By Hongjie Wang, Fulcrum
The Pareto principle, also known as the 80/20 rule, was named after Italian economist Vilfredo Pareto, who observed that 80 percent of income in Italy went to 20 percent of the population. Interestingly enough, such phenomena occur in many disciplines and industries. Marketing is no exception, so much so that Pareto analysis has become one of the standard must-haves in customer analysis.But in performing Pareto analyses on customer profitability for financial institutions, we have identified important questions that financial services marketers should consider.
Yes, we usually see a small percentage of customers responsible for almost all the profit. No surprise there. Some consumers are heavy buyers and some are light buyers, and financial services is no exception to this rule. While the degrees of concentration may vary from product/industry category to category, the existence of concentration is common.
But often, the same pattern keeps emerging. Why doesn't the percentage of unprofitable customers reduce over time, despite financial institutions' identifying unprofitable customers and taking innovative measures to fix this imbalance?
Are we focusing on the right issues? First of all, we need to interpret profit concentration cautiously. Many Pareto analyses we have observed do not consider customer tenure and the time dimension. For different product categories and in varying time periods, it could be that different customers are responsible for the concentrated profits.
We also need to recognize that a customer's profitability changes over time. It is driven by intrinsic customer characteristics, as well as many contextual and situational factors. From a CRM standpoint, we need to be careful about investing heavily in customers that are not persistently profitable. Understanding profitability requires a time-based analysis rather than a single snapshot.
Third, for any company performing such analysis, we need to realize that unless this company has a dominant market share, we often only observe a partial picture of customer behavior and spending. This is why share of wallet is so important in CRM-many of these customers in the bottom 80 percent could be very profitable, if we can win them over.
How do we define profitability? Profitability as a metric might not be as concrete and definitive as it seems. It is relatively difficult for marketing or CRM to define profitability by considering all costs and sometimes, even revenues. For example, many fixed costs are usually not allocated to individual relationships, for good reason: they are a structural expense of the business that will exist so long as the company offers its particular products and services.
There is also the issue of fairness. As an executive from a grocery retailer recently pointed out to us: "It is one thing that a customer cherry-picks deals all the time, and it is quite another if she buys lots of bakery products. But my bakery department is operating at a loss due to labor costs. It is not her fault that her profitability is low, yet I need to offer a bakery department, even if it operates at a loss."
Finally, we should not overlook the fact that unprofitable customers may contribute positively to the overall portfolio value, because of the economies of scale. For example, if a bank decides to "fire" its bottom 80 percent of unprofitable customers, unless it can replace these customers with profitable prospects, it will need to cut expenses sharply by reducing services, hiking fees, and closing branches to make the remaining 20 percent customers profitable. Following this logic would likely result in a death spiral. So, in a sense, a certain portion of that bottom 80 percent unprofitable segment should be considered part of the cost of doing business.
Make Pareto work smarter To be more accurate and effective, Pareto analysis should tap into these key areas of customer information:
1. Understand the fundamentals of the analysis, particularly on how such concepts as "profitability" are formulated. Changing the underlying definition affects the distribution of customers in your analysis.
2. Consider time-based factors. If you perform a cross-sectional analysis of your customers today, you are likely to find that new customers are disproportionately unprofitable. But is this because your acquisition programs are attracting the wrong customers, or simply that these customers have not had sufficient time to become profitable? Similarly, any individual customer may go through phases where they are more, or less, profitable. In fact, every marketing action affects customer profitability, either increasing it by retaining or growing the relationship or decreasing it.
3. Understand the larger dynamics of your market share. Are some of your less profitable customers giving you a minor share of their spending in the category? Or do they just not consume much at all, because they have no needs? In the first case, there is a significant opportunity; in the second, creating new demand will be difficult.
Banks are re-focusing on customer profitability as a core aim of customer management. But imperfect information may hinder their success. Addressing these critical points can help financial services marketers boost the effectiveness of their Pareto customer profitability analysis right away.
Hongjie Wang is vice president of customer analytics and manages the analytical team at New York-based Fulcrum where he has developed statistical and optimization models, as well as segmentation solutions for a diverse range of clients to support their marketing and management operations.