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SUMMER 2004
Hedging Your Customer Portfolio
Marketing Professor Rashi Glazer on the Lifetime Value of Customers

By Mickey Butts

Professor Rashi Glazer is co-director of the Center for Marketing and Technology and teaches the core marketing course at Haas. He was recently named interim director of the Center for Executive Development. He spoke to CalBusiness about his recent research into customers, portfolio theory, and smart markets, on which he elaborated with coauthor Ravi Dhar of the Yale School of Management in a groundbreaking article, “Hedging Customers,” published in 2003 in Harvard Business Review.

Q: Peter Drucker wrote way back in 1974 that "the customer defines the business," not the brand or the organization, and that the mission of every business is to satisfy the customer. Is that all there is to it?

A: That should be the organizing principle, and I think it's the ultimate test of a successful business. Firms need products and customers, but ultimately the test of a company is if you have a customer, which means someone who's willing to pay for your product. The scare resource, the scarce asset, for a firm is a customer, because the cost of acquiring new customers compared to the cost of retaining the customer is getting astronomical.

Q: You hear a lot in marketing circles about building a brand. That's also an asset -- an intangible asset -- but is the brand as important as what you're talking about in terms of customers?

A: The ultimate asset is the customer. A brand is an aspect of the relationship between the firm and the customer. So from a marketing metrics standpoint, the value of a brand is something that's interesting to know, but ultimately the value of a brand is subsidiary to the value of a customer.

Q: In your HBR article, you talk about lifetime value of the customer. What's wrong with the traditional way of measuring LVC?

A: It's not so much that there's anything wrong with it, but we can push it farther than we have. What we did was to borrow from financial portfolio theory. What's the value of any asset – a stock, for example? It's the present value of a set of cash flows through time. What's the value of a customer? It's the present value of a set of profits from a customer through time.

The normal lifetime value model says the following: Rank your customers in terms of who are the most valuable and then pick the customer who's the most valuable. But the normal lifetime value approach treats each customer independently. The idea of a financial portfolio is about risk – how to put together a basket of stocks. What I try to do is put together a basket of stocks that are correlated or uncorrelated in a certain way, such that if one stock goes up the other stock is likely to go down. That's how I can diversify.

So we say the same thing about customers. When you are computing the lifetime value of a customer, you want to focus not on the value of any one customer by itself, but on the relationships, the interdependencies, between the customers.

Q: You've said that you should add a riskier customer to decrease the riskiness of your overall customer portfolio. That seems counterintuitive…

A: What makes one customer by him or herself more risky is that the uncertainty is greater about what the returns are going to be. One customer, no matter what, every year is going to give me $50. Another customer every year is on average going to give me $30, but some years they may give me $100. That's a riskier customer. I may want to put that customer in my portfolio because it balances it out with the more conservative customer.

Q: In your work, you've also talked a lot about “smart markets.” In these markets, is the customer the asset, or the information about the customer?

A: Ultimately the customer is the asset. The problem is that when you think of an asset, you think of something you own. You don't own a customer the way you own a product. The firm thinks of its products as its assets, with profit and loss by product. What we're saying is profit and loss by customer. What I really own is the information about the customer.

The traditional markets are what I call “dumb markets.” When you say someone's dumb, it means someone who cannot speak. Dumb markets are markets that don't speak. Smart markets are constantly communicating. Information is constantly flowing through the marketplace. The products are constantly changing – and they have high information content to them. Smart markets are highly uncertain. Dumb markets are highly predictable.

The Holy Grail of business in the 20th century was to make your environment as predictable as possible, and if it wasn't, you tried to be as good as possible at predicting what was going to happen, which means avoiding uncertainty. In a smart market, the goal is not to get rid of uncertainty, and not just to live with it. Many firms are embracing uncertainty because that's what gives them a competitive advantage. They can turn on a dime. If anything uncertain happens, their competitors get flustered and don't know what to do. It's great there's uncertainty, because we can move quickly, we can adapt, we can learn.

Mickey Butts is a business editor and writer in San Francisco.



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Professor Rashi Glazer

Professor Rashi Glazer, co-director of the Center for Marketing and Technology


 
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