Mismanagement Of Customer Loyalty

THE BEST CUSTOMERS, we're told, are loyal ones. They cost less to serve, they're usually willing to pay more than other customers, and they often act as word-of-mouth marketers for your company. Win loyalty, therefore, and profits will follow as night follows day. Certainly that's what CRM software vendors--and the armies of consultants who help install their systems--are claiming. And it seems that many business executives agree. Corporate expenditures on loyalty initiatives are booming: The top 16 retailers in Europe, for example, collectively spent more than $1 billion in 2000. Indeed, for the last ten years, the gospel of customer loyalty has been repeated so often and so loudly that it seems almost crazy to challenge it.

But that is precisely what some of the loyalty movement's early believers are starting to do. Take the case of one U.S. high-tech corporate service provider we studied. Back in 1997, this company set up an elaborate costing scheme to track the performance of its newly instituted loyalty programs. The scheme measured not only direct product costs for each customer but also all associated advertising, service, sales force, and organizational expenses. After running the scheme for five years, the company was able to determine the profitability of each of its accounts over time. Executives were curious to see just what payoff they were getting from their $2 million annual investment in customer loyalty.

The answer took them by surprise. About half of those customers who made regular purchases for at least two years-- and were therefore designated as "loyal"-- barely generated a profit. Conversely, about half of the most profitable customers were blow-ins, buying a great deal of high-margin products in a short time before completely disappearing.

Our research findings echo that company's experience. We've been studying the dynamics of customer loyalty using four companies' customer databases. In addition to the high-tech corporate service provider, we studied a large U.S. mall-order company, a French retail food business, and a German direct brokerage house. Collectively, the data have enabled us to compare the behavior, revenue, and profitability of more than 16,000 individual and corporate customers over a four-year period.

What we've found is that the relationship between loyalty and profitability is much weaker--and subtler--than the proponents of loyalty programs claim. Specifically, we discovered little or no evidence to suggest that customers who purchase steadily from a company over time are necessarily cheaper to serve, less price sensitive, or particularly effective at bringing in new business.

Indeed, in light of our findings, many companies will need to reevaluate the way they manage customer loyalty programs. Instead of focusing on loyalty alone, companies will have to find ways to measure the relationship between loyalty and profitability so that they can better identify which customers to focus on and which to ignore. Here we present one way to do that-- a new methodology that will enable managers to determine far more precisely than most existing approaches do just when to let go of a given customer and so dramatically improve the returns on their investments in loyalty. We'll also discuss strategies for managing relationships with customers who have different profitability and loyalty profiles. Let's begin, though, by reconsidering the evidence for the link between loyalty and profitability.

Is Loyalty Profitable?

To answer this question, we looked at the relationship between customer longevity and companies' profits. We expected to find a positive correlation, so our real question was how strong would it be. A perfect correlation (that is, 1) would mean that marketers could confidently predict exactly how much money there was to be made from retaining customers. The weaker the correlation (the closer it was to zero), the looser the association between profits and customer tenure.

The results were hardly a ringing endorsement of the loyalty mantra. The association was weak to moderate in all four companies we studied, with correlation coefficients of 0.45 for the grocery retailer, 0.30 for the corporate service provider, 0.29 for the direct brokerage firm, and just 0.20 for the mail-order company.

But did the weakness of the overall correlation between profitability and longevity conceal any truth in the specific claims about the benefits of loyal customers? To find out, we tested the three claims usually advanced by loyalty advocates, the ones we started with at the beginning of this article: that loyal customers cost less to serve, that they are willing to pay more for a given bundle of goods, and that they act as effective marketers for a company's products. We tested each of these hypotheses for all four companies by looking at several cohorts of customers at each who had begun doing business at the same time, tracking the profitability of each member of each group. In this way, we saw how these customers' purchasing patterns and the level of service the companies accorded them evolved over time.

Claim 1: It costs less to serve loyal customers. Many advocates of loyalty initiatives argue that loyal customers pay their way because the up-front costs of acquiring them are amortized over a large number of transactions. But, of course, that argument presupposes that the customers are profitable in those transactions. A more plausible argument for the link between loyalty and decreased costs can be built on the idea that loyal customers will be more familiar with a company's transaction processes. Since they need less hand-holding, the company should find it cheaper to deal with them. Loyal--and therefore experienced-- customers of software products, for example, should be able to resolve problems on-line without needing the direct intervention of a technical assistant.

Our analysis, however, offers no evidence to back that argument. It is certainly true that within any one company, the monthly cost of maintaining a relationship with an individual customer--not just for the actual transactions but also for communications through mailings, telephone, and so forth--vary enormously, sometimes by a factor of 100 or more. But in none of the four companies we tracked were long-standing customers consistently cheaper to manage than short-term customers. In fact, the only strong correlation between customer longevity and costs that we found--in the high-tech corporate service provider--suggested that loyal and presumably experienced customers were actually more expensive to serve.

That last finding isn't without precedent. There's a sizable body of academic research documenting the often poor profitability of long-standing customers