Balancing Risk and Return in a Customer Portfolio

Abstract

Marketing managers can increase shareholder value by structuring a customer portfolio to reduce the vulnerability and volatility of cash flows. This article demonstrates how financial portfolio theory provides an organizing framework for (1) diagnosing the variability in a customer portfolio, (2) assessing the complementarity/similarity of market segments, (3) exploring market segment weights in an optimized portfolio, and (4) isolating the reward on variability that individual customers or segments provide. Using a seven-year series of customer data from a large business-to-business firm, the authors demonstrate how market segments can be characterized in terms of risk and return. Next, they identify the firm's efficient portfolio and test it against (1) its current portfolio and (2) a hypothetical profit maximization portfolio. Then, using forward-and back-testing, the authors show that the efficient portfolio has consistently lower variability than the existing customer mix and the profit maximization portfolio. The authors provide guidelines for incorporating a risk overlay into established customer management frameworks. The approach is especially well suited for business-to-business firms that serve market segments drawn from diverse sectors of the economy.Keywords: customer portfolio management, market-based assets, financial portfolio theory, return on marketing, market segmentation A lthough risk management is central to financial portfolio theory and occupies much of chief financial officers' time, researchers have given sparse attention to risk in the theory and practice of market segmentation and customer portfolio management. The existing portfolio of most firms reflects incremental and uncoordinated decisions from the past, when they gave little attention to how newly acquired customers contributed to the profitability and risk of the entire portfolio. For example, Homburg, Steiner, and Totzek (2009) find that firms tend to overestimate the value of top-tier customers and underestimate that of bottom-tier customers. In a similar vein, Dhar and Glazer (2003, p. 88) observe that few companies consider "whether all of their individually desirable customers are, from the standpoint of risk, desirable collectively." This practice is at odds with financial portfolio theory, which posits that although assets are selected individually, performance is measured on the entire portfolio, in which there is a tradeoff between risk and return (Markowitz 1952). We theorize that, like a financial portfolio, a customer portfolio is formed by making choices among market-based assets (i.e., customers) that present different risk-reward characteristics and allocating resources to optimize performance (Gupta and Lehmann 2005; Srivastava, Shervani, and Fahey 1998).The purpose of our research is to explore how financial principles of diversification and the tenets of financial portfolio theory can be effectively applied to manage a firm's customer portfolio. We demonstrate how fundamental tools of analysis that professio...

Driving shareholder value with customer asset management: Moving beyond customer lifetime value

“…Some studies discuss the risks related to relationship termination through concepts such as customer lifetime (Reinartz & Kumar, 2000, profitable customer lifetime or duration (Reinartz & Kumar, 2003), and risk-adjusted customer lifetime value (Ryals, 2003;Ryals & Knox, 2007). The authors of a handful of studies (e.g., Stahl et al, 2003;Tarasi, Bolton, Hutt, & Walker, 2011) deliberating the vulnerability and volatility of cash flows, also acknowledge that the value formation for the provider is under risk. However, we decided to leave these two risk management categories-reducing the risks of relationship termination and reducing the risks related to the value formation for the provider-outside our proposed conceptual framework because they essentially mirror some previously identified ways of increasing shareholder value.…”

Outward-looking and future-oriented customer value potential management: The sales force value appropriation role

“…In the business marketing context, various customer portfolio management studies represent a central perspective on managing customer relationships based on their value to the selling firm (Campbell & Cunningham, 1983;Fiocca, 1982;Homburg et al, 2009;Johnson & Selnes, 2004, 2005Ryals, 2003;Storbacka, 1997;Tarasi et al, 2011;Zolkiewski & Turnbull, 2002). The wide range of portfolio models focus on "analyzing the current and future value of a firm's customers for developing a balanced customer structure through effective resource allocation to different customers or customer groups" (Terho & Halinen, 2007;p.…”

“…The managerial focus lies on identification of valuable customers and estimating how various marketing campaigns affect CLV or the total customer equity, by utilizing a customer database or behavior-switching approaches to estimate CLV (see Homburg et al, 2009;Johnson & Selnes, 2004;Rust, Kumar, & Venkatasan, 2011). Interestingly, the importance of estimating the risk associated with customers emerges in all CLV approaches, and is usually approximated through the variability in a customer's cash flow (Tarasi et al, 2011). According to this logic, even if their revenue increases are predictable, customers that are growing are evaluated as more risky than those that are stable, making the modeling approach problematic from the operative sales-potential perspective (see Selnes, 2011).…”

“…For example, many customer portfolio models address the question of the customer's value potential, but mostly in parenthesis (Eng, 2004;Fiocca, 1982; see also Ritter & Andersen, 2014). In turn, the majority of CLV models estimate the future expected value of customer relationships, but only by employing firminternal data from realized transactions, leaving other aspects of value potential open (Mulhern, 1999;Ryals & Knox, 2007;Tarasi, Bolton, Hutt, & Walker, 2011). The backward-looking and inward focus in research is a major limitation, as it can provide a highly misleading picture of customers' market potential (Du et al, 2007).…”

Relationship Characteristics and Cash Flow Variability

“…Tarasi et al (2011) show how the efficient frontier of customer portfolios for a service firm is derived from clusters of business customers with distinctive cash flow patterns derived from ten industry sectors. (See their Figures 1, 2 and 3 on pages 7-9).…”