When to "Fire" Customers: Customer Cost-Based Pricing

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. This paper was accepted by J. Miguel Villas-Boas, marketing.