5% Increase in Loyalty

Posted on by Rags Srinivasan

You most likely have seen it or heard it repeated many times over in the business magazines,blogs and twitter. It is stated as self-evident truth, so simple that we did not think of it  by ourselves. Or you have read the books on it. It is indeed so simple, backed up with math and blindingly obvious. It is the 5% loyalty increase multiplier effect. While there are many forms of it as it went through the social media mill, the core statement goes like this

5% increase in customer retention rate  will deliver 75% increase in profit

After all holding on to customers you already have makes more economic sense than chasing new ones right? But, verifying the obvious  may show it isn’t true.

Let me break down how this multiplier effect comes into play.

  1. The book starts with an example of a business that has 90% customer retention rate.
  2. That means it has 10% annual churn rate – every year 10% drop out
  3. So the average lifetime of the customer is 10 years (1 over 10%) – simple and standard math nothing fancy here
  4. But if you increase the customer retention rate from 90% to 95%, that is increase by just 5% (rounded number, close enough) …
  5. Then the lifetime of the customer jumps from 10 years to 20 years.
  6. Not magic, just math. At 95% retention rate, churn is 5% and hence lifetime is  20 (1 over 5%)
  7. Since the customer lifetime is doubled, their lifetime value is doubled too. Adjusting for time value of money you get 75% increase in profit.

First, note that this multiplier effect is simply an artifact of the math and not due to any research from customer level longitudinal analysis. You plug in numbers, you will get the answer in the Excel.

Second and most important, it is not 5% increase in retention, it is 50% decrease in churn. When you really say you are increasing retention from 90% to 95%, you are decreasing customer churn from 10% to 5% – a 50% decrease.

How hard and cost effective is that compared to acquiring new customers?

Customers leave for many reasons, many of which you cannot control,  it is futile to chase 100% retention.

See also Barry Dalton questioning the gurus on data and models that prove retention is better than acquisition.

3 thoughts on “5% Increase in Loyalty”

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  3. Excellent analysis. You are spot on. this is simple math that is not based on any real industry or business model. You could plug any descriptors into this scenario and the answer will be the same. how about this:

    A social networking Zen God has 90% [friend] retention rate, meaning every year he loses 10% of his [friends]. So, each of his friendships has a 10 year life span, after which, those friends are so tired of his self-promotion and narcissism, that they block him from all of their networking lists.

    But if he increases is [friend] retention rate from 90 to 95% percent, then his friendship life span (FLS) increases from 10 to 20 years.

    Hummm… But like the CLV example, exactly how is he going to do this? Well, decreasing churn rate by 50% is probably about as likely as the narcissist being able to change his ways.

    Oh, and how exactly does that translate into 75% increase in profits? “Hey Rocky! Watch me pull a rabbit out of my hat!? (hope I didn’t date myself with that one. For you Millennials, Google “Rocky and Bowinkle)

    So, as i said in my post, its not that this assertion is inherently false. But, applied as generally as it is serves absolutely no purpose. We all need to do the math that is appropriate for our business, with the raw data that is relevant for our business. And, only then can we determine what the right mix is between retention and acquisition that drives the profitability and top line growth we seek.

    Has anyone actually read The Long Tail? Yish!

    thanks for the elegantly simple analysis and for the reference to my post above. Well done!

    Like

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