Choose Your Customer: Three Rules For Maximizing Profits

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We recently met with the CEO of a multibillion-dollar distributor. He had just conferred with his management team about how Amazon and the other digital giants had entered his business and were steadily vacuuming up market share.

This was the third meeting we had that week with CEOs of major companies asking us the same questions:

• How can I defend my company against these aggressive digital giants with overwhelming digital capabilities and price-cutting mentality?

• I’m cutting my costs across the board, but my profitability is dropping—what else can I do?

• How can I identify and invest in growing my real profit core—my business segments which will provide high growth, and remain profitable and defensible against my new competitors?

• How can I align my organization around my profit core and build dominance in my target market segments?

The Age of Diverse Markets

Today, business is transitioning from one major era, the Age of Mass Markets, to another, which we call the Age of Diverse Markets. The two ages could not be more different. While the transition began some time ago, it is rapidly accelerating and the seismic shift is leaving managers scrambling for a practical pathway to succeed in a new, very different world.

The Age of Mass Markets, which extended through most of the prior century, was characterized by fast-growing homogeneous markets. Railroads and roads integrated diverse geographic markets, and many large national enterprises emerged.

These companies were characterized by massive economies of scale in nearly every business function. Both prices and distribution costs were relatively uniform, so reporting tools based on averages—like aggregate revenues, costs, and gross margins—were sufficient. The key management imperative was to get big fast. The rules of thumb were that all revenues were good and all costs were bad.

Today’s Age of Diverse Markets is completely different. Today, there are very few mass markets, and more and more diverse markets where product offerings, pricing, and service packages are uniquely configured, if not by individual customer, than at least by highly segmented target markets.

Throughout our economy, pricing is becoming much more varied, both within market segments and even between one customer and the next. In parallel, the cost to serve each customer is becoming increasingly diverse, depending on the customer relationship, product/service mix, and other factors. This change has already overtaken the B2C markets, and it is rapidly transforming the B2B markets as well.

Today, companies succeed by micro-targeting particular customers and tightly specified market segments, and providing them with tailored packages of products and related services.

In the prior era, companies won with top-down management processes that kept their revenue-maximizing and cost-minimizing functions separate. Today, companies win by choosing customers who fit their strategic positioning and serving them with highly integrated sets of products and services that are delivered through decentralized organizations and processes. In the past, managers only needed aggregate metrics, while today, they need to understand the relationship between revenue and cost for literally every product sold to every customer every time.

The rise of the digital giants originated with their ability to market directly to customers, which enabled them to create micro-segments and to configure offers to individuals at scale using big data and algorithmic recommendations based on captured customer information.

The biggest problem in business today is that all too many managers are doubling down on tactical innovations and tuning up old practices from the Age of Mass Markets—usually with diminishing results. Savvy managers, on the other hand, are realizing that the new disruptors are not winning by doing old things better, but instead by doing new things that incumbent companies are simply not capable of doing with their current ways of doing business.

Three Rules for Maximizing Profits

Three rules provide the cornerstones for maximizing profits in today’s Age of Diverse Markets.

1. Choose your customer. Identify a target strategic group (a set of firms pursuing the same strategy) that is defensible, and will provide high sustained profits. This requires that you utilize transaction-based profit metrics, creating an all-in P&L on every transaction (invoice line), which you can combine and recombine to see the actual profitability of every customer and product. With this detailed understanding, you can determine the precise profit impact of upcoming changes, such as new competitors. This will enable you to create a detailed, defensible strategy.

2. Align your resources. Build the capabilities that will enable your company to be the best competitor in your target strategic group. Your transaction-based profit metrics will enable you to identify your own best practice (most profitable) customers and products, and to understand exactly how the less profitable customers and products can be improved to meet your own best practice.

3. Manage your organization. In the homogeneous Age of Mass Markets, functional command-and-control organizations were ideal. In today’s heterogeneous markets, companies need to provide integrated packages of products and services through decentralized multi-functional teams focused on micro-segments or even individual customers. Companies need to shift to this more appropriate organization.

The pervasive fear felt by so many incumbent company managers is rooted in the false assumption that the currents of change, of which Amazon is emblematic, will completely disrupt industries and leave no place to prosper.

In fact, hundreds of studies of industry profitability in the industrial organization economics literature show the opposite: the most profitable overall industry configuration is one with a relatively small number of competitors, with each having a different strategy, and each being very profitable—some serving small customers, others serving large customers; some offering arm’s length service, others building integrated customer relationships; and so on. In fact, contrary to popular belief, the industry model of a big winner and a lot of losers consistently provides low overall profits to all industry participants.

The Winning Strategy

Today, the winning strategy is “choose your customer.” For example, while Amazon is destroying many traditional brick-and-mortar businesses, the company only has dominant strengths along a few dimensions: arm’s length digital services mostly to small customers with prodigious network effects. This leaves a large, lucrative open playing field.

The overwhelmingly important problem for many managers in incumbent firms is that they are stuck in the obsolete strategic paradigm of the fading Age of Mass Markets in which the primary goal is to maximize all revenues while minimizing all costs. In essence, they are choosing all possible customers, which is no choice at all.

This objective is deadly today because transaction-based profit metrics consistently show that only a small portion of revenues are highly profitable (where the cost to serve aligns with the customer’s profit potential), and that the cost to serve high-profit customers is often higher than average because giving them outstanding service is a great investment.

Today, traditional metrics, such as aggregate revenues, costs and margins—which show managers whether their companies are profitable—actually prevent managers from understanding where they are profitable. While this granular profit knowledge was unnecessary in the Age of Mass Markets, in today’s increasingly heterogeneous markets, it is a life-or-death problem.

Continuing to act on the obsolete assumption that all revenues are good and all costs are bad leads all too many managers to dilute and waste resources trying to hold onto all of their business, rather than adopting the winning strategy: choosing their customers and focusing on building their high-profit, defensible business in their target strategic group.

This is the single most important issue in business today, and most managers do not even see it.

Two Cases

General Electric. Several years ago, General Electric’s aircraft engine business undertook a sweeping transformation that brought it a major increase in strategic advantage, profits and market share.

The business always had a variety of offerings, including engines, spare parts, and a variety of related services. It had innovated by improving and proliferating each of these offerings. The problem was that the company was increasingly vulnerable to niche competitors like aftermarket parts distributors and fixed-base service providers.

In response, the company decided to form a new strategic group by combining its products with enhanced service offerings to create a hard-to-follow strategic advantage.

At that time, the company took a close look at its customers, figuratively “walking in the customer’s shoes,” and determined that what most of the customers really wanted was working aircraft engines, and not an array of individual products and services that enabled that to happen.

Based on this insight, General Electric developed a breakthrough offering called “Power by the Hour,” in which it offered its customers an all-in price that reflected the customers’ engine usage. In this way, it created a customer value footprint that strongly aligned with the customers’ real need. This not only produced powerful sales and marketing advantages, but importantly, most of their competitors, many of whom were niche players with limited capabilities, could not follow.

In essence, General Electric redefined its industry by “drawing a bigger box around its business” —from selling products, to selling products plus services, to selling all-in results—to create a strategic positioning that implicitly defined most of its competitors out of the industry. General Electric chose customers who wanted an all-in service, aligned its functions to provide this package of products and services, and managed to coordinate internally to produce this complex, unique offering at scale.

Nalco. The company, which provides chemicals to water treatment systems, had a problem. It was losing money sending trucks to scattered locations in response to its unpredictable customer orders. Nalco decided to install sensors that could be read remotely in the chemical tanks on customer premises. This enabled Nalco to be much more efficient at routing deliveries. Soon, the company realized that it could stabilize its production as well. But the company didn’t stop there.

Nalco’s managers developed a deep understanding of the customers in their target market. They had many conversations and onsite visits with their counterparts in customer organizations, which enabled them to “walk in their customers’ shoes.”

Through this process, they realized that their innovation allowed it to monitor the actual rate of chemical draw-down and compare it to the expected rate if the customer’s water treatment system were operating at peak efficiency. When the Nalco engineers saw a variance, they would call the water system’s managers and alert them to adjust the system. This routinely led to customer savings many times the cost of the chemicals.

This innovation enabled Nalco to create a unique strategic group with decisive differentiation which even digital competitors with big data and AI could not follow because once Nalco modified a customer’s chemical tank and established its information links with the customer’s engineers, it had an inside track into the account. This gave Nalco compelling first mover advantages and sustained competitive advantage.

This made Nalco indispensable, transforming the company’s positioning from vulnerable commodity supplier to essential strategic partner with strong information and relationship-based barriers to entry. Nalco drew a bigger box around its business, expanding its customer value footprint in a manner that internet-based competitors could not follow.

Nalco created high sustained profits by choosing the customers that had the scale and sophistication to respond to Nalco’s observed improvement possibilities; aligning its resources to develop the data bases and customer relationships to monitor the customers’ water system functions; and managing its organization to deploy and manage integrated multi-functional teams to work with its major customers.

In this way, astute managers use the three rules for maximizing profits to produce both near-term profit gains, and sustained profitable growth into the future.