percent of their customers are hugely unprofitable. So even in these cases, managers have an opportunity to make their company still more profitable.

It’s crazy so many managers refuse to believe they lose money on some customers. Wall Street analysts should be all over this issue, digging deeply into the facts of customer profitability at the companies they cover, especially at companies that are failing to earn their cost of capital. Yet most analysts aren’t doing so. In fact, two of Wall Street’s top- rated food retailing analysts told us unequivocally there are no unprofitable customers at any of the companies they cover. Little did they know: We had performed analyses at some of these very companies and had found, as we find at every company, that some customers were deeply unprofitable. Yet the news wasn’t all bad, for we also discovered highly profitable customers at these companies. But the analysts didn’t have a clue.

A Better Way to Boost the Share Price
These analysts, like most managers, are missing what we consider the most powerful way to understand the true economics and influence the share price of a company: analyzing the profitability of its portfolio of customers. Here we begin to see the second of the three vital principles that leap out from this work and that will be elaborated much more fully in Chapters 2, 3, and 4:

Principle No. 2: Every company’s portfolio of customers can and must be managed to produce superior returns for shareowners—meaning a consistently better than average share price appreciation—not just to produce earnings per share or EBITDA or revenue growth or customer satisfaction or anything else.

This sounds obvious. Why is it so important? Because it truly is a matter of corporate survival, now more than ever. Capital today travels around the globe instantly, continually, relentlessly seeking its best use. Information about your company and everything that affects it is far more widely available than ever in history, and it, too, travels instantly, globally, continually. Every company now gets a daily report card, in the form of its share price, on how it’s doing in the worldwide competition to attract capital, and the grading is getting tougher. Even in Japan and Germany, former bastions of what some analysts used to call, admiringly, “patient capital,” the party is over. No capital is very patient anymore. Global capital is demanding performance, and companies that don’t deliver are finally being forced to do the unthinkable: fire CEOs, reform boards of directors, and face the new music.

This new imperative is truly unavoidable. Even if your company has an eccentric majority owner who just sits at home watching MTV and couldn’t care less what his stock is worth, failure to beat the crowd in making it worth more will lead to trouble in the company’s day-to-day operations:

The best employees, who increasingly want to be paid partially in stock so they can participate in the success they help create, won’t want to join a company that lacks a reputation for creating superior returns for shareowners. Further, companies that don’t offer stock-based compensation may have a tougher time holding excellent employees; if they’re paid only in cash, it’s easy to leave for a better deal elsewhere. Without the best employees, the company will only go further downhill.

A history of poor value creation makes new capital more expensive to attract, so the company will have a harder time funding research, development, and expansion that will let it serve customers better. As disaffected customers turn elsewhere, the situation gets worse.

Companies often need to buy other companies in order to acquire technology, customers, or employees and keep them out of competitors’ hands. Valuable shares make an excellent currency for such acquisitions, but if a company’s shares haven’t grown sufficiently in value, then these acquisitions may be too expensive. The company’s competitors win these prizes instead, and yet another downward spiral begins.

We hope it’s obvious that creating superior returns for shareowners isn’t just in the shareowners’ interest. It’s in everybody’s interest. The company that creates tons of shareowner value will employ more people, pay more taxes, and serve more customers— all while enriching shareowners, who nowadays are most likely ordinary citizens who need their pension funds and mutual funds to perform well in order to pay for retirements and college educations. Failing to create superior shareowner value means none of these good things will happen.

Now a number of leading companies—including Dell Computer, Toronto–based Royal Bank, Fidelity Investments, Best Buy, Britain’s Tesco, and others—are getting a grip on their portfolio of customers and managing it to build substantial competitive advantages. What they are doing contributes powerfully and quickly to topline growth, profitability, and a rising share price. The risks of not putting customers at the center therefore become unbearable, and companies that don’t do it will face an ugly future. Companies that do it ahead of their competitors will position themselves to dominate.

We must declare up front that this isn’t easy to do. That’s good news and bad news. The bad news is that it will strain your organization and require a lot of work. The good news is that it will probably be just as hard for your competitors. The even better news is that putting customers at the center offers significant first-mover advantages. So if you can do it first, your company may be able to establish competitive advantages that will last an extraordinarily long time.

Why You’re Not Really Customer Centered
What we’re asserting here is much more far-reaching than you may be tempted to think. We can hear you (or your boss) objecting: “We already do this!” The fact is most managers will insist they already put customers at the center. “We put our customers first!” and “We’re committed to our customers’ success!” claim virtually all companies. Indeed, customer centric is one of the loudest business buzzwords of the era. One of America’s largest retailers, which we’ll identify in a moment, claimed in 2001 to have just three “strategic imperatives,” one of which was “creating a customer-centric culture to better satisfy and serve our customers.” A Wall Street analyst reports that one of this retailer’s top executives told him at the time, “We have a heightened sense of urgency and a clear focus on the customer, and we are working as one unified team to make retail history!” Which retailer was this? It was Kmart. We have to admit the firm did make retail history: In 2002 it filed the largest bankruptcy petition of any retailer, ever. The claims of customer centricity at most companies are an outright fraud. These companies don’t put customers at the center—not really, not as if they truly mean it, not like we’re talking about. If you doubt that, ask three questions:

1. Who in the company “owns” the customer? That is, which one, specific, identifiable person is responsible for understanding a designated customer or customer segment thoroughly, for figuring out those customers’ total needs and desires, and for figuring out and executing a value proposition that meets them better than the competition, driving the share price as a result? At most companies the answer is: no one. Or rather, more insidiously, the proudly declared answer is, “Lots of people own the customer!” But when a number of people have responsibility for any given customer, the truth is that nobody owns him. Probably not one of those people is responsible for the customer on behalf of the whole company. Instead, each probably represents only a part of it, most likely a product or a function or a territory. Employees in any of those organizational areas may say they own a given customer, but they can’t all own him. In fact, they are responsible only for those needs and desires of the customer that happen to intersect with the employee’s area of the organization. Does this arrangement seem logical? It does to the vast majority of companies everywhere, which are organized in exactly this way. Just remember that it is precisely what got the Bank of Outer Mongolia into so much trouble.
2. Who is accountable for the profitability of any given customer or customer segment? Again, the answer is usually: no one. In fact, as we will see in shocking detail very soon, most companies don’t even know how profitable any customer is. It’s ludicrous to claim you’ve put customers at the center if you don’t know which ones are making you money and which ones are costing you money, and no one is in charge of managing profitability through creating, communicating, and executing value propositions.
3. How significantly does the company differentiate its interaction with different customers? Companies that put customers at the center don’t treat them all the same. On the contrary: These companies understand the importance of a mutually beneficial value exchange, treating different customers very differently because they know that customers have widely varying needs and desires. Meeting these needs better than competitors offers the company the opportunity for earning superb profits, thus turbo-charging its stock. To treat all customers the same makes no sense—yet many companies try hard to do just that and even try to claim that it’s a virtue.

For most companies, answering these questions in a customer-centered way amounts to a deep reconception of how they do business. It’s a real mind bender for many business people, but the companies doing it are hardly the ones you’d think of as radical. Royal Bank is 138 years old and has 10 million customers. Dell Computer is the world’s largest maker of personal computers. Fidelity Investments is one of the world’s largest sellers of mutual funds. The surprising fact is that many of the companies at the leading edge of a clear trend toward putting customers at the center are big, established—and producing spectacular results.

Remember Where the Money Comes From
Putting customers at the center has always made sense for a simple reason that seems so obvious it wouldn’t be worth saying except that managers continually forget it:

Customers are where the money comes from. We will return to this simple but profound truth a number of times because it is, after all, the ultimate reason for putting customers at the center. Ignoring it will almost always get a manager into trouble, if only because it will render him unable to maximize profitability.

Consider: If your company is organized around products, then top management makes decisions based on measures of product revenue or product profitability. But that is not really what management most needs to know. Why? A major retailer with which we worked was earning a handsome profit selling certain dresses to Customer A and losing money selling those very same dresses to Customer B. The reason was that Customer B demanded an enormous amount of the salesperson’s time, made lots of returns, was always unhappy with alterations, causing rework, and always paid her house charge account promptly—a potential demon. If the retailer had known this, it might have found ways to turn that demon into a profitable angel, perhaps by discouraging returns (“Let’s make sure this is the right size, shall we?”), by offering a broader selection of sizes to replace problems with alterations, or by offering the customer highly profitable products (shoes, handbags, belts) that would logically go with the dresses but that she hasn’t been buying.

Most companies, however, amalgamate all their financial data into a measure of product revenue or profitability. As a result, the clueless product manager in charge of those dresses just keeps trying to sell more of them, and her efforts—repositioning the garments on the sales floor, motivating sales and alteration people, running advertising, and sending out mass direct mailings—may very well cause Customer B to continue behaving in an unprofitable way, dragging profits further downward. Because product managers typically have no idea which customers are profitable and which ones aren’t, they waste lots of resources on the wrong products and customers and leave vast amounts of money on the table by not fully meeting customers’ needs.

The benefits of putting customers at the center go far beyond fixing unprofitable customers. When accountable operating executives focus on customer segments rather than on products, functions, or territories, their behavior changes. Rather than just trying to sell more of the product or service for which they’re responsible, they try to fulfill more of the customer’s total needs. In the previous retail example, the accountable executive focuses on customer segments. She may discover that some of the highest profit potential customers may be petite Asian women who require extensive, expensive alterations due to lack of appropriate sizes. Fixing this problem could easily spark huge increases in profitability through lower costs and increased revenue.

Rather than trying only to take product market share away from direct competitors, managers try also to capture more of specific customers’ total spending. Their perspective—and the company’s opportunities for profit—expand enormously. This observation leads us to the third of our three vital principles:

Principle No. 3: Companies enhance customer profitability and drive their stock by creating, communicating, and executing competitively dominant customer value propositions.

Consider our bank customer. For the Bank of Outer Mongolia, this story is even more tragic than it first appears. Not only does this customer trade lots of securities through the bank’s brokerage operation, he also does loads of trading through other institutions as well. He maintains big cash balances at the bank but also elsewhere. He buys insurance, but not through the bank. Someday soon he will need trust services. He’d like technical help getting his whole financial life on-line and would be happy to pay for it, but he doesn’t even know where to start. In short: huge opportunities for the bank.

Needless to say, no one at the bank knew any of this. Yet someone there could have known all of it and more, either through third-party data sources or simply by paying attention to the customer. (For example, just knowing how much money he made by trading should have tipped off managers that he wasn’t keeping all his cash balances with the bank.) Armed with this knowledge about the customer’s specific needs, the relative importance of these needs, and the degree to which competitors were meeting them, the bank could have put together a knockout customer-value proposition to attract all of this customer’s financial services business: lower commissions and faster execution on his trades, lower interest rates charged on his margin debt, higher interest rates paid on his cash deposits, a better deal on his mortgage, lower premiums on his insurance, technical help getting his finances on-line, and trust planning—the customer would have been better off in every way. We’re well aware that if it isn’t careful, the bank could discount itself to a loss. But in this case the bank could have been much better off because it could have more total business and more total profit from this customer even after allowing for discounts. Indeed, if the customer’s primary need was saving time—one-stop shopping with a single, high-quality point of contact—discounts might not have been needed. His relationship with the bank would be so deep that competing banks would find it almost impossible to pry him loose. Because the bank would know him so well, it could offer him products and services tailored to his needs, on which the margins would likely be substantial. The customer would be such a fan of the bank that he’d help generate new business through friends, family, and business associates. The bank would be more profitable immediately and for years in the future.

But of course none of this happened.
This customer went to the head of the bank’s retail operations. He called him and told him this story. Yes, said the executive, it sounded all too familiar. He’d love to do something about the situation. Trouble was, every idea for addressing the problem seemed to take power away from the managers who ran the product fiefdoms— mortgages, brokerage, etc.—so they found ways to kill every proposal. Because this bank puts products at the center, not customers, it never came within a million miles of realizing its huge opportunity with this customer or the thousands like him. Nor does it even realize how awful its performance is, since it measures itself against other similarly awful institutions and therefore thinks it’s doing fine. Heaven help it if Royal Bank ever comes to its turf.

Acknowledgments vii

Chapter 1
The Trillion-Dollar Opportunity You’re Missing 1
What It Means—and What It’s Worth—to Be Truly Customer Centered

Chapter 2
Will This Customer Sink Your Stock? 34
Understanding How Your Average Customer Creates or Destroys Shareowner Value

Chapter 3
The Astonishing Truth About Customer Profitability 45
The Surprising Things You Discover When You Learn How to “Deaverage” It

Chapter 4
Managing Customer Profitability the Right Way 60
What Your Real Goal Is and a Practical Scorecard to Track Progress

Chapter 5
Organizing Around Customers 91
Why Do It and Why More Companies Don’t Do It

Chapter 6
The Right Way to Segment Customers 118
Reconceiving Your Company as a Customer Portfolio

Chapter 7
Knowing and Winning Customers 139
The Beginning of Value Proposition Management

Chapter 8
Driving It to the Ledger 163
Making Value Proposition Management Pay

Chapter 9
Becoming Truly Customer Centered 177
The Nuts and Bolts of Making It Happen in Your Organization

Chapter 10
A Better Way to Do M&A 199
How to Stop Takeovers from Making Shareowners Poorer

Chapter 11
Your Action Plan 220
What to Do on Monday Morning

Notes 231

Index 237