The Loyalty Effect: The Hidden Force Behind Growth, Profits, & Lasting Valueby Frederick F. Reichheld, Thomas Teal
Reichheld lays out a new "economics of loyalty" that provides a framework where the "soft" elements of business -- loyalty and learning -- can be effectively linked to the hard science of cash flows and cost/benefit analysis. Because of this connection, Reichheld argues, there is enormous potential for improving a company's performance by increasing customer, investor, and employee loyalty. Reichheld's research demonstrates that loyalty drives profits in direct and quantifiable ways through its impact on growth, learning, and productivity. In addition, loyalty generates a spiritual energy that powers the value creation process that is at the heart of sustained business success. In many industries, loyalty explains the differences in profitability among competitors more effectively than scale, market share, unit costs, or most other factors usually associated with competitive advantage.
- Harvard Business Review Press
- Publication date:
- Product dimensions:
- 6.60(w) x 9.36(h) x 1.24(d)
Read an Excerpt
Chapter 2: The Economics of Customer LoyaltyMAKING RATIONAL DECISIONS
In our experience, once companies understand the potential value of customer retention, they tend to fall into a trap. Eager to produce rapid improvement, they shortcut their analysis of customer cash flow. Understandably but foolishly, they conclude that getting bogged down in the details of a proposition they already accept as fact-that improving customer retention will improve profits-is a waste of time and money. The omission usually comes back to haunt them. The only way to put loyalty at the heart of daily decision making is to take the economic effects of loyalty seriously, measure them rigorously, and link them firmly to reported earnings. The best way to reduce misunderstandings between different parts of the organization, and to surface and resolve them when they do occur, is to make the loyalty numbers so trustworthy that everyone accepts them as a basis for investment and strategy decisions.
Take the case of a large insurance company. Having studied the economics of loyalty at the broadest level, and having compared the company's own retention rates with the competitions, senior management introduced half a dozen new customer retention programs, from service quality enhancement to modified sales commissions and customer recovery units. A year later, however, they found little or no compliance with their initiatives. Middle managers were dragging their feet. Closer examination located the root of the problem in the actuarial staff, a powerful department in most insurance companies. The actuaries disagreed with the financial consequences of increased loyalty as estimated by theaccounting department. They believed that greater customer retention had to mean holding onto unprofitable, high-risk customers that the company ought instead to purge. It took a thorough analysis of the claims and cash-flow records of former customers to convince the actuaries that defectors were attractive customers-much more attractive than the average new customer. Even then a few were not convinced but had to be shown precisely how the superior retention rates of their best competitors explained their superior profits.
Retention economics lets companies make rational, dollars-and-cents decisions about the value of increased customer loyalty and tells them accurately, for the first time, which loyalty-enhancing investments will meet their hurdle rates of return. Where retention economics remains an off-line system-an article of faith for some departments, perhaps, but an unknown quantity for others-loyalty will never carry real weight in key investment decisions. Where retention economics has never been tested under fire, even companies that have bought into the concept will quickly revert to old measurement systems in times of profit pressure. Companies that are serious about improving customer loyalty will eventually find that they must invest in the systems that measure retention and its economic consequences. The, earlier they make this investment, the better.
REVISITING REPORTED EARNINGS
To this point, we have been speaking the language of investment and net present value. But to make loyalty economics a trusted part of management's toolbox, we must perform one final operation. We must translate these numbers back into the kind of reported profits on which so much of today's decision making is based. Outside of the insurance and direct-marketing industries, very few companies have taken this last step. Walking through an example will help to show how it's done and perhaps explain why it hasn't been done before.
Let's stick with the credit card example, and look at what happens to reported earnings over a ten-year period if a firm operates at 95-percent retention as opposed to 90-percent retention. Figure 2-9 shows reported earnings in each of these two scenarios. A real company will first need to unravel its current inventory into tenure classes, or cohorts. It can be a little embarrassing to go to your customers and ask them how long they've been doing business with you, but it can be done. From this starting point, future earnings streams can be estimated on the basis of the long-term earnings and defection patterns we've already seen. In the hypothetical example in Figure 2-9, we assumed that the firm has one million customers, operates at 90-percent retention, acquires customers at a steady rate of a hundred thousand per year, and has an unchanging customer profit pattern (Figure 2-4). The result is a company with an average customer tenure of seven years and earnings of $80 million at the beginning of the period.
In the 90-percent retention scenario, as you can see, earnings grow very slowly to $96 million at the end of ten years. With 95-percent retention, however, earnings grow almost 50 percent faster, to $141 million by the end of the tenth year. If we make some reasonable assumptions about customers' terminal value-the profit stream they will produce during their remaining years with the company - the increase in total value for the 95-percent retention case is even higher, approaching 75 percent.
These numbers are not merely impressive; they are also simple and straight forward. And the kind of customer-tracking systems we're talking about are no more complicated than many of the accounting systems companies have in place today. A few businesses-a few whole industries-have built accounting systems based on the economies of customer retention. Life insurance companies have tracked their customers this way for decades; so have direct marketers like L. L. Bean and Lands'End. USAA has a near-perfect customer tracking system that other companies might use as a model. The question is why more companies have not built them. Part of the answer is that regulators and investors don't require it. Managers have to provide shareholders with information on current profits but no one demands an accounting of any of the factors that loyalty economics builds on....
What People are saying about this
and post it to your social network
Most Helpful Customer Reviews
See all customer reviews >