Managing Unprofitable Customers

Inside edge strategies, in particular, can be effective at targeting unprofitable customers and helping to rectify the issues they cause. You can either cut out deadwood or directly make the problematic accounts more profitable. From an edge-oriented lens, this means identifying the parts of a core offering that customers do not universally appreciate. Once identified, you can selectively unbundle these elements so that they are no longer standard across the entire customer base. Importantly, this step does not necessitate that you reduce the base price in the newly de-contented standard offer.

Once you have made this distinction, you can charge for these marginal elements à la carte. The introduction of these options can actually create a very equitable situation. Customers who don’t value these elements don’t have to buy them, while those customers who do value them will now be asked to pay. Take the example of W.W. Grainger, a $10 billion distributor of maintenance, repair, and operating (MRO) supplies.¹ From safety and security supplies to lighting and electrical products, from hand tools to cleaning supplies, Grainger helps its customers get what they need to run their businesses.

Grainger builds service-level agreements with its customers around exactly what supplies it delivers where and when, and with what frequency. Nevertheless, some customers will be good and others bad, and not merely in terms of how promptly they pay their bills. Given the varied nature of their order patterns, different accounts will end up generating very different levels of profitability for Grainger. For example, rush orders, returns, and restocking activity all layer tangible cost on top of the base distribution model. Grainger can absorb a certain level of this irregular activity and could choose to go even further and tolerate outliers under the banner of good customer service. Alternatively, the company can identify which costly elements most affect its account profitability and unbundle them accordingly. In each year that a company like Grainger reevaluates variable-value elements, assessing which it should carve out and how much it should charge, results in one of three customer outcomes.

The first outcome is a protected set of accounts. This set comprises such important customers that Grainger is willing to underwrite some level of nonstandard, costly service, regardless of how much these customers value it. These customers pay for themselves, and the company needs to be careful not to antagonize them. For those who value the elements in question, Grainger creates a loyalty incentive by ascribing value to an extra level of service that they happen to enjoy for free. Grainger also explicitly demonstrates, by charging others for these elements, that customers who do not require this extra level of service are not directly subsidizing those that do.

The second outcome is a set of accounts for whom the economic equation changes. These customers now pay enough to cover the cost of providing the elements that previously made them unprofitable. Either they can pay Grainger extra for, say, restocking supplies, or they can modify their behavior to demand less of this costly activity. This group now produces an acceptable margin, but only because of the inside edge strategy that required them to pay more. This clearly changes the deal for them, and you must handle communication carefully. The important thing to remember is that inside edges do not result in the imposition of mandatory fees. Instead, they create a distinction between a basic option that is clearly acceptable to many, and voluntary options that can be used to build a fuller-service solution. The fact that you must charge for variable-value elements that were previously given away makes this the most awkward of all edge strategies to implement. Nevertheless, this change is justified when it provides a more sustainable economic situation.

The third outcome is a set of customers who were previously unprofitable and now choose to defect rather than pay a new à la carte charge tied to the variable-value element. The fact that they leave may be painful to watch, but it can ultimately be a very good thing. Imagine that one of Grainger’s customers demanded expedited shipping four days per week, driving significant real cost and opportunity cost. Unbundling expedited shipping and charging for unplanned truck rolls would be an appropriate response. That way Grainger could be fairly compensated for the nonstandard burden of servicing the customer at that level. If that customer chose to walk away instead of paying for the extra level of service, we don’t suppose that Grainger would mind. In the same way that you would shut down an unprofitable factory, close unprofitable stores, or terminate an unprofitable product line, so too should you aim to reduce the number of unprofitable customers you serve.

In our study of the world’s largest companies, we found that 8 percent employed an inside edge strategy of this sort.² The impetus for de-contenting or unbundling the offer is nearly always margin compression. But this is really a mechanism to segment customers based on profitability. We have also found evidence of this strategy, most prevalent in financial services, in sectors of the economy as diverse as industrials, consumer staples, and health care.³ In the pages that follow, we profile how the US airline industry used this strategy to fundamentally transform its economic position.

How the US Airline Industry Found Its Edge

Ever since Leonardo da Vinci started sketching designs for flying machines in his notebook, aviation has attracted bold, blue-sky thinking. But since deregulation in 1978, airlines in the United States have done everything Da Vinci could have asked of them, except make money.⁴ Between 2001 and the end of 2008, for example, no fewer than fifteen US airlines filed for bankruptcy.⁵ Around 2008, however, something unexpected occurred. Airline performance suddenly leveled off. In the past few years, profits have become positive across the industry, and market capitalizations are soaring from prior lows.⁶

So what happened? The turnaround can’t be attributed to a bold initiative such as new carbon-fiber aircraft, the pioneering of new markets, or even low-cost innovation. Rather, it was the result of something far more modest: the slicing of airlines’ base offerings into customizable options and extras. For many airlines, this simple innovation was the difference between survival and insolvency. For us, it provides the quintessential example of an inside edge strategy applied to combat margin challenges.

Toward the end of 2007, John Tague, a rising executive and future president of United Airlines, the third-biggest carrier in the United States, held a series of meetings with his leadership team at the company’s sprawling Elk Grove campus near Chicago. For much of the previous five years, Tague and his team had battled to get United Airlines out of bankruptcy and back into profitability.⁷ By 2006, they had achieved this goal, but their work was far from complete. In fact, by our estimates, the vast majority of airlines worldwide had failed for years to return their cost of capital to investors. And against this sick-industry backdrop, United, Delta, and American Airlines were among the lowest of the low on the basis of economic profit (operating income adjusted for a capital charge) of a total of eighty global airlines that we analyzed.⁸

The price of oil had started to spike upward. In January 2007, Brent crude was $54.30 per barrel, but by the end of the year, it had risen to $91.45.⁹ Fuel was already a significant cost for the airlines, accounting for around 25 percent of United’s operating expenses at the time.¹⁰ So a doubling of the oil price could have been catastrophic. Also, in the wake of the financial crisis and the onset of the Great Recession, businesses slashed travel budgets, and the cost-conscious leisure segment opted to travel less. The word “staycation”—spending your holiday at home—joined the common parlance. In 2007, United’s passenger revenue was $15.3 billion, but had commenced a two-year, 22 percent downward march.¹¹ The airline was shrinking as quickly as it could to right-size its capacity to a “new normal” level of market demand, but margins were not only declining; they had turned negative again.¹²

Having recently emerged from bankruptcy and unable to maintain strong economic performance in a dog-eat-dog industry plagued with low barriers to market entry, extraordinary capital costs, and margin-eroding price transparency, United had to determine how to keep flying profitably. To combat an untenable situation, Tague and his team devised a series of what we would term edge strategies. Central to this thinking was challenging the inside edge of the offer and creating options designed to turn unprofitable customers into profitable ones. With the pressure for action at an all-time high, Tague decided to accelerate the introduction of a particular change that he knew would be the most controversial: the now-notorious checked bag fee.

In those days, a typical airfare covered the cost of traveling from point A to point B. It also allowed passengers to take up to two bags per trip. The cost of supporting this is significant; from the moment you check your bag, it is tagged, scanned, and sent via conveyer belt to be handled, sorted, and loaded into the belly of a plane, often with little elapsed time before takeoff. At the other end of the flight, much of the process is reversed before you collect your belongings at baggage claim. The multiple airline employees who touch the bag cost money. The IT systems, conveyers, and vehicles must also be operated and maintained. A customer service staff is employed to clean up after inevitable logistical service failures. Finally, there is the incremental cost of jet fuel for each checked bag, the weight (up to fifty pounds) of which must be carried into the air two to four times per round-trip ticket (depending on connections).

The logic of applying an inside edge framework here is self-evident. The cost of United’s defined service provision exceeded the average revenue it could collect, forcing it to revisit the very definition of its core offering. An obvious place to look, in retrospect, was a segmentation of customers based on how lightly they pack. Bags cost money, but not everyone needed bag-check services. For example, the highest-yielding passengers, business travelers, often didn’t check bags at all. Yet in a one-size-fits-all model, those who didn’t want this service effectively subsidized those who did. So, in February 2008, one month before the oil price broke through the $100-per-barrel barrier, United announced that passengers could continue to check one bag for free, but if they wanted to check a second bag, they would be charged a $25 fee.¹³

United took great care when implementing the strategy to protect its more valuable customers. Basically, if you were a profitable customer for United, almost nothing changed for you. Those who gave the company consistent business were likely already “elites” in United’s Mileage Plus loyalty program, and they were exempt from any charges.¹⁴

Most importantly, business is business. Margin pressure forced United to make some hard choices, and it demonstrated that it was willing to make a conscious trade of some consumer backlash in exchange for a rational and, arguably, more equitable structure. Parsing out the inside edge of the business proved a more strategic way to square the circle of profitability than many slash-and-burn alternatives. At their heart, edge strategies deal with different customers differently.

While much is credited to industry consolidation, ancillary revenue remains the difference between profit and loss for the airlines. Nearly all the major airlines quickly followed United’s lead and went on to differentially price for both first and second bags.¹⁵ While many consumers decried the loss of their windfall, it is questionable whether it has actually hurt the airlines much. One airline, Delta, actively managed perception with a marketing campaign focused on how it was reinvesting billions into the customer in the form of value-added capital projects and, ultimately, a better product.¹⁶ According to J.D. Power and Associates, a researcher of consumer satisfaction, Delta now has better customer feedback than it did before the institution of bag fees.¹⁷

Then there are the economic results. In 2014, according to the US Bureau of Transportation Statistics, US airlines earned $3.5 billion in baggage fees. Between 2012 and 2014, ancillary revenues averaged approximately 2 percent of total operating revenue, but delivered an astonishing 37 percent of industrywide operating income.¹⁸

A Platform for Further Innovation

This edge mindset also paved the way for many outside edge innovations. The more recent evolution of this optionality has focused on the techniques we described in chapter 5—upselling passengers to an improved experience. Application of the outside edge mindset has led to selling fast-track boarding, lounge access, extra legroom, and premium food and beverage choices. In 2014, the major US airlines earned an estimated $15.4 billion from such “ancillary revenue” alone, grown from a negligible base eight years prior.¹⁹ Since the capability to provide these services was often already in place, all the airlines had to do was provide passengers with an ability to buy them.

Characteristic of the edge strategies we have outlined, these relatively incremental efforts proved highly profitable. United, along with some of its rivals, has seen its fortunes rise dramatically. From 2003 to 2007, when they were digging themselves out of bankruptcy, United and Delta sat at the foot of our economic profit performance table (see table 6-1). By contrast, from 2009 to 2014, both United and Delta ranked at the top of the table, ahead of Emirates, Southwest, and more than seventy other airlines that previously outranked them.²⁰

Breaking the Service Bundle

In chapter 5, we discussed how services could be layered onto a core offering to create an upsell opportunity, charging more and delivering more only to those who value the added-on elements. Yet what if the services are already included in the standard offering but, again, not universally valued?

As in the prior discussion, we are still solving an optimization equation in a world where the end goal is more profitable customers. However, while one application of the edge mindset is manifested in pricing strategy (charge more for doing more), another approach is to simply reduce the product or service cost to create an economic surplus (charge less, but do less). This involves pulling the cost lever (as opposed to the revenue lever). As in upselling, a mismatch of your core offering exists with the customer permission set for at least a subset of customers. Like upselling, you also start by redefining—and therefore redesigning—your core offering to address this asymmetry. But in this case, you engineer a smaller or de-contented offering. Stripping away services at the edge of your product or journey and making them separately salable allows more precise calibration to different customer segments. In this way, self-service is an inside edge response to margin pressure.

For example, take the case of gasoline stations. While self-service gasoline is a market standard in the United States today, this was not always the case. The original core offering included an attendant to not only pump your gas, but also wash your windshields, check your oil, and then take payment.²¹ Going back in history to when this inside edge strategy was deployed provides interesting insight into the motivations and execution of a now intuitive de-contenting strategy, one that ultimately proved highly customer-friendly.

Using Self-Service to Increase Margins

Pumping gasoline is a very low-margin business. For every gallon of fuel, a gas station makes a profit of just three cents, equating to a profit margin of 1 percent or less. However, 80 percent of gas in the United States is distributed via gas stations with convenience stores. While these stations still generate more than two-thirds of their top line revenue from gas sales, two-thirds of their profit is derived in other ways, such as selling snacks, coffee, and other items to the people buying the gas. It’s not surprising that over the years, they have worked to innovate and evolve the core model.²² The initial shift took place by redefining the edge of this core service with the arrival of self-service pumps. The story begins in 1947 at Frank Urich’s convenience store in Los Angeles.²³

A born entrepreneur, Urich opened the world’s first self-service gas station. This was long before automation, so he still required some attendants, typically gliding from pump to pump on roller skates collecting cash and resetting the meters for the next customer.²⁴ But the reduction in labor costs was significant and meant that Urich could offer his customers a better deal.²⁵

Yet, for all this, the gas stations that offered full service continued to dominate the business.²⁶ It helped that these were mostly owned by deep-pocketed oil companies that spent a fortune lobbying state regulators to prohibit their self-service rivals.²⁷ Two years after Urich’s pioneering move, New Jersey was persuaded to prohibit self-service gas stations. They are still banned there.²⁸

Despite technological improvements, skepticism about self-service continued to reign. In 1966, two years after the introduction of automated pumps, there were still just seventeen states that permitted self-service gas stations.²⁹ Also, many proprietors did not think customers would accept a reduced service.³⁰ Why would they want to get out of the car to fill up the tank when there was someone ready and willing to do it for them?

Then came the tipping point for the industry. In March 1974, when the OPEC oil embargo was lifted, oil prices had quadrupled to $12 per barrel.³¹ Contrary to popular perception, gas stations do not do well when the price of gas rises quickly. A highly competitive industry, gas stations are forced to reduce their markup when their wholesale cost increases, leading to a lag before wholesale price increases translate to retail prices, putting margins under severe pressure. Moreover, the shock itself resulted in an elastic response from economically strapped consumers.³²

Margin compression forced gas stations to revisit the successive self-service edge strategies they had tried in the past. The solution to flagging industry profits could be solved by fractionating the cost of serving different customer groups, depending on their varying need for the service element that had long accompanied fueling. The tide shifted. By 1982, some 72 percent of all gas sales came from self-service stations, up from just 16 percent in 1969.³³

Importantly, the innovation required a relatively minimal investment in the new technology. Imagine you own a station. The location is already selected on a well-trafficked route, the regulated underground tanks are already approved, and the convenience store is already in place. In this case, the incremental dollars to create an automated option would be relatively modest, but it would enable a very different cost structure. Interestingly, this example is a case where the stripped service model proved even more popular than the fully loaded original. Self-service now accounts for about 90 percent of US gas sales. Unpacking services from what was previously bundled creates a customer choice that is a true win-win. The self-service model lowers the cost to the consumer by approximately 10 percent.³⁴ For the operating stations, it simultaneously results in a doubling of daily gasoline profit.³⁵

As we observe increasing efforts to bring self-service checkout to the worlds of grocery stores, home improvement stores, and other retail settings, we are witnessing not only the march of technology but analogous applications of the same phenomenon we saw in gas stations. In an overbuilt, declining comparable-store-sales environment, retailers of all sorts also face severe pressure on already razor-thin margins. By unpacking their own service bundles, they are challenging the inside edge of what it means to be a retail distributor. Transacting doesn’t necessarily require a human touch, and if technology can reduce labor cost and, in some cases, increase customer satisfaction through expedited checkout, then what is now sporadically offered as a choice may soon also become the predominant market standard.

Using Self-Service to Preserve Margins

What is the fundamental cause of margin pressure? Typically, it is a function of one or both of two forces working against your organization. In the first instance, cost creep has imposed itself upon your corporate fabric, meaning that the increasing complexity of delivering your core offer, often as a result of growth, no longer adheres to the original business model. The second cause is increased competitive rivalry; others have sufficiently mimicked your offer such that the balance of pricing power has shifted out of your favor and back to the customer. In either case, it is unsustainable to continue along the current path.

As we have tried to underscore, any edge-based solution to this problem must begin by analyzing your offer through the eyes of your customer. The medical device world provides a fascinating example of companies doing just that. By deeply investigating the components of their offer from a customer perspective, some of these organizations are challenging their product and journey edges to combat forces threatening to erode their profitability.

Take, for example, Smith & Nephew, one of the leading manufacturers of knee and hip implants. The company is one of five major players that collectively control 95 percent of the US hip and knee replacement market.³⁶ Sales reps at device makers like Smith & Nephew have traditionally had a major presence in the operating room—helping surgeons select the appropriate tools for procedures. This is an important role. Sales reps consult with the doctors immediately prior to an operation, bringing multiple implants and advising what devices might work best. It is not uncommon for the rep to help doctors navigate more than a dozen product trays in a single surgery, each with hundreds of instruments.³⁷

Health-care reform has created margin pressure on the hospitals that are Smith & Nephew’s clients. Declining reimbursement rates, lower-cost procedures, and payor pressure have all contributed to significantly increased cost-savings targets, and they have started to look carefully at their partners. The high-value sales rep support that Smith & Nephew provides these hospitals is extremely costly; it generally accounts for 40 percent of the final price of an implant.³⁸ Hospitals have noted this and have started to push back.

Smith & Nephew could have responded in the form of pure discounting, compromising its margins and inviting competitors into a devastating price war. Worse, once price is lowered for some hospitals, it would become exceptionally hard to hold it for others. However, by revisiting the scope of its core offer, Smith & Nephew discovered an inside edge that it could parse out. Not every hospital valued the sales rep service equally. Some found the service less valuable, as they had developed in-house capability to assist surgeons with tool selection. Some had also started to become wary of having suppliers so close to clinical decisions. Others had merely started to bristle at paying for bundled selling. Whatever the reason, there was clearly an opportunity to pioneer a model where, in exchange for a reduced price, sales reps no longer provided technical support to operating room staff.

Smith & Nephew’s “rep-less” program is called Syncera. When announcing the new sales model during a July 2014 investor call, the company estimated that its hip and knee products would be sold for a 30 percent to 40 percent discount through the program and that 10 percent of its customers would participate in the new model. Syncera offers only past-generation products and does not include direct sales rep support. This version of the product will use an iPad app, instead of human hand-holding, to help surgeons navigate tool selection.³⁹

The paradigm shift is spreading across the industry; numerous surgical device companies seem to either be considering or outright embracing it.⁴⁰ The approach is not expected to cannibalize mainline sales and is aimed squarely at preserving margins. “We feel the model can coexist with the traditional model,” said Stuart Morris-Hipkins, general manager of the Syncera business for Smith & Nephew.⁴¹

Like many edge strategies that require reconditioning customers around new product definitions, it is accretive at the industry level and improved by wider competitive adoption. The rep-less model has reduced costs for both the suppliers and their hospital customers.⁴²

At the time of writing, this shift is very new. The jury is out on whether this will stick permanently or will alone be enough to stem the tide of margin pressure for implant suppliers. Regardless, it is a highly innovative approach. It applies a classic inside edge mindset to the core offer and effectively creates options that heretofore did not exist. Other manufacturers have introduced different inside edge strategies aimed at reducing their footprint (for example, remote teleconference, drop shipping, direct shipping). We believe we are seeing the beginning of an exciting wave of strategic moves applied in an effort to, as our health-care partners say, “bend the cost curve.”⁴³

Vignette: A Nonprofit Application in Cash-Strapped Schools

An unfortunate consequence of the Great Recession is that many US municipalities face severe budget pressure. Tax revenue decreased, state funding was curtailed, and massive cuts in school funding resulted. This shortfall existed in the context of ever-rising school expenses. By some estimates, the average cost of educating a student had skyrocketed by over 40 percent in the two decades preceding the crisis.⁴⁴ This is the public-sector equivalent of margin compression or, more precisely, of operating deeply in the red.

Many school districts reconciled this by simply cutting whole departments (music and foreign languages were typical candidates) or by deleting entire sports and extracurricular programs.⁴⁵ By contrast, other schools addressed the issue in a different way, by finding and isolating the inside edge of the core educational offer. The strategy on the part of these latter educators was to challenge the one-size-fits-all model, reduce the level of foundational content, and then allow those who most value the newly classified elective services to buy back in. “Students have to realize, as our country is realizing, that you can’t have everything,” said Randy Stepp, superintendent of schools in Medina, Ohio. “We all have to make tough choices.”⁴⁶

Given that different student segments have intrinsically different needs, this sounds like an inside edge approach to us. The interesting thing about these elective charges is that they are, by definition, optional. Students are not charged for English or math. In some cases, the incremental cost to the “customer” is zero. If your child never had any intention of taking French or running track, then nothing has changed for you. However, if a parent views these as essential to a child’s upbringing or college-prep plan, she still has an option to buy back in to the more robust suite of offerings that was previously available. While this à la carte model has proved controversial, we would argue this is a far better solution for everyone than an alternative that many districts have taken to simply reduce the scope of education for all.⁴⁷

The point here is not that everyone is better off; life is filled with challenges for which there is no quick fix. But applying an edge mindset can create an equitable construct to accommodate needed cost reduction, where less of what matters is lost by fewer people. In the words of Collene Van Noord, superintendent of schools in Palmyra, Pennsylvania, “If we can pass on the added costs for some of our more expensive courses to direct users, it seems more fair than to pass them on to the entire community [in the form of tax hikes].”⁴⁸

Practitioner’s Notes

• The trouble with many core offerings is that you are, in effect, giving away parts of your products and services for free to those who don’t value them. You can be left with some unprofitable customers, which is certainly undesirable and may be unsustainable in the long term. As we saw with upselling opportunities, margin compression often forces us to view and ultimately treat customer segments differently.
• Inside edge strategies, in particular, are promising mechanisms for combating margin pressure. Fundamentally, this is a calibration exercise.

  – If a significant number of customers demand features and attributes that are less than the standard offer, then the edge of the product can often be better mapped to a new de-contented state.

  – At that point, the company can either capture the surplus and charge more (fees) of those who want more than the new standard or do less to reduce the overall cost of service.

• In the case of “do less” inside edge opportunities, the organization can either capture all of the cost savings for itself or share some of the newly found economic surplus directly with the customer in a win-win proposition. In situations where the organization keeps the surplus, it can still share benefits with the customer indirectly via increased investment in improving the core offer.
• Finding the inside edge often starts by challenging whether each of the features and attributes that are part of the core product is really equally valued by everyone.

  – Features that are not universally valued (and exceed the redefined minimum) are candidates for strategies that involve product redefinition.

  – Customers that only value the true minimum typically experience no change with the introduction of a de-contented product or service.

  – Other customers, who are intrinsically less profitable, must support the incremental cost they are driving by buying back into the fully loaded offer.

  – Customers who are already highly profitable should be treated separately and not charged for the decoupled features.

• In a world of constrained resources, edge strategy creates constructive choices that allow more people to ultimately get what they want. Even if some people are a bit worse off economically, they are better off having a choice of whether to experience less of the offer or to buy back in; the alternative is a blanket judgment that leaves many people categorically worse off.