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.