Is Customer Loyalty A Predictor Of Profitability?

[tweetmeme source=”pricingright”] Much has been said and written about the need for customer loyalty. The need to focus and attain customer loyalty is intuitively clear to all marketers. Some of the key arguments for customer loyalty include

  1. Reduced Customer Acquisition costs – Since it costs $X to acquire new customers, any customer you hold on to saved you $X. For example, it takes mobile providers $350 to acquire new customers and there are similar metrics for most products.
  2. The Loyalty Effect: Longer a customer stays longer they keep paying you. There was a book by the same name that claimed up to 75% increase in lifetime value of a customer if they stayed longer.
  3. Cross-Sell & Up-Sell: Since you keep your customers and come to know more about them it creates additional revenue opportunities through cross-sell and up-sell opportunities.
  4. Price Tolerance: Loyal customers keep buying from you because they are delighted by your product and are less sensitive to prices.  Some even claim that loyal customers do not even bother to use coupons and promotions, thereby saving you money.
  5. Decreasing Cost to Serve: The more you understand your customer’s usage behavior and needs fewer the mistakes in servicing them and hence lower the cost to serve them.
  6. Bump From Word of Mouth: Loyal customers are also your best marketers, they are happy to write online reviews and promote your products to all their friends and web communities. This means they generate additional incremental revenue.

All these factors seem plausible and the “gut feel” says these must be true.  If even a subset of these six factors are a work, customer loyalty must be a very good predictor of sales growth and profitability.

We should be able to validate the following models

Sales Growth =   Constant  +   ß1 * (Customer Loyalty)

Profitability =  Constant  + ß2 * (Customer Loyalty)

(ß1 and ß2 are the weights of  customer loyalty )

In a study published in circa 2000 in the Total Quality Management journal, researchers studied precisely these two models for a large set of products and services. The result?

Loyalty is a poor predictor of both sales growth and profitability. Their R-square values are 6% for profitability and 2% for sales growth. (For services the number goes to 14.7% and 7.8% respectively). That means only a tiny fraction of the changes in sales growth and profitability are explained by changes in customer loyalty.

Loyalty has positive impact on sales growth but more strikingly, for products, the impact on profitability is negative, which means higher the loyalty lower the profitability. This means any attempt to “buy loyalty” with price cuts does bring you loyalty but at lower profitability.

The net is, what seems too obvious isn’t so. This is not to categorically dismiss need for loyalty but the positive effects of loyalty are clearly overrated. If their effects are so low then there is a high opportunity cost to improving them. You cannot put all the  wood behind the loyalty arrow!

Sidebar:

Correlation means two variables are associated and the extent of association si expressed as correlation coefficient. It ranges from -1 (low,high)  to +1 (high,high). A value of 0 means no correlation.

Predictability, R-square, means one variable is a predictor of other. It is measured as a square of correlation coefficient. So two variables that have a correlation coefficient of 0.8 have a predictability of only 0.64. R-square is usually expressed in %, so 64% means 64% of changes in dependent variable are explained by changes in predictor variable. That said, correlation does not mean causation. There are other factors to consider including but not limited to statistical significance of weights of variables, omitted variable bias, etc

3 thoughts on “Is Customer Loyalty A Predictor Of Profitability?

  1. Rags,
    sorry for this late reaction, hope this is still usefull.
    I would see this from the volume forecasting angle. Say we are looking at fast moving consumer goods, ie a bottle of shampoo that makes your hair shiny and healthy again.
    In year 1 you have 100 consumers that try your product, and only 40 that buy you a second time (i.e. repeat purchase)
    If you would starts year 2 with only the “loyal” consumers you start with only a fraction of your previous year volume. In order to just maintain your share you have to recruit new consumers to use your brand.

    If we are looking more at services, you quickly realise the same dynamic is in place. People rarely buy only at one place. Or only for very specialised and infrequent purchases. For example if you buy your vacation at a travel agency, it is likely that in the future you could buy at this same agency, or another or even on line. The travel agency will face the same need of recruiting new customers

    Since for most markets recruiting new consumers/customers means raising awareness and that is done via channels that reach both new and old customers, you quickly see the absence of correlation between loyalty and market share….Market shares correlates at .9 in FMCG markets with penetration. And penetration is both new and old customers.

    That being said, in services the more you know the client the better your competitor advantage. So you should carefully balance your efforts between retaining your current customers and recruiting new ones. Most successful firms are the one who apply the right balance there according to their current state of client portfolio, and always recruiting new ones.

    Additionally, suggest to have a look at the work of Peter S.Fader (www.petefader.com) and Bruce S.G. Hardie(www.brucehardie.com) in particular “counting your customers” , or the tutorial they gave to the ART forum in 2006.

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