Overview

All firms have a theoretical maximum capacity and a theoretical optimal capacity. From a strategy perspective, it is essential to see how that capacity is being allocated to each customer segment. Ensuring a proper amount of capacity is allocated to various customer segments, while offering a differentiating value proposition within each segment, is an essential element of implementing price discrimination strategies. It also prevents bad customers—those who are not willing to pay for the value you deliver—from crowding out good customers.

Customer Grading Criteria

It has become common for firms to grade customers and focus attention on the “A” and “B” customers and even hold out incentives to the “C” customers to upgrade to higher status. Along with your human capital selection, your customer capital criteria are the most important aspect of crafting your firm’s success. The traditional customer grading criteria are most likely familiar to you; they usually include:

Amount of annual revenue

Prompt payment history
Potential for growth
Potential for future referrals
Actual referrals
Profitability of customers
Risk of having customer in portfolio
Timing of work (fiscal or calendar year)
Reasonable expectations
Willing to take advice
Profitable and not undercapitalized

Certainly these are important criteria and should be made part of any firm’s pre-qualifying process. Ric Payne, Chairman and CEO of Principa, advocates the following 12-point criteria for selecting customers:

In business for at least three years.
Pleasant, outgoing personality.
Willing to listen to advice.
Positive disposition.
Technically competent.
Business is profitable.
Business is not chronically undercapitalized.
Business is not dominated by a small number of customers or suppliers.
Clearly established demand for the product or service.
Business has a scope for product or service differentiation through innovative marketing.
Business has scope for improved productivity through innovative management planning and control.
Business has a strategic plan.

These are all good criteria to judge potential new customers, as there is no point in working for and with people whom you do not like, or are indifferent about. Paul Dunn, co-author of The Firm of the Future, wrote this about customer selection and de-selection.

Case Study: Grading and Firing Customers

If there was just one phrase that readers should pin up on their walls, it would be Baker’s Law: “Bad customers drive out good ones.” In every gathering of professionals I'm asked to address, I always ask the question: "How many of us have customers we wish we didn't have?” I've never yet seen such a gathering where fewer than 99 out of every 100 raised their hands in the air (most of them held up in what you might call an enthusiastic way, along with another part of their anatomy—their eyes, literally in the top of their heads, as if to say, “Yes, I have them and what a drag it is.")

You know the customers they're thinking of—the ones that don't pay the bills, the ones that sap your energy rather than build it, the ones you simply don't like being with—the list goes on and on. Or consider this…imagine you could put the work you do into these 3 categories:

I really love doing this type of work.
I can tolerate it.
If I'm brutally honest, I hate it.

How much of your typical week would be in the bottom two?

It may come as no surprise for you to read that, for many professionals, the number in those bottom two categories is frequently around 80 percent. Or, to put it another way, they're only loving what they do 20 per cent of the time. Yet they smile through it because they're getting paid. As David Maister points out in his book True Professionalism, there is another "profession" that says, "Pay me the money and I'll fake it.” Some call it the oldest profession in the world.

So why does the profession prostitute itself so frequently? Maybe it's because many (most?) in the profession have been, as one practitioner in the United Kingdom put it to me, "indiscriminate" about the customers they work with. To put that more bluntly, if it looks like the customers have a checkbook, they take them on. Some don't.

Take Tom Weddell of the Newburgh- and Poughkeepsie-based practice, Vanacore, DeBenedictus, DiGovanni & Weddell (try answering the phone there!). Weddell, forty-two years old [at the time] and the youngest of the partners, had been appointed managing partner just six weeks before he attended a four-day program I presented in Chicago. Weddell really got the message. On the way home from the program, he said this to his partners, “Clearly, there’s so much for us to do to implement this material. I want to know right now if you’re with me.”

It was a completely general question with no implied reference to “re-organizing” the firm’s customer list. "Well, yes, of course Tom," they replied. “Are you certain?” Weddell asked. “Yes, we’re really with you Tom.”

So the next day, Tom went into his office early. He got a full list of the firm’s customers and copied it 27 times (the number of team members he had at that time). He gave it to each member with the instruction, "Circle everyone's name on this list who you don't like dealing with and give it back to me by 11:00 a.m., please." That was his only criterion. The other partners had no idea he’d done this at the time (Weddell presumably was taking them at their word that they were “with him”).

That afternoon, Weddell took every customer whose name was circled and fired them (nicely). He even recommended another accountant they might like to try, who would welcome them with open arms. By 4:00 p.m., the job was done. Weddell had gotten rid of the customers—along with $64,000 worth of revenue.

When Weddell told the team what he'd done, they cheered! At 4:15, the other partners, who by now realized what had happened, called a meeting. In essence, the message was, "We're not sure we're with you, Tom!" But three months later, the partners were absolutely sure.

Weddell showed me his financials and pointed to the additional $300,000 worth of revenue the practice had generated in the period. And he made this wonderfully simple point: “We couldn’t have gotten that unless we’d created $64,000 worth of space.”

Do you have any customers taking up space? Many firms are trying to be all things to all people. Yet they’re advising their clients to be “selective” when those clients choose customer segments. The answer really does come back to that earlier comment about professionals choosing their clients “indiscriminately.” Want to prove it? Take out your latest firm brochure (if you’re still one of the people who believe in brochures) and mark anywhere on it where it specifically says something like, “You’ve got to be special to be one of our clients.” I doubt you’ll find it. Even your brochure or your website probably implies that all customers have to do is breathe and you’ll take them on.

After years of “preaching” this message, I’ve never known any firm to regret that they took action in the way that Tom Weddell did. You won’t either. Bad customers drive out good ones.

When a firm accepts a new customer, it is not merely closing a sale; it is beginning a lifelong relationship. We select our spouses, friends, and other important relationships very carefully, why would we not perform a proper amount of due diligence before selecting a customer? If the customer is worth having, he or she is worth investing some time and resources in determining if she is a good fit for your firm.

Reed Holden has a wonderful saying: The price isn’t wrong, the customer is! The essence of strategy is choosing what not to do. Saying no to a new customer is not necessarily easy, but it is vital if you want to accept only those customers who are pleasant to work with, have interesting work, and enhance your firm’s intellectual capital.

Complexity kills a business and by accepting any customer—especially those that do not fit your purpose, strategy, and value proposition—you are adding a layer of bureaucracy that will starve your best customers and put them at risk of going elsewhere. To manage this inevitable effect, let us now explore the Adaptive Capacity Model for professional firms.

The Adaptive Capacity Model

Think of your firm as a Boeing 777 airplane. When United Airlines places a Boeing 777 in service, it adds a certain capacity to its fleet. However, it goes one step further, by dividing up that marginal capacity into five segments (the percentages shown are suggested capacity allocations for a professional firm):

A. First class (5 to 8 percent)
B. Business class (15 to 24 percent)
C. Full fare coach (30 to 50 percent)
D. Coach (15 to 35 percent)
F. Discount/Priceline.com (10 to 20 percent)

Your firm has a theoretical maximum capacity and a theoretical optimal capacity, and it is essential to see how that capacity is being allocated to each customer segment. Your maximum capacity is the total number of customers your firm can adequately service (not how many hours you have), while the optimal capacity is the point where customers can be served adequately and crowding out does not affect customer behavior. Usually, for most professional firms, optimal capacity is between 60 and 80 percent of maximum capacity.

Too many firms will, in fact, add capacity—or reallocate capacity from higher-valued customers—to serve low-valued customers. Furthermore, firms will turn away high-value, last-minute work for its best customers because it is operating near maximum capacity and usually at the low-end of the value curve for price-sensitive customers. This is common during peak seasons, where high value projects will arise from customers, but the firm is at maximum capacity and cannot handle the marginal work. The lost profit opportunities because of this are incalculable.

Firms worry about running below optimal capacity and cut their prices to attract work, especially in the off-season. This strategy is fine, but you must understand the trade-off you are making. Usually, that capacity could be better utilized selling more valued services to your first-class and business-class customers. This way, the firm does not degrade its pricing integrity to attract price-sensitive customers. According to most pricing consultants, one of the leading causes of pricing mistakes is the result of misallocating capacity to low-value customers due to the fear of not running at optimal (or maximum) capacity.

Remember, the objective of pricing is not to fill the plane; it is to maximize the profit over a given time period. If that can be done at 60 percent capacity, so much the better, as the excess capacity can be invested elsewhere.

How to Fire a Customer

What happens when your plane becomes filled with too many “C,” “D,” and “F” customers? Many consultants to firms estimate that the average firm contains between 10 and 40 percent of “F” customers. It is never easy, but it is necessary, to remove these customers from your firm. Start with those customers whose personalities clash with the culture of your firm, or whose character is in question. Once that is completed, then you can focus on removing other low-valued customers (such as the “Cs” and “Ds”). These customers are usually the ones who complain most vociferously about your price; and the debilitating effect is that we tend to listen to them the most and this effects how we price our “A” and “B” customers. One caveat: Be sure you have done everything within your power to turn a low-value customer into a high-value customer. The fact of the matter is, your customers are not going to get better until you do.

All that said, how should you fire a customer? There are many strategies, some more effective than others. Many firms in the early days of implementing this strategy would simply raise their prices by a factor of two or four, and to their surprise, a super-majority of the customers remained with the firm (an indicator of just how much money professional firms leave on the table through suboptimal hourly billing).

Nevertheless, it is strongly advised that you not utilize this strategy. The goal is to remove the customers, not simply increase their price. Getting two or four times more from an “F” customer does not make him a “C,” “B,” or “A” customer (this is the ethic of the world’s oldest profession, not of true professionals).

A phone call or a meeting is the best—and most dignified—strategy. You may line up other professionals as potential referral sources (one of your “D” or “F” customers could be his “A” or “B” customer); or, some firms have even sold off these customers to other firms. Here is an example from a CPA firm of a possible conversation you might have:

“Mary, we need to talk about how well we’re working together. We need to be sure that the range of services we offer matches your needs. Here in the firm we want to work with people where we can add significant value to their business, rather than just crunching some numbers and filling in some tax returns for them.
“This means we are reducing the number of clients we work with and increasing the range of services we provide for them. We’re working with them on growing their businesses by offering consultative services. Naturally, this means that our price levels are increasing, too. Many of our clients are comfortable with that extra investment because of the value we are providing them in return.
“Mary, unless I’m very mistaken we simply can’t provide you with that value. It seems to me that your needs would be better served by an accountant who just wants to stick to the numbers. How do you feel about that?”

The Forced Churn

In the mid-1990s, Lake Tahoe began a major renovation, where many older motels, stores, and other buildings were bulldozed down by the lake, just on the California side of the state line. A local newspaper article claimed that for every new room added, somewhere between two and three would be lost. Obviously, the developers were shifting up the value curve by constructing higher-end hotels, time-shares, condominiums, and so forth. Why shouldn’t (some) firms remove somewhere between one and four customers for every new one added? This led to the concept of what we have since labeled the forced churn.

As a way to upgrade your firm’s customer base from “C,” “D,” and “F” customers, each time a new customer is obtained, you would fire somewhere between one to four old customers. Of course, the exact ratio would depend on how many “C,” “D,” and “F” customers your firm has and what factor the leaders are comfortable with.

Not only would this free up capacity to serve new customers, it would shift the firm up the value curve, allowing your plane to add more full-fare coach, business-class, and first-class seats. By implementing this strategy gradually, many firms feel more comfortable upgrading their customer base, and their sense of security is not jeopardized by firing a large number of customers all at once.

Tom Peters is fond of making this point: “It’s axiomatic: You’re as good—or as bad—as the character of your Customer List. In a very real sense, you are your Customer List.”

Our colleague Tim Williams likes to say that a firm is defined by the customers it doesn’t have. The most successful firms in the world today turn away more customers than they accept because they have a rigorous prequalifying process and they understand that, ultimately, bad customers drive out good customers.

Tools to Help You Get There

During our live show (the recording is linked at the top of this post), we referenced several tools to help you get to a better understanding of your customer mix.

The Customer Likability Score