ONE OF THE best books I’ve ever read on the subject of customer retention is “The Loyalty Effect” by Frederick F. Reichheld (Harvard Business School Press).
Many of Reichheld’s conclusions are inarguable. For example, he asserts that successful companies tend to have loyal customers, loyal employees and loyal owners. But some of his ideas bear further analysis.
Case in point: Reichheld maintains that a 5% increase in the retention rate can increase lifetime value by as much as 75% in such industries as insurance, banking and auto service. I had my doubts when I saw this number.
And he adds two items to the list of variables that affect lifetime value that surely require more study.
One is price. As Reichheld sees it, loyal customers not only buy more over the years from their supplier, they also buy more expensive products. For example, personal insurance premiums tend to go up about 8% a year as families earn more, buy more expensive cars, improve their homes and add life insurance coverage.
The other is cost of service, which is not commonly covered in lifetime value tables. Reichheld argues that the costs of servicing a new customer are typically much higher in the first year. Software customers call for help more in the first 60 days than they do in the next 60 months. The cost of servicing a bank loan or insurance usually soars during the application phase. Since these costs do drop with length of service, he reasons, the reductions should be reflected in an accurate lifetime value table.
Unwilling to take all this at face value, I slipped out the old calculator and applied some of Reichheld’s ideas to a modern lifetime value table. Using the variables in Fig. 1 (all put forward by Reichheld as examples of what happens when you have loyal customers), I tried to validate his concept that lifetime value could rise as much as 75% if the retention rate increased 5%.
To do this, I pretended that we were looking at a department store, bank or insurance company that normally loses 40% of its customers in the first year. However, the retention rate soon jumps to 80%, and continues rising. The referral rate also goes up from 4% during the first year, then doubles in the years that follow.
The customers make only five purchases during that initial year, averaging $48 apiece. For loyalists who last to the second year, the purchases double and the price they pay increases. Finally, first-year costs (which include the cost of products delivered plus the cost of delivering those products) amount to 70% of revenue. Thereafter, costs drop to 60% and below.
As you can see in Fig. 2, we compare first-year retention rates of both 80% and 85%. It costs about $80, on average, to acquire a new customer.
(For my purposes, I assumed we had acquired 100,000 customers, perhaps over several years. In addition, though some companies have shorter or longer customer lifetimes, five years is a good average number for our test.)
So what did I find? Well, in my test, the lifetime value went up by 17%. That’s not 75%, but it is a very healthy and profitable increase. I have worked with the figures for some time, and I can’t get them to go much higher than 23% with any set of reasonable assumptions.
Then there’s this problem: How do you get the retention rate to increase from 80% to 85%? Obviously, it has to come from treating customers better in some way-i.e., sending them letters, birthday cards and newsletters, surveying them, or giving them gold cards and gold-card treatment. But these things cost money, and the extra costs are not factored into these calculations. In fact, when I include these extra costs, the increase in lifetime value is less than 17%.
So it sounds like Reichheld’s book is a bust, doesn’t it?
Not so fast. He argues that the increase in retention comes not so much from the way you treat customers (although treating them well is important) but from recruiting the right customers in the first place. He rests his case on these points:
* Some customers are predictable and loyal. They prefer long-term relationships.
* Some customers are more profitable than others. They spend more and need less service.
* Some customers like your products and services more than those of your competitors.
Reichheld concludes that we should look for people who have one, two or three of these factors, adding up to what he calls a high loyalty coefficient.
As an example, he cites an insurance company that studied the demographics of its customers in an effort to explain their loyalty. According to Reichheld, the company found that:
* Customers in the Midwest and rural areas tended to be more loyal.
* Customers in the Northeast and city dwellers tended to be less loyal.
* Married people were more loyal than singles.
* Renters were less loyal than homeowners.
* Young people were less loyal than older people.
* Income levels affected loyalty.
The different population segments had average retention rates varying from 72% to 94%. While it might cost more to acquire loyal customers, it’s worth it in the long run.
Some other case histories serve to illustrate this point:
* Credit card issuer MBNA acquires a very large and intensely loyal customer base by cultivating 3,800 organizations and developing an affinity card for each. The resulting loyal customer has a $59,000 income, has been employed for 14 years and is a homeowner who has paid his bills regularly for that amount of time. MBNA’s members use their cards 12% more than the national average and spend 4% more per transaction.
* Lexus targets former Mercedes and Cadillac owners, whereas Infiniti seeks younger people who drove BMWs and Jaguars. Infiniti focuses on fashion and high performance. Lexus owners are older and more attracted to service, reliability and long-term value. Result: The Lexus repurchase rate was 63% two years in a row, while Infiniti rates were stuck at 42%. Lexus got loyal customers by seeking loyalists in the first place.
A few more tidbits:
* Customers who are acquired by coupons and price discounts are less loyal than those who come from other sources.
* Companies that expect to achieve sustainable high performance are studying life-cycle profit and tenure patterns, and are using this insight to find the right customers.
* If you look for the right customers in the first place, you can increase your retention rate without spending additional money. You have to treat people right, of course, but the job is much easier if you begin with loyal people.
Reichheld is right that loyalty is vital to success today. With the maturing of the markets for most companies, he writes, “the smartest of the smart will shift their growth strategies away from new-customer acquisition toward broadening their relationships with the good customers they’ve already won.”
Getting the right customers is only the first step. The next is to use the superior cash flow from superior customers to hire and retain superior employees.
For my part, I will rethink my lifetime value calculations to consider price levels and service costs. I will take to heart Reichheld’s key point that the most important way to build customer loyalty is to recruit loyal customers to begin with.
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