Are Loyal Customers Less Price Sensitive?

Let us start with seed questions on loyalty:

  1. Are loyal customers more likely to be less price sensitive and hence more profitable?
  2. Can a marketer maintain price premiums with loyal customers?
  3. Does customer loyalty drive long term profitability?

To some the questions will come as a surprise because the answers to them are self evident. But leaving out intuitions, is the causation relationship that loyalty means price tolerance and consequently higher profitability supported in the data? A few studies suggest this causation relationship based on correlation ( see here).

There is one other popular book, The Loyalty Effect, that states, “Companies can boost profitability by 75% by increasing loyalty by 5%”. But that is not based on research. The author makes that statement based on his example that reducing customer churn from 10% to 5% for a business with 90% customer loyalty doubles customer lifetime  (that is correct) and hence the profitability increases by 100% (tautology). However, his model and numbers are not correct  because he confuses two different percentages (see here for explanation).

Let me raise questions on what seems like a self-evident truth:

  1. Yes there is correlation but does that imply causation?
  2. Is there a hidden variable that drives loyalty and profitability?
  3. Is there Omitted Variable bias – that is there exists another variable that drives loyalty?
  4. What if price tolerance (and profitability) instead of being caused by loyalty is actually the driver of loyalty? In other words, is it possible that sensing price tolerance and high profitability of certain parts of their customer base, businesses may be doing everything they can to keep them (i.e., increase their loyalty).

I do not have data to prove these three possibilities but I raise here questions you as a decision maker must ask before accepting any claims of the need for driving customer loyalty.

Loyalty Reality

“0.5% reduction in mobile subscriber churn rate can increase revenue by 74%” – No really, but don’t stop reading, let us talk realistically about customer loyalty, customer lifetime value and  effect of loyalty on your profit.

Let us take AT&T as an example. It has a current monthly churn rate of 1.17%, the lowest among top 3. Churn rate is the % of current subscribers leaving the service provider. This translates to 14% yearly churn rate. Conversely, AT&T’s customer loyalty is 86%. So lifetime of an average customer with AT&T is  1/14% = 7.14 years.

Let us assume all customers bring in same revenue for simplicity (even though this is wrong)  of $x/year. So customer lifetime value is 7.14x. Let us say AT&T spends $200 to acquire a customer and the monthly bill is $50. The Lifetime Value of the customer (ignoring PV calculation) is$4084.

If AT&T can reduce their monthly churn by 0.5% –  0.5% reduction in churn makes the churn rate 0.67%/month, 8.04%/year, 12.4 years, that is 5.26 years more than previous state and hence 74% increase in revenue. If only AT&T can decrease its monthly churn by 0.5%, it can increase its revenue by 74%.

QED?

Let us pick apart this spurious reasoning and sleight of hand:

  1. Anytime you increase average lifetime of customers you increase revenues proportionately. There is nothing magic here. So stating, ” increasing loyalty, when everything else like prices is held constant, increases revenue ” is self evident truth and not an insight.
  2. I said reduction of 0.5% monthly churn rate. In reality this is reduction from 1.17% to  0.67% – this is confusing two different percentage scales. In reality this is 43% reduction in monthly churn.
  3. What is it going to cost me to reduce churn by 43%? What is the new infrastructure investment needed? What is the opportunity cost of this investment? What is the incremental profit from this investment? Is this going to require “buying loyalty” with price cuts and promotions? Even if you gain or buy loyalty, is that stable and sustainable? If AT&T is going to spend money on this, will Verizon and Sprint stay still? Can the money be better spent in acquiring new customers?

Without answering these questions, it is pointless for me or any management guru to say to you to focus on customer loyalty because, “5% increase in customer retention (from 90% to 95%) will increase profit by 75%“.  It is irresponsible for a decision maker to accept these pseudo-facts without challenging them.

PS3 Price Drop Not A Game Changer

Sony was used to being the market leader in gaming consoles prior to PS3. Their previous model, PS2 sold 138 millions units worldwide, far ahead of Microsoft’s XBox and Nintendo’s Gamecube. That all changed in the next generation of gaming consoles. Now Nintendo, with its Wii and its  innovative wireless controller is the leader with 50 million units sold in the three years since its introduction. Sony managed to sell only 24 million units so far.

In an effort to drive up its market share, Sony cut the price of PS3 by $100. Technically it is on a different model they introduced called PS3 Slim.  Is this a good profit maximizing move?Is low market share a concern that requires such drastic price cuts?

I have written before the need to focus on profit share over market-share. In the case of gaming consoles, it is a platform market. The sale does not end with the console rather starts with it. There are many revenue opportunities from sale of games and accessories over the lifetime of the console. Now there is also a new opportunity for subscription revenue from online gaming. It is not enough to just look at gross margin on the hardware, we should include margins from all the complements. In other words, the customer margin.

Larger the market share, larger is the number of games available for it as more developers will commit to developing games for that platform. With marker leadership comes exclusivity. A console maker can convince the game developers to  make certain popular games available only for their platform, at least for a limited time. But this has not been the case lately as Financial Times reports

With many third-party game developers no longer willing to make games exclusive to PlayStation, Sony has also suffered from a lack of hits by its in-house games division compared to Microsoft’s success with its Halo franchise, Mr Baker said.

Suppose we assume the gross margin on the new PS3 is $120 per console. Assume that at current market share and growth rate the incremental margin from sale of games and accessories over the lifetime of the console is $150.  So the total customer margin today is $270. With the price cut of $100  and the expected increase in market share from it, let us assume that the incremental margin per unit goes from $150 to $200. There is however  no reason or data to believe this, given the point made by Mr.Baker in  the FT.com story.  So the total customer margin in the new case is ($120-100+$200) $220.

Sony will be  losing $50 in customer lifetime value per unit sold with its price cut. To make up for it, its sales have to increase (over its current sales rate) by  50/220 = 23%.

The price cut would have given them competitive sales advantage only if Microsoft and Nintendo could not do the same. But it is not the case. Microsoft cut its prices by $100 and Nintendo might do the same (although doubtful).

Microsoft acted to consolidate its lead over Sony in the current generation of games consoles as it cut the price of its top-end Xbox 360 on Thursday to counter a similar move last week by its Japanese rival.

It is now questionable whether Sony can deliver a sales increase of 23% from its price cut. Note that this number will be much higher if the customer margin numbers we used are lower.

The net is, price cut is not going to be a game changer for PS3 sales.