When to Fire Customers? Customer Cost-Based Pricing

Management Science, Forthcoming

Posted: 8 Feb 2012

See all articles by Jiwoong Shin

Jiwoong Shin

Yale School of Management

K. Sudhir

Yale School of Management; Yale University-Department of Economics; Yale University - Cowles Foundation

Dae-Hee Yoon

Yonsei University

Date Written: February 7, 2012

Abstract

The widespread adoption of activity-based costing enables firms to allocate common service costs to each customer, allowing for precise measurement of both the cost to serve a particular customer and the customer's profitability. In this paper, we investigate how pricing strategies based on customer cost information affects a firm's customer acquisition and retention dynamics, and ultimately its profit, using a two-period monopoly model with high- and low-cost customer segments. Although past purchase and cost information helps firms to increase profits through differential prices for good and bad customers in the second period (“price discrimination effect”), it can hurt firms because strategic forward-looking consumers may delay purchases to avoid higher future prices (“ratchet effect”). We find that when the customer cost heterogeneity is sufficiently large, it is optimal for firms to “fire” some of its high-cost customers, and customer cost-based pricing is profitable. Surprisingly, it is optimal to fire even some profitable customers. This result is robust even when the cost to serve is endogenous and determined by the consumer's choice of service level. We also shed insight on acquisition–retention dynamics, on when firms can improve their profitability by selectively firing known old “bad” customers, and on replacing the old “bad” customers with a mix of new “good” and “bad” customers.

Keywords: customer cost information, activity-based costing, behavior-based price discrimination, forward-looking customers, customer relationship management

JEL Classification: C70, D82, M30, M40

Suggested Citation

Shin, Jiwoong and Sudhir, K. and Yoon, Dae-Hee, When to Fire Customers? Customer Cost-Based Pricing (February 7, 2012). Management Science, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2000455

Jiwoong Shin (Contact Author)

Yale School of Management ( email )

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06520 (Fax)

HOME PAGE: http://faculty.som.yale.edu/JiwoongShin/

K. Sudhir

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-432-3289 (Phone)
203-432-3003 (Fax)

Yale University-Department of Economics ( email )

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Yale University - Cowles Foundation ( email )

Box 208281
New Haven, CT 06520-8281
United States

Dae-Hee Yoon

Yonsei University ( email )

School of Business
Seoul
Korea, Republic of (South Korea)

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