Thought-starter # 2, the calculus of loyalty

Thought-starter # 2: the calculus of loyalty

There is a calculus of loyalty. Experience, coupled with the latest findings published by Bain and TARP, now demonstrate this. In business, as in our personal lives, loyalty (etymologically related to the Latin lex or “law, faithfulness”) has definite rewards. The single most compelling reason for a business to exist is to create value for its customer community. If your purpose in life (for your business) is to create value, you’ll prosper and grow and loyalty will be the single largest contributing factor. If not, you’ll be out of business in the next five to ten years.

Until recently, the rewards of business loyalty were understood only intuitively. It made sense to us as marketers that loyal customers bring with them greater profit over time. In fact, the original frequency programs were designed to capitalize on, and are direct evidence of, this intuitive knowledge.

Frequency programs and frequency measures may be destructive, however, unless the economics of loyalty are taken into account.

Loyalty reliably measures whether superior value has been delivered. Most of

us now recognize that “value” is completely customer-defined. The equation might look something like this:

your customers’ expectations for the experience – “the actual”

VALUE = ____________________________

Cost

When our customers experience continuous, reliable, and increasing value we know that they will be Loyal. Loyalty brings with it a series of second-order economic effects, which cascade through the business system:

1. Revenues and market share grow through repeat sales,

purchase of other products and referrals.

2. Costs to acquire and to serve existing customers shrink.

3. Profits go up.

4. The company culture change.

A self-renewing, continuous improvement process installs itself. Employees have increased job pride and satisfaction. Employees stay longer while customers come back.

In achieving customer loyalty, the single most important decision any company can make is selecting its customers. We can neither serve every customer well nor be all things to all customers. It’s a costly istake, a diminishing of our resources and skills, to try to retain each and every customer because, quite simply, not every customer is worth retaining. In fact, we need to learn how to identify and disengage with customers who are not profitable to serve.

To wrestle with the subject of loyalty, it’s vitally important that we define who a customer is and then define their lifetime value, expressed in net potential value (NPV) terms.

Then, we must understand how much of the customers’ “share of wallet” belongs to us today and how much of their wallet we can earn. We can then make intelligent decisions about how to invest in our current and potential customer audiences based upon their reciprocal commitment to us (as demonstrated by their pocketbooks).

What Variables Do We Me a s u re ?

We define a customer by at least two variables; e.g., a customer is someone who buys X number of dollars worth of my products over Z period of time. We can add dimension to this definition by expanding the definition;

e.g., someone who buys X number of dollars of Y number of products over Z period of time. Finally, we would want to add the contribution margin of that customer and/or net profit dollars.

Share of Customer and Lifetime Value

While this is an important step in all forms of marketing, in the business-to-business environment we further need to understand how much our customer spends on competitive products That is, the share of wallet (share of customer). For example, if Sue Ann buys $400 of our widgets and a total of $600 of widgets, her loyalty coefficient to us is much higher than if she buys a total of $7,500 worth of

widgets. (Note, however, that some buyers may have constraints on having a single source for any product family; the realization of this “truth” and including this variable in our understanding helps flesh out the calculus.)

In addition to understanding the value of our customer, it is essential that we define the rate at which we lose customers — the defection rate — as well as how many customers we acquire during a given year. Caution is called for here: a greatly skewed picture of the value of our customer community will result if we average the defection rate out, e.g., over 10 years. That’s because most companies report their defection rate is highest over the earlier years of a customer’s lifetime. Any loyalty valuation must recognize this.

I know that many of us see the admonition to “define who a customer is” and laugh or belittle the maker of the statement. But keep in mind the fate of IBM — while IBM touted the fact that everybody was their customer, millions of dollars of replacement parts and add-on business went elsewhere.

A customer, then, is someone who buys X-number of dollars of Y-product offerings in Z-period of time. That is, we define a customer by the dollar amount, the penetration or depth of products purchased, and the factor of pertinent recency.