Customer Loyalty’s Increasing Return

There are any number of reasons why delivering a better customer experience is good for business, generating incremental revenue as well as cost savings. A better customer experience will likely increase the rate at which customers refer others to you. And your own service costs will almost certainly decrease when you make it easier for a customer to engage with you, because there will be fewer costly customer problems to deal with.

But all these benefits pale beside the central economic fact that a better customer experience increases customer loyalty, and from a purely mathematical standpoint improving customer loyalty generates an ever increasing return. Each percentage point by which you improve your average customer retention rate provides an ever higher financial benefit!

I can illustrate this with a very simple hypothetical company:

• This company has an annual customer loyalty rate of 75%, which means it loses 25% of its customers each year. Mathematically, the average tenure of its customers is therefore 3 years (75/25), and each new customer it acquires can be expected to yield about 3 years’ worth of annual profit, on average.
• Now let’s say it improves customer loyalty by 5%, going from 75% annual loyalty to the 80% level. This will increase its average customer tenure from 3 to 4 years (80/20), representing a 33% improvement in lifetime value.
• The next year, if the company improves loyalty by 5% again, from 80% to 85%, then it will raise customer tenure from 4 to 5.7 years (85/15), an improvement of more than 40% in lifetime value!

In 1994, Swedish-born professor Claes Fornell founded the American Customer Satisfaction Index, and over the next 20 years ACSI has grown into one of the pillars of customer satisfaction metrics. According to Fornell, “Customer retention is one of those curves that have increasing returns.”

You could say that customer loyalty is the gift that keeps on giving.

In his book The Satisfied Customer: Winners and Losers in the Battle for Buyer Preference, Fornell considers how this simple mathematical truth about customer loyalty might apply to banks, for example:

Some have a 90 percent retention rate per year. Consequently, they lose 10 percent of their customers per year. Suppose now that a typical bank also succeeded in holding onto an additional 2 percent of its current customers, bringing the customer retention rate to 92 percent. That's an increase in the value of the customer asset by 28 percent. Note that the value of 90 percent retention is an average of nine years in terms of customer lifetime value to the company. But a small increase of 2 percentage points to 92 percent (92/8 = 11.5) gives us 11.5 years [28% more than 9 years].

So the good news is that the rate of return on customer loyalty increases at an escalating rate, producing financial benefits that become ever more significant with each small increment in improved loyalty.

But Now the Bad News…

The downside of improving customer loyalty, however, is that the cost of improving it also increases at an escalating rate. The more loyal your customers already are, the more expensive every 1% improvement in loyalty will be.

Think of it this way. In any population of customers, there will be some customers whose loyalty is easier to get than others. As you implement any sort of customer loyalty initiative or customer experience upgrade, these are the customers who will respond first. Once these “easy” customers have been made loyal, however, the remaining customers won’t be so easy. And so on. 

So it will cost you more to gain a 1% increase in customer loyalty when 90% of your customers are already loyal than when just 75% of them are. Said another way, reducing attrition from 10% to 9% will almost always cost more than reducing it from 25% to 24%.

As I’ve said before, customer loyalty should never be your only goal. As with everything else in business, a balance must be struck. You want the higher top-line revenue and increasing returns that better customer loyalty will generate, but you don’t want it to cost more than it will be worth, either.