Market Oriented Value Creation in Service Firms Rod B. McNaughton Eyton Chair in Entrepreneurship, University of Waterloo, Ontario, Canada Phil Osborne Marketing Department, School of Business, University of Otago, New Zealand Brian C. Imrie Marketing Department, School of Business, University of Otago, New Zealand Key Words: Competitive Advantage, Market Orientation, Performance, Value Address for correspondence: Professor Rod McNaughton Department of Management Sciences University of Waterloo 200 University Avenue West Waterloo, Ontario, Canada N2L 3G1 Telephone: 519-888-4567, extension 6203 Fax: 519-746-7252 E-mail: rmcnaugh@engmail.uwaterloo.ca

Market Oriented Value Creation in Service Firms Abstract

A fundamental proposition in marketing strategy is that a market orientation is

positively related to firm performance. However, the mechanisms of this

relationship have yet to be explored in detail, especially in service industries

where intangible assets are relatively more important. This paper addresses

this issue by proposing a model that identifies important intermediate variables

between a market orientation and increased firm value. The model posits that a

market orientation guides investment in market-based assets and other asset

types, that these assets may be levered to create a competitive advantage and

value for customers, and that this results in loyalty and easier customer

attraction. Quicker and more extensive market penetration, shorter sales

cycles, and decreased marketing and sales costs enhance the cash flow of a

market-oriented firm. This may be recognised in higher valuations, which

ultimately translate into higher share prices and wealth creation for the owners

of the firm.

Introduction

A key objective of research into marketing strategy is to uncover how

firms develop and sustain a competitive advantage, and how an advantage

translates into superior performance. Market orientation – a business culture

focused on the continuous creation of customer value (Slater and Narver,

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1994) – is one intangible that is posited to be a source of competitive

advantage that positively influences business performance (Narver and Slater,

1990; Jaworski and Kohli, 1993; Deshpande, Farley and Webster, 1993). A

substantial number of studies are reported in the literature that test hypotheses

relating a market orientation to firm performance as measured by financial

measures such as profit, relative profit, return on investment or assets, and

non-financial measures such as new product success and innovation. Empirical

results generally confirm a positive relationship with measures of

performance, though the strength of the association is often weak (e.g.,

Ruekert, 1992; Deshpande, Farley and Webster, 1993; Jaworski and Kohli,

1993; Slater and Narver, 1994; Pelham and Wilson, 1996).

Most empirical studies of the market orientation – performance link are

set in the context of traditional manufacturing sectors. However, there is

evidence of a market orientation – performance link in the context of service

industries (e.g., Van Egeren and O’Connor, 1998; Chang and Chen, 1998;

Kumar, Subramanian, and Yauger, 1998; Pitt, Caruana, and Berthon, 1996;

Han, Kim and Srivastava, 1998; Voss and Voss, 2000). The often cited service

characteristics of intangibility, heterogeneity, inseparability and perishability

(Sasser et al., 1978) highlight both the reduced emphasis upon tangibles and

the increased role that a consumer plays within the service process. Within the

service industries, competitive advantage is less likely to come from tangible

factors, and is more likely to be derived from intangibles that contribute to

unique capabilities. Intangible assets are also important because they are

increasingly considered in determining the market value of companies (Kaplan

and Norton, 2001).

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The integral involvement of the consumer within the service process

suggests the need to develop close and trusting relationships to increase

customer perceived value, and such relationships are logically fostered by a

market orientation. As an active participant in the service “performance” the

consumer interacts with personnel, the service script and supporting tangibles

in a manner that does not occur in a product marketing context. The

consequent transparency of the service encounter enables an impression to be

formed of the firm’s commitment to creating customer value. Equally the

interaction that occurs with service personnel enables enhanced market

sensing by the firm, a capability of a market oriented company (Day, 1994).

As a result it is possible that a market orientation is even more central to the

performance of services firms.

The papers in this special issue are important as they reveal more detail

about the relationships between the dimensions of a market orientation, the

creation of value for buyers of services, and the performance implications for

the producers and sellers of those services.

The extant body of marketing orientation theory, no matter the sector

in which it is applied, focuses on the processes whereby market orientation

creates customer value. (For example, see Figure 2 in Slater and Narver,

1994.) But, the bulk of empirical studies make a substantial leap in positing a

relationship between a measure of market orientation and improved financial

performance. The processes that underlie the links between market orientation,

customer value, and financial performance are largely treated as a “black box”.

This paper develops a conceptual model that makes explicit the

processes whereby a market orientation and emphasis on customer value can

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enhance financial performance, and ultimately create wealth for the owners of

a firm. It builds on and refines our model of market-based value creation,

which we recently used to characterise the restructuring of British Telecom

PLC’s marketing activities (McNaughton, Osborne, Morgan and Kutwaroo,

2001). In particular, by drawing on the services literature relating to quality,

satisfaction and loyalty, we are able to be more specific about the interface

between customer value and firm performance. Our model postulates an

explanation of the process whereby a market orientation is transformed into

customer value and how this in turn creates value for the owners of the firm. It

also contributes to management practice by providing a logical rationale for

investments in market-based assets, justification for efforts to develop a

market oriented organisation, and framework that can be used to both guide

and analyse the strategies of market-oriented firms.

Market Orientation and Service Firm Performance

Despite continuous debate over the specific dimensions of the market

orientation construct (for an excellent review see Lafferty and Hult, 2001), the

link to organisational performance is almost universally accepted (Sheth and

Sisodia, 1999). However, empirical tests of the robustness of the relationship

to the unique characteristics of the services environment are a relatively recent

addition to the market orientation literature. Early considerations of a market

orientation in the services industries include Greenley and Matcham (1986),

and Qureshi (1993). Bharadwaj, Varadarajan, and Fahy (1993) included

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elements of market-oriented behaviour in their conceptual model of the drivers

of sustainable competitive advantage in service industries. A number of

empirical tests of the market orientation-performance relationship appeared in

the literature in the late 1990s. Table 1 highlights a sample of these

investigations. Most of these studies support the market orientation –

performance link, but there is enough contrary evidence to suggest the

relationship is not as straightforward as is often perceived (Au and Tse, 1998;

Caruana, Pitt, and Berthon, 1999; Sargeant and Mohamad, 1999). While these

negative results are usually accompanied by study-specific reasons for the

“anomalous” findings (e.g., Caruana, et al 1999), even supportive findings

explain little of the variation in firm performance, with coefficients of

determination typically being less than 0.10.

>>>> Take in Table 1 about here<<<<

Our conclusion from the extant literature is that understanding of how

a market orientation influences performance is still nascent and requires

development (McNaughton, Osborne, Morgan and Kutwaroo, 2001), a view

that has also been expressed by Uncles (2000), and Deshpande (1999). This is

especially the case in the context of the services industries where a high degree

of intangibility may confound the relationship (Sin and Tse, 2000), and

intermediate variables such as service quality are also likely to significantly

impact firm performance (Chang and Chen, 1998).

The role of intermediate variables is key. The processes that underlie

the market orientation - performance relationship are poorly identified in most

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empirical studies, though the improbability of a direct causal link (e.g., as

postulated by Narver and Slater, 1990 and Ruekert, 1992) is acknowledged by

exploration of potential moderators (e.g., Day and Wensley, 1988;

Diamantopoulos and Hart, 1993; Greenley, 1995, Jaworski and Kohli, 1993).

The established logic is that a market orientation provides the basis for

devising a strategy that creates value for customers, and that such a strategy

provides the foundation for a sustainable competitive advantage that

contributes to financial performance. (For example, see the hypotheses related

to business performance developed by Jaworski and Kohli, 1993, or by

Deshpandé, Farley and Webster, 1993.) However, this line of reasoning does

not in itself explain why a firm can realise value for its shareholders by

pursuing a strategy of creating customer value. Nor is an explanation readily

apparent in the market orientation literature. Kohli and Jaworski (1990, 1993),

for example, found that an emphasis on profitability was “conspicuously

absent” as a component of a customer value-based business strategy.

Chang and Chen (1998) make an important contribution to identifying

the steps that fall between a market-oriented business culture and performance

outcomes. These authors developed a conceptual model that postulates both a

direct effect for market orientation on business performance, and an indirect

effect through helping to improve service quality. (See Figure 2 in Chang and

Chen, 1998.) The model is tested with a sample of retail stockbrokers in

Taiwan. The results support the hypothesis that a market orientation can assist

firms to achieve a higher quality level, and that quality has a positive

relationship with profitability. Quality is found to explain more of the

variation in profitability than does market orientation. The model including

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service quality (and a number of covariates) explains 38 percent of the

variation in profitability between firms, and the addition of market orientation

to the model only increases this to 45 percent. Chang and Chen (1998, 257)

conclude: “Given that there are other potential intermediate variables

unaccounted for, the pure direct effect of market orientation on profitability

may be even smaller. This illustrates the importance of the identification of

intermediate variables.”

A Model of Market Oriented Value Creation in Service Firms

Figure 1 presents a model that maps a path from market orientation to changes

in cash flow that can influence firm value. The model identifies a number of

the intermediate variables, or steps, that fall between a market orientation and

eventual performance outcomes. The performance outcome in our model is

changes in the cash position of the firm rather than profitability per se. The

rationale is that cash flow ultimately determines the value of the firm, and

there are several mechanisms for this – of which profitability is one. Increased

earnings, accelerated cash cycling, increased residual value of cash, and

decreased volatility of cash flow all influence firm value (Srivastava, Shervani

and Fahey, 1998). Further, an emphasis on cash flow recognises the time lag

between implementation of market orientation, which can have costs, and

realisation of benefits in later periods (Gauzente, 2001).

>>> Take in Figure 1 about here<<<

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The model begins with the market orientation of a firm, which we link

to the creation of market-based assets, and other asset types. Market-based

assets are largely intangible, and consist of intellectual assets (knowledge

about the market), relational assets (outcomes of relationships with

stakeholders including channel members, customers, and other players), and

the interaction between these asset forms (Srivastava, Shervani and Fahey,

1998). Market-based assets accumulate by developing knowledge, skills and

resources that are unique and difficult to imitate (Barney, 1991; Hunt and

Morgan, 1995). They can be built or acquired through various forms of

investment, including staff time spent in relationship building, databases,

advertising and promotion, and sponsorship. Market-based assets can create

value for a firm by building strong barriers to entry that divert competitors to

higher cost or less effective strategies (Grant, 1991, 1996), leveraging the asset

(Srivastava, Shervani and Fahey, 1998), and deploying the asset to create

customer value (Slater, 1997).

The deployment of the asset to create customer value is of most

interest to us as this is the method by which a market orientation influences the

way in which a firm interacts with its customers. There is also a relationship

between market-based assets and other asset types. First, a market-oriented

firm may uncover through its intelligence about customers or a competitor that

investment is required in a non-market asset to achieve or maintain their

competitive position. This might, for example, be a new store location or

technology. Second, there is potential synergy between market-based assets

and other asset types. A hotel, for example, has greater potential value when

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branded and managed with an international hotelier’s business systems, than it

does if operated by a local property developer.

The unique assets of a firm, both market-based and of other forms,

create the competitive advantage of a firm. This in turn can be used to create

value for customers. Value is judged as part of an equation in which customers

compare perceived benefits and the perceived total costs (or sacrifice) of

ownership (Monroe, 1991). Market-based assets can create value for

customers through a positive quality perception (Chang and Chen, 1998),

lowering search costs, matching performance requirements and price (Day,

1994), improving service and trust, risk reduction, and by generating

innovative new offerings (Slater and Narver, 1994). Customer perceived value

is also influenced by comparisons made with offerings by competitors. Thus,

the competitor intelligence gathered by a market-oriented firm can be used to

improve the positioning of the offering (or the firm itself). Market orientation

thus influences both the numerator and the denominator of this equation. To

construct a positive value equation, a firm must define, deliver and

communicate a proposition that is recognised by the target market as better

than that delivered by the competition (Christopher, 1996).

A positive value equation attracts customers, and if their expectations

are met, they become part of a growing pool of satisfied customers. The

literature postulates that firms providing customer value have more satisfied

customers who demonstrate stronger brand loyalty (Aaker, 1991; Oliver,

1997). Satisfied customers also generate positive word-of-mouth, which helps

to recruit new customers (Swan and Oliver, 1989; Singh and Pandya, 1991).

There is a substantial body of literature that addresses these relationships in

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general, and in the specific context of service industries. Interestingly,

attempts to relate measures of quality or satisfaction at the firm level to

profitability (or firm value) have met the same result as those testing the

market orientation – performance link; generally the relationship is positive

but the effect is weak. Examples of this research include Yeung and Ennew

(2000), Aaker and Jocobson (1994), and Anderson and Fornell (1994). These

studies show a much weaker quality-performance relationship than was

originally suggested by the PIMS data (Buzzell and Gale, 1987).

Research into the behavioural aspects of these relationships has met

with more success, by investigating the relationships between variables that

are intermediate between quality and performance outcomes. Namely: quality

- satisfaction, satisfaction - loyalty, satisfaction - positive word-of-mouth,

loyalty - customer retention, and customer retention - performance. Examples

of this literature in the context of the service industries are described in Table

2. One reason why the evidence for these individual links is stronger than that

for quality - performance is the difficulty of linking micro- and macro-

constructs (Yeung and Ennew, 2000). Concepts like satisfaction or loyalty are

attitudes and behaviours of individuals, often associated with particular service

experiences, while performance is an aggregate characteristic of an

organisation. In our model we illustrate this problem by embedding customer

value (the shaded box) within the broader construct of firm value. The

variables which fall outside of the customer value box, loyalty and word-of-

mouth, are associated with the behaviours of individuals, but have conceptual

equivalents at the level of the organisation – retention and referrals.

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>>>Take in Table 2 about here<<<

Both retention and referrals have the potential to increase incoming

cash and decrease outgoing cash, and thus to influence the value of a firm

(Table 3). For example, loyal customers are less likely to switch and require

less ongoing marketing effort to retain (Reichheld and Sasser, 1990). The

literature on both brand equity and customer satisfaction suggests that loyal or

satisfied customers will pay price premiums (Farquhar, 1989), adopt line

extensions more readily (Keller, 1993), try and refer products more frequently,

and have lower sales and service costs (Reichheld and Sasser, 1990). The

overall effect of these processes is to speed receipt of cash, widen the gap

between incoming and outgoing cash (for marketing related expenditures), and

reduce working capital and fixed capital requirements. All else being the same,

this should help to create higher earnings, reduce the volatility of cash flow,

and increase the residual value of cash flow (Srivastava, Shervani, and Fahey,

1998); effects which have the potential to increase firm value (Day and Fahey,

1988). The owners and managers of a firm also have to decide how to allocate

the retained earnings associated with this higher net marketing contribution.

The resulting cost advantage could be used to increase customer perceived

value through price reductions, possibly stimulating demand, or it could be

reinvested in the creation of further market-based or other assets.

>>>Take in Table 3 about here<<<

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Finally, while the construct “service quality” does not explicitly

appear, it has an important role in our model. Chang and Chen (1998)

identified quality as an outcome of managerial action, which is in turn

motivated by a market orientation. However, we perceive service quality to be

a ubiquitous influence. When a firm’s personnel (at all levels) are market-

oriented, activity focuses upon the creation of quality service through

deployment of both intellectual and relational market-based assets. The Gap

Model (Parasuraman et al., 1985) inventories the activities (gaps 1-4), by both

managerial and front line personnel, that are required to create a consumer

perception of service quality (gap 5). Service quality is considered an outcome

of the successful application of market assets while also adding value to the

firm and taking its place amongst the stock of market based assets (Zeithaml,

2000). Lastly, the value that service quality creates for all stakeholders

establishes it as an effective competitive advantage. The service quality

construct is embedded within our model as a market based asset, competitive

advantage and influencer of customer perceived value.

Conclusions

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Our model traces the theoretical effects of market orientation on firm

value. The model furthers understanding of the market orientation -

performance relationship by making explicit the mechanisms whereby creating

value for customers can also improve the financial position of a firm. This

addresses a gap in the stream of research that seeks to demonstrate a positive

empirical relationship between market orientation and measures of financial

performance (e.g., Narver and Slater, 1990 and Ruekert, 1992; Day and

Wensley, 1988; Diamantopoulos and Hart, 1993; Greenley, 1995, Jaworski

and Kohli, 1993).

The model postulates that a market orientation helps a firm to both

create market-based assets and guide investment in other types of investments.

These become the basis of a competitive advantage that can be deployed to

create customer value. Increased customer perceived value attracts customers,

and results in satisfied customers that are more loyal and who act as marketing

agents by spreading positive word-of-mouth (Reichheld and Sasser, 1990). A

growing pool of retained customers helps to accelerate net cash flow, increase

the residual value of cash, and decrease the volatility of cash flow. The model

also acknowledges that a market orientation may improve the performance of

service firms by contributing to service quality.

This model emphasises cash flow, which has three clear benefits. First

it provides the ability to communicate the benefits of a market-oriented culture

across functional areas within a firm. The language of cash flow is universal.

Second, it emphasises that market-based assets are an important investment

type. Valuation measures could be applied to market-based assets, providing a

common framework for firms to compare the benefits of a market orientation

with alternative internally focused strategies (or indeed, the complementary

effect of a market orientation on other asset forms). Finally, an emphasis on

cash flow impacts also clarifies that the benefits of a market orientation are not

realised in the same period as the investment. This is a problem for empirical

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studies that seek to correlate a market orientation with traditional measures of

financial performance, particularly profit.

The implementation of our model as a strategic framework would

require an accounting method that is able to relate changes in cash position to

specific marketing activities. Goebel, Marshall and Locander (1998) recently

addressed this issue by describing how activity-based costing can assist

analysis of the costs and benefits of a market orientation. The cost-per-

customer and revenue-per-customer metrics that are being used to both value

and track the performance of Internet-based firms are also relevant. These

metrics make a direct link between the costs of marketing activities and the

benefits derived in terms of customer retention, and the frequency and quality

of sales (Whyman, 1999).

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Figure 1 A Model of market oriented value creation

Asset Creation

Market-basedAssets

MarketOrientation

Other Asset Types

CompetitiveAdvantage

PerceivedCustomer

Value

CustomerAttraction Satisfaction Cash Flow

Impacts

Cost Advantage

Firm ValueCustomer Value

Loyalty

Word ofMouth

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Table 1 A sample of market orientation - performance relationship investigations in service industries Author Sample Country

(Usable responses)

Performance Relationship

Direct Mediated None Van Egeren and O’Connor (1998)

70, diverse, large, individual (non-SBU), SIC Code 5000, 7000, 8000

Mid western U.S (70)

Kumar, Subramanian, and Yauger (1998)

Healthcare US (159)

Pitt, Caruana, and Berthon (1996)

Diverse , large UK (161) and Malta (193)

Caruana, Ramaseshan, and Ewing (1998)

Universities NZ and Australia

Chang and Chen (1998)

Retail Stock Broking

Taiwan (116)

Au and Tse (1995)

Hotels Hong Kong (41) and NZ (148)

Lado, Maydeu-Olivares, and Rivera (1998)

Insurance Belgium (34) and Spain (32)

Han, Kim, and Sristava (1998)

Banks Mid West US (134)

Sargeant and Mohamad (1999)

Hotels UK (200)

Caruana, Pitt and Berthon (1999)1

Diverse, large UK (161)

1 The research reported in this paper appears to use the same data reported in Pitt, Caruana, and Berthon (1996). However, a contrary result is presented and discussed. The authors suggest problems with the conceptualisation of market orientation used, though no such qualms were expressed in the earlier paper. Further, the later paper explores a more complex model that may have confounded the identification of the earlier ‘direct’ relationship.

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Table 2 Research linking satisfaction, loyalty, and performance Topic Author(s) Research Finding Service Quality and Performance

(Aaker and Jocobsen 1994)

In an analysis of 34 major U.S. brands (both services and products) a positive relationship was established between the stock price index and quality perceptions.

(Rust et al. 1995) A framework is developed for determining the impact that service quality has upon profitability. A simulation is then used to illustrate the impact of service quality on profitability.

Service Quality-satisfaction-loyalty-behaviour

(Brady and Robertson 2001)

In a cross-national study it is found that service quality’s impact upon loyalty and behavioural intentions is mediated by a consumer's level of satisfaction and that this relationship is consistent across cultures.

Satisfaction and loyalty

(Singh and Sirdeshmukh 2000)

The authors model the key mechanisms that shape satisfaction in an individual encounter, and loyalty across ongoing exchanges. Central to the model is the way in which agency theory interacts with trust to affect satisfaction in an individual encounter and loyalty in the long term.

(Jones et al. 2000) The results of this study indicate that the influences of service satisfaction on repurchase intentions decreases where high switching barriers exist.

Loyalty and performance

(Reichheld and Sasser 1990)

Within a services context four mediating variables (cost, increased purchases, price premiums, word of mouth) are introduced as increasing with retention and subsequently positively impacting firm performance. Evidence is presented from a cross-section of industries to illustrate this contention

(Anderson 1993) A model is developed to link explicitly the antecedents and consequences of customer satisfaction in a utility-oriented framework. It is found a positive relationship exists between customer retention and profitability.

(Heskett et al. 1997) It is demonstrated that customer retention has a greater impact upon service firm performance than economies of scale, market share and other factors.

Satisfaction and performance

(Anderson 1994)

Using a sample of 77 prominent Swedish firms the authors found a significant relationship between satisfaction and return on assets (ROA).

Satisfaction, loyalty and firm performance

(Heskett et al. 1994)

The service-profit chain is introduced. The links in the chain are as follows: Profit and growth are stimulated primarily by customer loyalty. Loyalty is a direct result of customer satisfaction. Satisfaction is largely influenced by the value of services provided to customers. Satisfied, loyal, and productive employees create value.

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Table 2 (Continued) Research linking satisfaction, loyalty, and performance Topic Author(s) Research Finding Satisfaction, loyalty and firm performance

(Fornell 1992) Utilising the Swedish Customer Satisfaction Barometer (CSB), a national economic indicator of customer satisfaction, the authors find a significant relationship between satisfaction, loyalty, price elasticities and firm profitability.

(Hallowell 1996) The service profit chain was tested in a retail bank setting. The relationship satisfaction, loyalty and firm profitability is supported.

(Bo 2000) This paper finds that the satisfaction-loyalty-performance logic has a greater positive impact upon services than products. It is reasoned that service firms must earn loyalty but product firms can lower prices to aid retention. The results suggest however that for services satisfaction is only one determinant of loyalty. It is also noted that service revenue growth is driven primarily by personal referrals and word-of-mouth.

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Table 3 Possible impacts on cash flow of customer loyalty and positive word-of-mouth Loyalty – customer

retention Word-of-mouth – customer attraction

Increase incoming cash • Price premiums • Adoption of line

extensions • Increased purchase

frequency • Increased purchase

volume (easier to cross-sell, companion sell and up-sell)

• Reduced switching

• Faster trial, adoption and diffusion of products

• Increased market share

Decrease outgoing cash • Lower cost of recruiting customers

• Decreased customer servicing costs

• Lower selling costs

• Shortened sales cycle • Reduced inventory levels • Lower selling costs • Lower innovation costs

and fewer new product failures