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.
- The book starts with an example of a business that has 90% customer retention rate.
- That means it has 10% annual churn rate – every year 10% drop out
- So the average lifetime of the customer is 10 years (1 over 10%) – simple and standard math nothing fancy here
- But if you increase the customer retention rate from 90% to 95%, that is increase by just 5% (rounded number, close enough) …
- Then the lifetime of the customer jumps from 10 years to 20 years.
- Not magic, just math. At 95% retention rate, churn is 5% and hence lifetime is 20 (1 over 5%)
- 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.
While working with a private school to address their customer churn issue, I looked for reasons why parents decided to switch schools. The customer research was done in two steps:
- A focus group of parents and a number of one on one in-depth interviews
- A survey of parents in the city and quantitative analysis
Here are some high frequency reasons parents cited:
- It was the beginning of the economic downturn, people were worried or lost one of their income streams. Private school was no longer affordable.
- Their second child was starting day-care and it was not anymore possible to pay fees to two children.
- Parents moved just a few miles and found it hard to schlep the child to the school and get to their work.
- Until a the early childhood care or the initial grades the school served the needs well but parents were convinced that it simply was not the right choice for the higher grades.
- The public school lottery they were waiting for came through.
None of these are related to the product itself and nothing the school could have done to increase the loyalty. It was clear that chasing zero defection would have been completely futile and the resources were better spent increasing the funnel and attracting new parents. This is the case for a product which naturally encourages loyalty, whose selection is not made that lightly and definitely no parent would switch schools on whim. In some of the cases the parents rated their previous schools very highly and yet they chose to switch – exhibiting a large attitude vs. behavior gap.
Businesses must accept that customers switch for reasons which are simply not under their control:
- Businesses fail, move, change direction
- Business got acquired and the acquiring company has a preferred vendor
- Economic shocks
- Technology shifts
- Price issues
- Changing in their needs as they grow
- Variety seeking – simply interested in trying new products
- Availability of alternative that was not an option before
None of these can be controlled by any loyalty program or five star customer experience your business can deliver. In fact blindly focusing on increasing loyalty without understanding the reasons will simply take away the resources that could be used for new business development and customer acquisition efforts.
There are a lot of unsubstantiated theories about increasing customer lifetime value by reducing churn – but these are simply models stating the obvious without taking into account such exogenous factors and the costs required to keep price sensitive customers.
So why should businesses focus their resources on loyalty when the reasons customers switch are completely out of their control?
In my previous post on MetroPCS $10 price drop I overlooked a key aspect – increase in profits from customers staying longer because of the price cut. Thanks to Gerardo Dada for pointing out the scenario of increased customer retention. In my previous model I accounted only for new subscribers and said they needed an additional 1.65 million subscribers (to their current 6.6 million sbscribers). The correct model for break even profit should look like
Lost profit per month = Incremental % customers retained * 6.6 * $40 +
Incremental new customers * $40
units are $ million, and $40 is revenue per customer and marginal cost is $0.
The two extremes are
(1) No change in churn rate (currently 1.77%), which means MetroPCS must add 1.65 million new subscribers (add 25%)
(2)No new subscribers added, which means they must retain an additional 25% of customers. Since their current churn is 1.77% per month, this case is impossible.
The best churn rate in the industry is 1.1% (AT&T). That is for its subscribers under 2 year contract and driven by iPhone. Even if MetroPCS can reach this level, that is a savings ofonly $1.77 million, it still needs 1.6 million new subscribers to make up for the lost profit.
The net is, while price cuts help stop customer defection they resulting increased profits are not enough to make up for total profit lost. Brands need to find considerably large number of new customers to make up for lost profit from price cuts.
I stand by my previous claim, price wars lead to value destruction!