Shifting technology and resulting new business models don’t have to sound the death knell for companies, as Netflix illustrates. Netflix went out of its way to avoid bad profits. It developed innovative ways to make its Web site more customer friendly. It eschewed late fees and “gotcha” pricing tactics, and it invested heavily in creating great customer service. If customers lost a DVD, they faced no threats from collection agencies; they simply had to explain the circumstances. Netflix trusted them unless and until an unreasonable number of recurrences demonstrated that it couldn’t. As technology shifted to enable online streaming of videos, Netflix wasn’t a victim. The enormous customer loyalty it had built helped the company lead the transition to the new technology.
Buying growth through discounts, sales promotions, and advertising is expensive. It tends to create a profit squeeze, which in turn usually deepens a company’s addiction to bad profits. Retail banks, for example, now depend on nuisance fees for as much as one-third of reported earnings. One mobile-phone operator calculates that proactively putting customers in the plan that was best for them would cut profits by 40 percent. This addiction to bad profits demotivates employees, diminishes the chances for true growth, and accelerates a destructive spiral. Customers resent bad profits—but investors should, too, because bad profits undermine a company’s prospects. Like the addicts they are, enterprises dependent on bad profits have no future until they can break their habit.
The Alternative: Good Profits
But it doesn’t have to be this way. Some companies grow because they have learned to tell the difference between bad profits and good profits—and to focus their efforts on the good kind.
Good profits are dramatically different. If bad profits are earned at the expense of customers, good profits are earned with customers’ enthusiastic cooperation. A company earns good profits when it so delights its customers that they willingly come back for more—and not only that, they tell their friends and colleagues to do business with the company. Satisfied customers become, in effect, part of the company’s marketing department, not only increasing their own purchases but also providing enthusiastic referrals. They become promoters. The right goal for a company that wants to break the addiction to bad profits is to build relationships of such high quality that those relationships create promoters, generate good profits, and fuel growth.
The Vanguard Group of mutual funds offers a compelling illustration of the difference between bad profits and good. Not long ago, Vanguard reduced prices by as much as one-third for customers who had recently made large investments or who had maintained healthy balances for an extended period. Vanguard’s management recognized that the economies of scale generated by those large-balance and long-tenured investors could be shared with them. The company had the opportunity to deliver more value to its best customers, widening the pricing gap they would experience compared to competitors’ offerings. It would have been more profitable to continue to charge these customers the same prices paid by newer and smaller-balance customers. To Vanguard, however, this didn’t make good business sense. Why not share the benefits of scale with the very customers who created them? When the company did this, its core customers were so delighted that they increased their holdings and boosted referrals. That helped turbocharge Vanguard’s growth, and pushed the company toward leadership in the mutual funds industry.
Nor is Vanguard alone in its pursuit of good profits. For example:
Amazon.com could easily afford to advertise more than it does; instead, it channels its investments into free shipping, lower prices, and service enhancements. Founder and CEO Jeff Bezos has said, “If you do build a great experience, customers tell each other about that.”3
Zappos.com, the online shoe and apparel retailer, followed a similar path. By avoiding investments in sales and marketing, Zappos was able to channel its resources into delivering a great customer experience. CEO Tony Hsieh’s strategy was to grow through repeat purchase and customer referral, which helped the company reach sales of more than $1 billion in just ten years. Amazon was so impressed with Zappos that it acquired the firm for $1.2 billion in 2009.
Southwest Airlines doesn’t charge for flight changes or for checked baggage; the carrier has also replaced the industry’s elaborately segmented pricing structure with a transparent pricing policy. Southwest now flies more domestic passengers than any other U.S. airline and boasts a market capitalization that tops the rest of the industry.
Costco, the leader in customer loyalty among warehouse retailers, rocketed from start-up to the Fortune 50 in less than twenty years while spending next to nothing on advertising and marketing. Its customers are so loyal that the company can rely on positive word of mouth for its growth.
Among Internet companies, the impressive early growth of eBay offered a remarkable contrast to the stalled growth of AOL. The eBay Web site says this:
eBay is a community that encourages open and honest communication among all its members. Our community is guided by five fundamental values:
We believe people are basically good.
We believe everyone has something to contribute.
We believe that an honest, open environment can bring out the best in people.
We recognize and respect everyone as a unique individual.
We encourage you to treat others the way you want to be treated.
eBay is firmly committed to these principles. And we believe that community members should also honor them—whether buying, selling, or chatting with eBay friends.
Of course, anyone can list high-minded principles on a Web site or a recruiting brochure. But eBay has found ways to translate these principles into daily priorities and decisions. The result: by 2010, eBay managed to turn more than 70 percent of its customers into promoters. (Only Amazon had a higher percentage of promoters—76 percent—in the online shopping sector that year, though by 2011, Zappos was large enough to show up on the surveys, and its Net Promoter score was in a statistical dead heat with eBay’s.) Referrals generate many of eBay’s new customers, creating multiple economic advantages across the business. The company has found that referred customers cost less to serve because they’ve already been coached by a promoter on how the site works and they usually have friends who help solve their problems instead of relying on eBay employees. EBay has also learned to tap the creativity of an entire online community, not just its own employees. The company encourages members to point out areas in which they believe eBay isn’t living up to its principles, and to identify new opportunities to better serve members. Community members are invited to rate sellers after each transaction, and the ratings are then shared with everybody. This process enables each member to establish a reputation based not on public relations or advertising spin but on the cumulative experience of members with whom they’ve done business. EBay’s virtual world is just like a small town: a good name is essential for success.
Conventional wisdom encourages companies to consolidate market power and then extract maximum value from customers. Yet eBay has done just the opposite. Although it has come to dominate the online auction market, the company tries to consider the needs of community members as well as the long-term interests of its shareholders when it makes decisions. Running a company like a community enables eBay to look beyond the next quarter’s stock price and to continually find ways to enrich the lives of community