The Upside-Down Economics of Customer Relationships

Traditional economics teaches us that unit costs decline with scale. If you manufacture a million widgets a year, the cost of each of these widgets will be far less than if you only manufacture, say, a thousand of them a year. All the raw material you buy in bulk for your widgets, all the retailing deals you strike in order to put your widgets in stores, and all the advertising you buy to promote your widgets – literally everything you do will cost less per widget, the more widgets you sell.

The economics of making and selling products to large numbers of anonymous customers is based on what economists call “economies of scale.” The bigger you are, the lower your unit costs are likely to be.

And there is a kind of natural limit to this idea, as well, because if you reach a scale large enough to dominate the market, your unit costs may become permanently lower than any of your smaller competitors could ever achieve. Walmart is a case in point. If Walmart were a country, its economy would make it the 26th largest country in the world. Bigger than Target, K-Mart, Sears, Kroger, Costco, and Home Depot combined, in the US alone Walmart accounts for roughly 25% of everything people spend on groceries. Once you become as big as Walmart, it’s considerably more difficult for your competitors to achieve the same scale economies as you do.

But customer relationships tend to undermine this bedrock principle of traditional economics, because they are based on “economies of scope” rather than scale. In a company’s relationship with any single customer, the more varied and different products and services are sold to that customer, the more efficient and profitable the relationship will be.

Simply put, economies of scale improve with the volume of products sold, while economies of scope improve with variety of products sold.

Economies or scope, based on improving the scope of relationship you have with each of your individual customers, turn traditional microeconomics on its head, because the real currency of relationship economics doesn’t involve the physical cost of production and distribution so much as it does the intangible cost of maintaining an ongoing, digitally available memory of customers, one customer at a time.

So even if your competitors have the benefit of larger scale – if they distribute more products, advertise more, and sell at lower unit prices – there is still hope for you in the principle of economies of scope. On the whole, the better your relationship is with any single customer the more advantage over your competitors you will have when selling to that customer. The more a customer buys from any one company, the more they will trust that company for future purchases, provided of course that the customer experience is frictionless and that the company remembers the customer as well as the customer remembers the company.

When two companies compete for the same individual customer’s business, the one with the greatest scope of information about that customer will almost certainly be the more effective competitor. Moreover, because technology now makes it possible for businesses of nearly any size to keep track of individual relationships with individual customers, the scale of any single company’s operations is likely to become less important as a competitive advantage.

As a competitive strategy, improving the scope of your relationship with an individual customer requires cultivating and acting on individual customer feedback, while using technology to minimize the cost of this individual attention and action. The most effective and profitable relationship with an individual customer will be one that works like a perpetual, ever-improving feedback loop: “I know you. You tell me what works for you, and I do it. You tell me if I did it right. I remember that, and I do it even better for you next time.”

As technology continues to improve it makes these kinds of individual customer relationships feasible in an ever-expanding variety of industries and disciplines. Over time, all companies are likely to come to depend more on scope economies with individual customers than they depend on scale economies with markets and populations.

So while I titled this post The Upside-Down Economics of Customer Relationships, perhaps it’s all a question of perspective. Perhaps it’s not really the idea of customer relationships that that turns economics “upside down” at all. Maybe traditional economics, without customer relationships, was upside down all along...