The Service Profit Chain: How Leading Companies Link Profit and Growth to Loyalty, Satisfaction, and Value

Chapter 1 Setting the Record Straight

How many of us have attended seminars or read recently written books that admonish us to: (1) treat customers like royalty, (2) exceed customers' expectations, (3) either seek low operating costs or some means of differentiating our businesses from competitors, and (4) assume that the customer is always right. They are led by master storytellers who move with ease among the audience and are filled with enjoyable anecdotes that seem relevant at the time. We know. We've given our share of these presentations.

Who hasn't heard a Nordstrom story at one of these seminars? Most often it's the one about the Nordstrom store that accepts the return of a set of tire chains by someone claiming to have bought them there even though Nordstrom doesn't sell tire chains. The misguided moral is that by wowing the customer in that manner, Nordstrom will gain a new customer and possibly great word-of-mouth advertising. However the story is designed to make a point that is not only illogical, but is supported by no substantial evidence, quantitative or otherwise. Fortunately, few of us try to act on the implied advice. And yet we remember the story, if not the point it is designed to make.

A WORLD OF MISLEADING ADVICE

Why is it that the advice implied by these storytellers is so difficult to apply? Or worse yet, leads to the opposite results that they forecast? It's because the advice too often is sometimes totally inappropriate and always partially wrong. It nearly always is offered out of context, is based on incorrect assumptions, emphasizes symptoms instead of real causes, in the process trivializes service issues by confining them to the front line, and overemphasizes process quality while underemphasizing results.

Too Much Advice out of Context

Too much anecdote-peppered advice is given by many service gurus today without a context. We're not told that what worked in one organization may not be appropriate for another. The advice is so overly simplistic that it leads us as managers to seek the elusive "one big idea" that can help us improve performance. It is offered with little real supporting evidence other than the fact that the subjects of the anecdotes are often regarded as successes.

On the other hand, how often are we told that Nordstrom actually "fires" customers? We rarely, if ever, hear that side of the story. In fact, Nordstrom wows some customers and fires others who may be especially difficult for its staff to deal with (by advising them that, because of Nordstrom's failure to find a way to meet their needs, they should perhaps seek out other stores) as part of a careful strategy to target people with a particular profile and a record of outstanding loyalty to the company. If the tire story ever did occur, you can bet that it involved a customer that Nordstrom's people, based on facts, knew they did not want to alienate. In the context of a more carefully planned strategy, it could have made sense, although one could question the loyalty of a customer who would pull such a stunt on the company and expect to get away with it.

The Tyranny of the Trade-off

Ever since the popularization of Michael Porter's research on competitive strategy, we have been advised to seek either the lowest costs or a significant means of differentiation from competition for our businesses. The assumption here is that managers must choose, because both can't be achieved. In some cases, this is simply wrong. In fact, there is little evidence that it was the message that Porter himself intended. Furthermore, it leads us to achieve "merely good" performances as opposed to outstanding achievements that can result from strategies designed to achieve both low cost and competitive differentiation, strategies that are more achievable than is generally believed.

James Collins and Jerry Porras, in their fascinating book Built to Last, which reports their study of companies with long-term staying power in the marketplace, call this "the tyranny of either/or." They point out that many companies with long records of success practice the policy of "and/also," assuming they can "have it all."

Management by trade-offs reached its peak during an era in which the price of low inventory investments was thought to be poor customer service, or in order to achieve the economies of long production runs, factories had to stop trying to supply "one-of-a-kind" items to customers. Information systems, computer-aided design and manufacture, and robotics have killed, or at least seriously crippled, assumptions underlying trade-off management. Yes, trade-offs are a part of some businesses. But truly outstanding competitors, often limited to one or two in any one industry, achieve both outstanding results for customers and the lowest costs. A good case in point is USAA, an organization offering casualty insurance and other financial services.

USAA (United Services Automobile Association) was founded by a group of military officers to provide casualty insurance only to other officers. Given the transient nature of military duty, the service delivery system best suited to military personnel was direct mail and telephone. In fact, few USAA policy holders have ever seen a representative of the company. Nevertheless, it is hard to find anyone who has ever received less than outstanding service from the company. "War stories" abound about how USAA sends checks to repair damage based entirely on the word of the policyholder, or how a USAA claims adjustor may have pointed out damage that the policyholder had not seen and written a check on the spot for a larger-than-expected amount. At the same time, the company's system of selling through word-of-mouth recommendations to a trustworthy, disciplined group of customers pre-screened by the military has led to some of the lowest sales, administration, and total costs in the business. Although the company has expanded its line of financial services and offers some of them to nonmilitary customers, its core business continues to be a refutation of "either/or" thinking. USAA offers a differentiated service at some of the lowest rates (prices) and costs in its industry.

Emphasis on Symptoms vs. Causes

Many of the great service stories are downright misleading -- for example, the one involving the Southwest Airlines counter agent who encountered a customer who had just missed the flight that would take him to his most important business meeting of the year. The attendant decided to have his own light plane pulled out of the hangar and fueled in order to fly him to the customer's destination. We're supposed to believe that it's just part of the great service at Southwest, an airline that charges no more than $39 for many of its tickets. If so, it's the kind of great service that, offered repeatedly, will put a company out of business.

The story behind the story is much more important. It is that the counter agent knew the customer by his first name because the agent had been at his job for seven years. He knew that the customer flew over 300 segments per year and was worth more than $18,000 a year in revenue to his airline. He regarded it as his airline because he, like all other Southwest employees, had owned stock in it since his first full year of employment. And he knew that Southwest's policy for frontline personnel was "do whatever you feel comfortable doing for a customer." As an owner, he felt comfortable flying this customer to his destination. But a run-of-the-mill customer at Southwest certainly shouldn't expect this kind of service. In fact, Southwest Airlines, the paragon of good service, also fires customers, especially if they are drunk or unruly. It doesn't just put them off its planes, it tells them it never wants to see them again. But rarely do the great stories go much below the surface to suggest causes rather than symptoms of great service.

The "Trivialization" of Service

Many services occur, are marketed and produced, at the point of contact with the customer. Thus, the service "encounters" between customers and frontline service providers or electronic media are central and critical to successful results. It is entirely appropriate that a great deal of attention be drawn to the challenge of producing successful service encounters. But too much research, including some of ours, tends to confine service to the front line, neglecting the broader strategies of which the encounter and its design are a part. It overlooks the fact that frontline services are products of fundamentally strategic issues, issues that have to be understood and addressed by top management.

For example, Southwest Airlines is known for its ability to turn its planes, from arrival at the terminal gate to departure from the gate, much more rapidly than other airlines. This is undoubtedly in part due to the fact that Southwest's ground services employees work as teams, helping each other out as needed in an effort to turn two out of three flights in less than twenty minutes, less than half the time required by other major airlines.

But it is due also to the fact that Southwest's management has shunned the hub and spoke system used by other airlines, a system that slows aircraft turnaround in order to provide a larger time "window" for the arrival of connecting flights. Southwest also has structured its routes to utilize less-congested airports and cater to short-haul flyers expecting little in the way of baggage handling, catering, and other amenities that eat up ground time. The route structure and market to which it is targeted are strategic decisions made by top management. Without those decisions, the outstanding accomplishments of the frontline personnel would not be possible.

Fixation on Service Process Quality

Pick up any trade journal, management magazine, or even academic journals devoting space to service, and you rapidly conclude that service quality is the key to success. Too often, service quality is defined solely in terms of those things that contribute to process quality: dependability, timeliness, the authority and empathy (identification with the customer) with which a service is delivered, and the extent to which tangible evidence is created that a service has been delivered.

Rarely is any mention made of results delivered to customers in these reports. Carl Sewell describes this in his book Customers for Life, as follows: "Being nice to people is just 20% of providing good customer service. The important part is designing systems that allow you to do the job right the first time. All the smiles in the world aren't going to help you if your product or service is not what the customer wants."

Michael Hammer of reengineering fame is even more pointed. As he puts it, "A smile on the face of a limousine driver is no substitute for an automobile."

In fact, customers report time and again that both results and process quality are important to them in their selection of service providers. These are important elements in what we call the value equation, a concept on which we will elaborate later.

THE SERVICE PROFIT CHAIN AND OUR SEARCH FOR EVIDENCE

In part as a reaction to the repeated service stories that we got tired of hearing and the frustrated managers who have tried to apply the advice they were supposed to illustrate, we sought to understand why some service organizations succeed year-in and year-out. In addition to collecting lore and listening to countless stories emanating from outstanding service organizations, we did a risky and audacious thing. We started to collect data. Our work has grown a data base comprising inputs from several dozen well-known service organizations operating in a number of different competitive environments.

In addition to seeking facts, we developed measurements and began looking for relationships in our data that could shed light on ways of achieving service excellence and organizational success. Our work covered three phases: (1) discovery, (2) naive and simple-minded revelation, and (3) selective rejection and application. The first phase was the most exciting. The second phase was frankly exploitative. But the third, still ongoing, has yielded the deepest insights and most practical output for managers. This book is a record of our odyssey, the fact-based insights it has yielded for managers, and the translation of those insights into action in outstanding service organizations. We came to these conclusions from three very different directions.

Heskett and the Strategic Service Vision

In the mid-1980s, James Heskett set forth a set of relationships, based on a number of observations, called the strategic service vision. The "vision" comprised four important elements: (1) markets targeted on the basis of psychographic (how people think and act) as well as demographic (who people are, where they live, and how well they are educated) factors, (2) service concepts, products, and entire businesses defined in terms of results produced for customers, all positioned in relation to the needs expressed by targeted customers and the offerings of competitors, (3) operating strategies comprising organizations, controls, operating policies, and processes that "leverage" value to customers over costs to the offering organization, and (4) service delivery systems comprising bricks and mortar, information systems, and equipment that complement associated operating strategies. Questions characterizing the strategic service vision are shown in Figure 1-1.

Heskett concluded that companies achieve high profitability by having either market focus (as in ServiceMaster's almost single-minded concentration on providing cleaning and related support services to hospitals in the early years of the development of its institutional service business) or operating focus (as in United Parcel Service's long-time insistence that all packages it handled in its retail and consumer package delivery service had to weigh less than seventy pounds and have a combined length and girth of 130 inches). Organizations that achieve both market and operating focus are nearly unbeatable.

One interesting symptom of market focus is a small, but vocal group of dissatisfied customers. In fact, one of the phenomena we've observed in recent months is the growing number of pages on the Internet devoted to "clubs" of disaffected customers from service organizations with highly targeted and focused strategies. Clearly, these customers represented a poor match with the service in the first place. They should have been discouraged from utilizing the service or given the opportunity to select themselves out at an early stage in the process.

The strategic service vision embraces the idea that value is achieved by leveraging results for customers over costs, something that is integral to other concepts that would follow. As helpful as the strategic service vision might be in facilitating the development of strategy, practicing managers continued to express the need for a set of concepts that would assist them in implementing strategies, not formulating them. This need inspired Earl Sasser as he tried to identify money-making decisions and outcomes.

Sasser and Customer Loyalty

For years, managers have been led to believe that share of market is the primary driver of profitability. The PIMS (Profit Impact of Market Share) studies of the mid-1970s reinforced this notion. But in situation after situation, Earl Sasser, working with a former student, Fred Reichheld, found this not to be true. In the process, based on the collection of the factual experiences of a number of organizations, they identified a factor more often associated with high profits and rapid growth -- customer loyalty. This finding has become the basis for a successful consulting practice and a book, The Loyalty Effect, for Reichheld.

This work led to the exploration of determinants of customer loyalty such as customer satisfaction, and more basically the value of goods and services delivered to the customer. It laid the groundwork for several relationships in what would later come to be known as the service profit chain.

Schlesinger and Determinants of Employee and Customer Loyalty

Concurrent with the work of Heskett and Sasser, Leonard Schlesinger, as executive vice president and chief operating officer of a French bakery cafe chain, Au Bon Pain, was experimenting with incentives and other ideas designed to encourage Au Bon Pain's managers to exercise wide latitude in creating differentiated services for their customers while delivering exceptional profits for the company. They were designed to break what Schlesinger and his colleagues called the "cycle of failure" practiced by many of Au Bon Pain's competitors who paid their employees and managers low wages, offered them little training and other support, and suffered high turnover of employees and limited customer loyalty as a result.

During Schlesinger's tenure with Au Bon Pain, the company implemented a Partner/Manager Program that enlisted unit managers in a program in which they would split with the company on a 50/50 basis all operating profits over an agreed-on sum. In return, Au Bon Pain gave managers greater latitude to manage as they might choose, taking responsibility as well for all physical changes to the premises of their respective stores, subject only to quality control limits and certain matters, such as standard signage and standard "core" products, that every store had to practice. The results were so good that he knew he was onto something. The "something" consisted of a set of ideas examined in field studies with Heskett and others that is described in detail later in this book as the "cycle of capability," making up a significant part of the service profit chain. The philosophy behind the cycle of capability is that satisfied employees are loyal and productive employees. Their satisfaction stems, at least among the best frontline employees, from their desire to deliver results to customers. In order to deliver results to customers, they must have the ability to relate to customers, the latitude (within well-specified limits) to use their judgment in doing so, the training and technological support needed to do so, and recognition and rewards for doing so.

Schlesinger and his colleagues applied this philosophy to managers, some of whom extended it to frontline employees in Au Bon Pain restaurants, greatly reducing the turnover of employees and increasing customer satisfaction in the several restaurants where it was implemented. The results of the Partner/Manager Program related to findings from other research studies that there were direct links between customer and employee satisfaction and loyalty. By now a compelling body of evidence was being accumulated that suggested that the cycle of capability was a significant management tool, one that encompassed several additional important relationships in the service profit chain to come.

THE SERVICE PROFIT CHAIN

Simply stated, service profit chain thinking maintains that there are direct and strong relationships between profit; growth; customer loyalty; customer satisfaction; the value of goods and services delivered to customers; and employee capability, satisfaction, loyalty, and productivity. These relationships are shown in Figure 1-2. Notice that market share is not mentioned in these relationships. In few industries studied by Sasser and Reichheld was market share a more important predictor of profitability than customer loyalty.

The strongest relationships suggested by the data collected in early tests of the service profit chain were those between: (1) profit and customer loyalty, (2) employee loyalty and customer loyalty, and (3) employee satisfaction and customer satisfaction. They suggested that in service settings, the relationships were self-reinforcing. That is, satisfied customers contributed to employee satisfaction, and vice versa.

The Centrality of Value

Central to the chain, as shown in Figure 1-2, is the customer value equation, suggesting that the value of goods and services delivered to customers is equivalent to the results created for them as well as the quality of the processes used to deliver the results, all in relation to the price of a service to the customer and other costs incurred by the customer in acquiring the service. It is a "customer's eye view" of goods and services, influencing decisions to buy and use them. Further, we have found that value defined in this way is directly related to customer satisfaction.

Note how this concept of value plays out in the migration of banking customers from "face-to-face" teller banking to automatic teller machines to home banking by telephone or computer. For most customers who have begun this migration, every element of the value equation changes as they move through each stage.

Automatic teller machines provide results comparable to those available from face-to-face relationships with human tellers. The range of transactions possible with the machine may not always be as great as those available from a teller, but all frequently used services are possible, including, of course, the dispensing of money. For many customers, particularly those anxious about transacting personal business in English, the machine programmed to "speak" many languages can actually provide better process quality than a human teller. The same can be said for "control freaks" concerned about the accuracy of transactions made by human tellers. Until recently, when several banks began charging for transactions by human tellers, the "price" of consumer banking by human and automatic tellers has been the same. But the twenty-four-hour availability and greater number of locations of the machines greatly lower acquisition costs incurred by customers using automatic teller machines. Many customers would actually be willing to pay more for this form of service than for face-to-face service even though it is more economical for banks than transactions by human tellers.

Going one step further, from automatic teller machines to home banking by phone, the relationships become more complex. Results available through the latter are not as great as by machine; the customer can't obtain cash through his telephone. Nevertheless, speedier transaction time represents enhanced process quality for many customers. In addition, phone banking is low cost, primarily because of greatly reduced acquisition costs for the customer, who saves gas, time, and anxiety in the comfort of his home.

When home banking is extended to the computer, "results" are once again enhanced. In addition to the convenience of in-home banking, the consumer using a computer enjoys added services, such as financial software that enables her to keep a running budget of expenditures and other financial records, all while paying bills. For some customers, an incremental value has once again been achieved over even phone banking.

It is important to note that value enhancement in this fashion in banking has been accompanied by dramatic reductions in costs per transaction to banks themselves. John Reed, CEO of Citibank, estimated for us several years ago that the costs of serving a customer totally by credit card and automatic teller machine were twenty-five times lower than through a Citibank branch. If the relationships could be maintained by phone and computer, costs would be only 25 percent of those incurred by credit card. Of course, individual customer preferences and the limitations of each of these service delivery systems has made it necessary for Citibank to continue to offer all three.

Given the favorable economics of this "migration" to banks, they might well foster it by providing incentives, including free services and equipment, to consumers willing to take part in it. Instead, to date banks have tended to create disincentives for people to use human tellers by, in some cases, imposing user fees on them.

Quality as One Element of Value

The service profit chain and value equation it comprises helped us put into perspective much of the work on service quality. To the extent that it has focused largely on the elements of service process quality while ignoring results, it is essentially one of four elements of the value equation. In fact, in many cases it may be much less important to customers than results they obtain, regardless of process quality. In other cases, price and other acquisition costs may be more important than process quality in determining value for customers, their satisfaction, and their loyalty.

Price

Value is not equated with low prices. Goods and services of high value may carry high or low prices. In fact, customer needs are so different that they are often willing to pay greatly differing prices for a given service, depending on its importance at a given time and place. Because price is only one element of value, it can be influenced as well by the ease of accessing a service. That is, by making a service easier to acquire, it can be made less sensitive to price, thus enhancing margins and profits.

Results, Costs, Price, Value, and Profit

We said earlier that results for customers, an important element of value, is leveraged over cost to a service provider by means of the way in which an operating strategy is structured. It's not coincidental that those organizations testing every new product or service idea against the criterion of whether or not it creates results (and potentially value) for the targeted customer are able to maintain operating focus and outstanding profits. As David Glass, CEO of value-conscious Wal-Mart Stores, points out, one of his most important jobs is insuring that everyone in the organization acts as an "agent for the customer," whether negotiating with suppliers or thanking customers for their business as they leave Wal-Mart Stores.

The resulting leverage of value (to customers) over costs (to a service provider) creates potential for profit. How much of that profit is realized depends on the level at which the service is priced in an effort to calibrate the value that a customer will attach to the service. Price and cost in turn are the determinants of profit to be realized from the business by the service provider. Thus, "leverage" is achieved in the strategic service vision by designing an operating strategy to produce maximum results as well as process quality for customers in relation to costs to the service provider. This leverage provides a "window" in which to price the service and make it more or less costly for the customer to access, essentially passing on some potential profit to the customer in the form of lower price or reduced acquisition costs.

Relationship to Service Profit Chain

Service profit chain management provides the means for implementing a strategic service vision. The two concepts are complementary, as suggested in Figure 14-2 on page 254. Both reflect an important objective of achieving market, operating, and human resource focus around a service concept that delivers results that customers desire.

WHAT DIFFERENCES DOES IT MAKE?

What difference does service profit chain management make? A lot. Between 1986 and 1995, the common stock prices of organizations from which we have drawn examples for this book increased 147%, nearly twice as fast as those for a group of companies representing their closest competitors (including well-known companies such as Microsoft Corporation, NationsBank, and the Coca-Cola Company), as shown in Figure 1-3. By contrast, the share prices of stocks included in Standard & Poor's 500 index increased only 110 percent during this same period.

While it is impossible to know exactly how much of the remarkable competitive advantage implied by the data in Figure 1-3 can be attributed to service profit chain management, we suspect it is a defining factor. But we'll let you be the judge as we explain in more detail the implications of service profit chain management for these organizations.

SPREADING THE WORD

The relationships described by the service profit chain made sense, not only to us but also to senior managers with whom we shared them. Cursory examination of data from perhaps twenty multiunit service organizations confirmed these relationships. In fact, the service profit chain relationships described above became the basis for well-received consulting and other presentations. They could be put to work in any organization desiring to improve the focus of its operations and marketing effort, positioning itself more effectively against its competition.

But as we began to apply the findings from our work and dig deeper into the data files of companies supporting our work, increasingly we found cases in which the findings were puzzling and didn't correspond to our expectations. Worse yet, under certain circumstances, we concluded that advice consistent with tenets of the service profit chain might, in some circumstances, be just plain wrong. This led us to explore our assumptions and expectations further. In the process, we have been able to develop more powerful guidelines for managers applying this philosophy.

As a result, this book is intended to relate what we know now about the service profit chain. It addresses the questions of when and where to apply what we have found, at least to the degree we are able to know at this stage of our work.

Before getting into its shortcomings and possible applications, it is first important to set forth in greater detail the service profit chain and some of the data on which it is based.

Copyright © 1997 by James L. Heskett, W. Earl Sasser, and Leonard A. Schlesinger