Posted on Harvard Business Review: November 19, 2010 9:51 AM
Take a hard look at your most profitable customers. Not the biggest, not the best, not the most satisfied: the most profitable.
Then ask your colleagues: Do we make most of our margins from our "smartest" customers or from our "stupidest" ones?
That is, does your firm capture the bulk of its profitability because your customers appreciate the value of what you do? Or because they're (effectively) ignorant or ill-informed and your product and price positioning successfully exploit that?
I once asked that question (in all innocence, I swear) of partners at a top-tier IT consulting shop and caused a fight. The firm was reviewing its growth projections and the PowerPoint with the top-10 client profit margins came onscreen. Several of those margins seemed enormous. So I wondered what was so "strategic" and significant about those contracts that allowed them to command such premiums. One of the younger partners with a well-earned reputation for charming CIOs turned to me and said, "There's nothing strategic about them; we understand IT costs and process consolidation much better than they do. Much better."
I was incredulous. He assured me that between failed outsourcing contracts, the rate of technical change and the usual suspects of organizational dysfunction, most of his most profitable clients had no clue what their "real" IT costs and value-adds were.
That's when I asked my question.
Immediately, a more senior partner piped up to point out that, in fact, at least three of the firm's most profitable clients were in the midst of genuinely strategic deployments both for supply chain and customer relationship management software. These companies, he declared, knew exactly what kind of top-line growth they were going to get from their investments. Their CIOs and management committees were best-in-class, not bozos. That's when they fight broke out. The partners genuinely disagreed over whether their most profitable clients and — more importantly, their best prospects for profit growth — were rooted in strategic sophistication or woeful ignorance.
In fairness, the more vociferously they argued, the clearer it became that the "stupidest" clients weren't quite as ignorant as their consultants made them out to be and that the "smartest" ones clearly had huge gaps in their knowledge.
Then again, "information asymmetry" is often just a politically correct euphemism for "smart vs. stupid." Growing a business based on "knowing much more" than one's clients is different from one in which growth is contingent on one's customers consistently knowing less. There's a reason why procurement arms of global enterprises are constantly pushing for ever-greater transparency from their suppliers. They want to know who gets paid how much for what. They're on the lookout for margin creep that could trigger competitive bids.
But even in an era of greater transparency around costs, the fundamental framing remains valid. Whether someone's selling a data plan for a device, a retirement plan to a couple, or a surgical procedure to an ailing child's parents, it's unlikely that "smart" customers will prove equally profitable as "stupid" ones. Quite the contrary, customer and client segmentation based on "information asymmetries" and "smarts" strikes me as central to the future of most business models. It also begs the question of what constitutes "smarter" and "stupider" customers.
For example, many of Amazon's most profitable customers rely disproportionately on that company's recommendation engines for their additional purchases. Are customers prone to follow recommendations from "people like you" best defined as Amazon's "smartest" or "stupidest?" Are people who buy extended warranties for their mobile phones and laptops "smart" or "stupid?" It's clear in retrospect that many, if not most, of the financial services industry's most profitable customers during the housing bubble were not smart. (Then again — with the exception of America's taxpayers — it's also not clear who was ultimately stupider; the institutions authorizing sub-prime loans or the individuals embracing them.)
The smartest/stupidest dichotomy is deliberately provocative. Because, really, how sustainable can a business dependent on customer stupidity really be? A popular advertising campaign once declared, "An educated consumer is our best customer." But for many firms, the smarter customers become, the more discriminating and less profitable they might be. Conversely, how many professions are there — neurosurgeon? criminal defense attorney? — where the smarter the customer is, the more likely they are to pay a premium for excellence? One could cynically argue that Apple's most profitable customers are very smart but that their "fanboy" obsession with the company's brand makes them foolish for paying such a premium for their favorite product.
But as insulting as it may be, the smartest/stupidest customer framing may be far more helpful to innovators and entrepreneurs than exhausted cliches about "good" versus "bad" customers or "early adopters" versus the mainstream. Profitability matters. How you and your colleagues perceive the source of those profits in the context of your clients' "smarts" — or "stupids" — is enormously revealing. It's an argument your organization probably needs to have.