Customer satisfaction, net income and total assets: An exploratory study Received (in revised form): 4th February, 2005

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1 Customer satisfaction, net income and total assets: An exploratory study Received (in revised form): 4th February, 2005 Chiquan Guo is an assistant professor of marketing and international business at the University of Texas-Pan American, USA. He has a wide range of research interests, but the main focus lies in market orientation, marketing strategy and management and e-commerce. Pornsit Jiraporn is an assistant professor of finance at Texas A&M International University, USA. His research interests include earnings management and acquisitions and mergers. Abstract Conventional wisdom believes that customer satisfaction has a positive effect on profitability, normally measured in such terms as return on assets (ROA). It is not, however, clear whether customer satisfaction has a current effect or a lagged effect on profitability an issue of importance but largely neglected. The authors fill the void by examining how current and past satisfaction performance affects net income (profit) and total assets because ROA is a ratio of net income to total assets. Results show that current customer satisfaction performance is negatively related to both net income and total assets, while past satisfaction is positively related to net income, but bears no relationship to total assets. Taken together, although it is still mathematically possible that current satisfaction is positively related to ROA, it is more probable that current satisfaction has a negative effect on profitability, while past satisfaction has a positive effect on profitability. That is, customer satisfaction performance has a lagged effect on profitability. Chiquan Guo Department of Management, Marketing and International Business, College of Business Administration, The University of Texas-Pan American, 1201 West University Drive, Edinburg, TX 78539, USA. Tel: 1 (956) or (956) ; Fax: 1 (956) ; chiquan@panam.edu Customer satisfaction as a key construct has been extensively studied in marketing. One of the enduring interests is the relationship between customer satisfaction and firms profitability such as return on assets (ROA). Research has established that customer satisfaction is positively related to a firm s ROA. 1 5 Although customer satisfaction is generally believed to improve a firm s bottom line, whether satisfaction has a current effect or lagged effect on profitability has not been precisely formulated nor carefully explored in the literature. If satisfaction has both current and lagged effects on profitability, there will be no controversy about implementation of customer satisfaction programmes. If, however, satisfaction initiatives are long term at the expense of short-term financial results, the strategic balance between a firm s short-term cash flow and its long-term survivability is at 346 Journal of Targeting, Measurement and Analysis for Marketing Vol. 13, 4, Henry Stewart Publications (2005)

2 Customer satisfaction, net income and total assets: An exploratory study stake. Given the gravity of the issue, the authors focus on whether there is a time lag between customer satisfaction performance and company profitability. Furthermore, instead of using ROA (ratio of net income to total assets) as the dependent variable, they explore how satisfaction affects net income as well as total assets since ROA is the ratio of net income to total assets. There are multiple combinations that could lead to an improved ROA: net income increases faster than total assets increase, net income decreases more slowly than total assets decrease or net income increases while total assets decrease. Due to the unique selection of the dependent variables chosen for the investigation, other financial variables are included in the study as they are relevant in explaining net income and total assets. LITERATURE REVIEW In today s competitive environment, firms that full-heartedly pursue customer satisfaction must have a good reason, especially in light of the fact that satisfaction programmes are not free, perhaps even very expensive in some cases. For the purpose of discussion, it is assumed that only solo (one time) market transactions take place in the marketplace. Firms with satisfied customers should have fewer organisational resources devoted to dealing with product returns, repairing defective items and handling and managing complaints. 6 9 Furthermore, satisfied customers are likely to engage in positive word of mouth promotion, helping firms to disseminate information about products and to acquire new customers The effect of product returns on a firm s bottom line is immediate. Barring repeated transactions, however, the effect of satisfaction on a firm s profitability in the short term is minimal in that most companies can churn out products of decent quality that customers will not return once purchased. As soon as repeated transactions come into play, the question of loyalty arises. That is, loyalty can be a mediating variable through which customer satisfaction affects profitability. Although satisfaction is not a sufficient condition for loyalty, 14 satisfaction in most cases is a prerequisite to loyalty. Once satisfaction upgrades to loyalty, it changes the dynamics. Transaction costs for satisfied customers are much lower than for novice customers. Loyal customers, by definition, repeat their purchases in the future, resulting in a steady stream of cash flow. 15 In addition, loyal patrons are likely to make purchases in greater volume and with more frequency, as well as to buy other goods and services offered by the firm. 16 Another way in which customer satisfaction can affect profitability is through reduced price elasticities. 17 Highly satisfied customers are less price sensitive and, therefore, more tolerant of price increases than dissatisfied consumers. Thus, firms with satisfied customers are able to increase prices without losing a large number of customers. Perhaps the firms can command higher prices for their products or services than their competition with a mediocre performance in customer satisfaction. A low transaction cost in combination with premium prices stemming from customer satisfaction, lead to larger profit margins. Firms with satisfied customers also tend to be viewed favourably by media sources and by the public, making their advertising more effective. 18 Customer satisfaction enhances the overall reputation of the firm, conducive to the introduction of Henry Stewart Publications (2005) Vol. 13, 4, Journal of Targeting, Measurement and Analysis for Marketing 347

3 Guo and Jiraporn new products by providing brand recognition and reducing the buyer s risk of trial. 19,20 Since repeated purchases require cycle time, which varies in length depending on the product (ie durable goods versus non-durable goods), the effect of satisfaction on profitability through loyalty may not be immediate. That is, whether satisfaction has a current or lagged effect or both on profitability must be examined carefully. There are myriad programmes that firms can implement to boost customer satisfaction. For example, companies can add new features to a product, improve attribute performance or offer more personalised services. But all these measures are costly. 21,22 At least the initial investment on the infrastructure that is necessary to ratchet up product and service quality, may constrain company resources in the short term. At the same time, pay off is unlikely to be palpable. Anderson, Fornell and Lehman 23 asserted that the economic consequence of improving customer satisfaction is not immediate, ie it takes time before any monetary benefits become apparent. As such, firms that are myopic will not have the vision and patience to see and reap all the potential long-term benefits accruing from otherwise expensive customer satisfaction programmes. Companies with a short-term focus may pare resources on after-sales services in order to meet quarterly or monthly earnings forecasts, a move that will hinder the firm s future position. Although it is tempting to investigate exactly how satisfaction affects profitability (eg larger purchase volume or decreased price sensitivity), the data available for this study preclude such micro-level investigation, although this could be the subject of future research. Nonetheless, time lag in the effect of satisfaction on profitability is an interesting topic in its own right, which is the main focus of this research endeavour. DATA AND METHODOLOGY To complete the study, the authors extracted data from two sources, the American Customer Satisfaction Index (ACSI) and COMPUSTAT. The ACSI database is administrated and maintained through a partnership of the School of Business at the University of Michigan, Ann Arbor, Michigan, the American Society for Quality Control (ASQ) and the international consulting firm, CFI Group. The ACSI consists of satisfaction scores on a 0 to 100 scale for more than 100 big corporations in the USA. The scores are derived from econometric modelling of survey data from telephone interviews with customers the actual users of products and services of those companies. Although surveys are conducted quarterly on a rolling basis, information for each firm in a given industry is collected only once a year. A detailed description of the survey methodology and procedure is available elsewhere. 24 Financial information such as net income (profit) and total assets for those companies included in the ACSI database were from the COMPUSTAT. Since data for 2001 and onward were not available in COMPUSTAT, the data from 1994 (beginning of the ACSI database) to 2000 were used in this study. The framework serving as the basis for the subsequent statistical analyses is in Table 1. In addition to satisfaction performance, a variety of variables are included in the analysis. As mentioned earlier, in lieu of ROA, net income and total assets are used as the dependent variables. While net income is net profit (loss), which is income after taxes and interest, total assets consist of equity and debt. AITMAN is a 348 Journal of Targeting, Measurement and Analysis for Marketing Vol. 13, 4, Henry Stewart Publications (2005)

4 Customer satisfaction, net income and total assets: An exploratory study Table 1: Conceptual framework Net income t = F (Customer satisfaction t, Customer satisfaction t 1, Total assets t, Debt t, Sales t, ALTMAN t ) Total assets t = F (Customer Satisfaction t, Customer Satisfaction t 1, Debt t, ALTMAN t, Net Income t 1 ) Table 2: The fixed effects model Dependent variables Net income Total assets Customer satisfaction t 17.44*** 44.88*** ( 24.11) ( 21.35) Customer satisfaction t *** 1.37 (17.93) (0.65) Total assets t 0.07*** (4.70) Debt t 0.10*** 1.40*** ( 5.66) (80.73) Sales t 0.03*** (12.34) ALTMAN *** *** (23.56) (37.12) Net income t *** (8.61) Adjusted R Durbin-Watson Statistic Note: *** denotes significance level at 1%. Underneath coefficients are t-statistics in parentheses. The intercept terms for each firm are not reported. Seventy-four firms were used in the analysis due to missing values. financial index designed to measure a firm s likelihood of going bankrupt. The reason for including these marketing as well as non-marketing variables deserves explanation. As critiques deplore the fact that marketing is losing its relevance in the business field, it is important to show the indispensable role marketing plays in achieving financial success for companies. 25 Inasense,thisisan exploratory cross-disciplinary study to explore how marketing and other variables affect companies bottom line. The impact of marketing variables on financial success can only be demonstrated through such an integral investigative approach. Furthermore, statistically speaking, the inclusion of irrelevant variables poses much less danger than omission of relevant information. 26 RESULTS As described earlier, the data for the study have large cross-section units but short time duration. As such, panel data techniques are appropriate for the analysis because they take into consideration differences in behaviour across firms. 27 which cannot be modelled with a cross-section data set. Since the time periods are very short, the number of lags for the satisfaction measure is one arbitrary, but appropriate to preserve degree of freedom. The coefficients for the fixed effects model as well as the random effects model were estimated using the pooled least squares procedure. For the fixed effects model, the seeming unrelated regression (SUR) procedure was not available to take care of possible autocorrelation and heteroskedasticity problems due to a large number of cross sections with short periods. The White heteroskedasticity procedure, however, was used to tackle general heteroskedasticity in the data. Also, autocorrelation was not found to be a major issue for the equation with net income as the dependent variable. The results of the fixed effects model are in Table 2. Henry Stewart Publications (2005) Vol. 13, 4, Journal of Targeting, Measurement and Analysis for Marketing 349

5 Guo and Jiraporn Table 3: The random effects model Dependent variables Net income Total assets Constant (0.36) ( 0.07) Customer satisfaction t 34.52** ( 2.48) ( 1.49) Customer satisfaction t ** (2.07) (1.28) Total assets t 0.08*** (6.41) Debt t 0.10*** 1.47*** ( 5.31) (57.62) Sales t 0.02*** (3.98) ALTMAN *** *** (3.45) (2.59) Net Income t ** (2.33) Adjusted R Durbin-Watson Statistic Note: ** and *** denote significance level at 5% and 1%, respectively. Underneath coefficients are t-statistics in parentheses. The intercept terms for each firm are not reported. Seventy-four firms were included in the analysis due to missing values. In the equation where net income is the dependent variable, all the coefficients are significant at the 1 per cent level, and the adjusted R 2 (0.73) is high, suggesting an overall good fit of the model for the data. While current satisfaction ( 17.44, p 0.01) has a negative coefficient, past satisfaction has a positive one ( 11.25, p 0.01). Total assets ( 0.07, p 0.01), sales ( 0.03, p 0.01), and AITMAN ( , p 0.01) all have a positive coefficient, whereas debt ( 0.10, p 0.01) is negatively related to net income. In the equation with total assets as the regressand, all independent variables but one are significant at the 1 per cent level. Although the adjusted R 2 (0.98) is very high, the low Durbin-Watson statistic (0.75) suggests that the results should be treated with caution. While current satisfaction ( 44.88, p 0.01) is the only variable that has a negative coefficient, debt ( 1.40, p 0.01) and ALTMAN ( , p 0.01) are positively related to total assets and past satisfaction ( 1.37) has a non-significant positive coefficient. For the equation with net income as the dependent variable, parameter estimates from the random effects model are similar to those from the fixed effects model. Current satisfaction ( 34.52, p 0.05) and past satisfaction ( 27.88, p 0.05) have opposite relationships, one positive and one negative, with net income both at the 5 per cent significance level. In the equation for total assets as the response variable, neither current satisfaction ( ) nor past satisfaction ( 67.74) has a significant coefficientatthe10percent level from the random effects model. The results must be treated with caution however, since the Durbin-Watson statistic (0.81) for the equation is low. Results for the random effects model estimation are in Table 3. DISCUSSION Although it is a widely held belief that customer satisfaction is positively related to profitability, whether there is an instantaneous effect or lagged effect between the two is not precise, a point that has not gathered much attention. 350 Journal of Targeting, Measurement and Analysis for Marketing Vol. 13, 4, Henry Stewart Publications (2005)

6 Customer satisfaction, net income and total assets: An exploratory study After controlling for other variables, such as total assets and debt, current satisfaction has a negative effect on net income, while past satisfaction is positively related to net income. The results are robust in that current satisfaction still has a negative coefficient with respect to net income as the dependent variable in the equation where past satisfaction is dropped out, everything else remaining the same. Although current satisfaction is highly correlated to past satisfaction, inclusion of both is the only way to evaluate the competing ideas between satisfaction s instantaneous and lagged effect on profitability. Furthermore, all variables have a highly significant coefficient in the regression on net income, revealing that multicollinearity is not a problem. In fact, the high R 2 for the equation indicates the adequacy of the model. It seems that satisfaction programmes such as quality initiatives or personalised services are indeed for the long haul. 28 This is especially true for service organisations where intimate customer care inevitably brings down productivity. 29 As resources spent on infrastructure in an effort to produce better or more innovative products and render individualised services put a dent on net profits in the current period, only market-oriented firms will have the aspiration and determination to see through their future pay-offs. 30,31 Top management of market-oriented firms is willing to take calculated and educated risk in its decision making. 32 As for total assets, the results are not in total agreement between the fixed effects and random effects models. Current, as well as past satisfaction, is not related to total assets in the random effects model, but current satisfaction is negatively related to total assets in the fixed effects model. Why does customer satisfaction reduce total assets? Perhaps firms with a high performance in customer satisfaction tend to return their earnings to their shareholders in the form of dividends rather than hoard the profits to expand the resource base of the firm. (This is purely speculation.) Another possible explanation could be due to the increased concern and effort in the business community to reduce the amount of inventory, which is part of total assets on the balance sheet. 33 Pursuit of customer satisfaction can significantly whittle down inventory through various customer-driven marketing programmes. For example, relationship marketing accentuates the importance of coordinated activities taking place along the supply chain and channels of distribution to increase material and product flow and reduce overstock. 34 As a consequence of enhanced trust among business partners and enlarged scope in applications of technology, such as electronic data interchange (EDI), the internet and extranets, firms along the value chain can freely share sensitive information. As a result, they are able to cut down or minimise the amount of inventory by incorporating cutting edge management programmes, such as just-in-time (JIT) and efficient consumer response (ECR) systems, to better meet customer needs and wants. 35 According to one study, a coordinated distribution channel in the grocery industry can reduce US$40bn of inventory while enhancing customer satisfaction. 36 This issue, a counterintuitive finding between satisfaction and total assets, however, has to be examined further before any firm conclusion can be made, which could be a fruitful area for future research. Considering all findings, current satisfaction is negatively related to both net income and total assets. Since net income and total assets increase over time, this means that satisfaction slows downtherateofincreaseinnetincome Henry Stewart Publications (2005) Vol. 13, 4, Journal of Targeting, Measurement and Analysis for Marketing 351

7 Guo and Jiraporn and total assets. If it is still believed that current satisfaction is positively related to ROA, the way in which current satisfaction influences ROA is through reducing the growth rate of total assets more than the growth rate of net income. Since current satisfaction is negatively related to net income, a measure of profitability, the inclination might be to say current satisfaction is negatively related to profitability rather than try to figure out the size of the effect current satisfaction has on total assets vis-à-vis net income. That is, current satisfaction is negatively related to ROA. On the other hand, past satisfaction has a positive effect on net income and no effect on total assets, suggesting that past satisfaction has a positive effect on ROA. Thus, customer satisfaction has a lagged effect on profitability as found elsewhere. 37 CONCLUSION Whether customer satisfaction has an instantaneous or lagged effect on profitability is a legitimate inquiry deserving more attention and discourse in the literature than it currently has. To fill the void, this study took a somewhat different approach to explore how customer satisfaction affects net income (profit) and total assets. Panel techniques were applied for the wide cross-section units with short periods data set, which has a fundamental advantage over a cross-section data set in modelling individual differences across firms. A variety of variables were included, marketing and non-marketing, to demonstrate the important role customer satisfaction has to play in affecting profitability. Current satisfaction is negatively related to both net income and total assets. Although it is still mathematically possible that current satisfaction is positively related to ROA (a ratio of net income to total assets) by slowing down the rate of growth for total assets more than the rate of growth for net income, it is more likely that current satisfaction is negatively related to ROA. Past satisfaction, however, is positively related to net income, and does not have any effect on total assets. Thus, past satisfaction has a positive effect on ROA, while current satisfaction may have a negative effect on ROA. That is, satisfaction has a lagged effect on firms profitability. Although the lagged effect of satisfaction on profitability was examined, thenatureofthedatasetavailable precluded the authors from digging deeper to answer more specific questions, such as how past satisfaction affects profitability, is it through word of mouth or reduced price elasticity? Similarly, some possible reasons why satisfaction constrains the growth of total assets were offered, an interesting finding, but more investigation is needed. It is hoped that this study is helpful in providing some hints for future research. References 1 Anderson, E. W., Fornell, C. and Lehman, D. (1994) Customer satisfaction, market share, and profitability: Findings from Sweden, Journal of Marketing, Vol.58,July,pp Caru, A. and Cugini, A. (1999) Profitability and customer satisfaction on services, International Journal of Service Industry Management, Vol.10,No.2,pp Fornell, C., Johnson, M. D. and Anderson, E. W. (1996) The American customer satisfaction index: Nature,purpose,andfindings, Journal of Marketing, Vol. 60, October, pp Yeung, M. C. H. and Ennew, C. T. (2001) Measuring the impact of customer satisfaction on profitability: A sectoral analysis, Journal of Targeting, Measurement and Analysis for Marketing, Vol.10,No. 2, pp Yeung, M. C. H. and Ennew, C. T. (2000) From customer satisfaction to profitability, Journal of Strategic Marketing, Vol.8,pp Crosby, P. B. (1979) Quality is free, McGraw-Hill, New York. 7 Garvin, D. A. (1988) Managing quality: The strategicandcompetitiveedge,thefreepress,new York. 352 Journal of Targeting, Measurement and Analysis for Marketing Vol. 13, 4, Henry Stewart Publications (2005)

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