More on Retention Vs. Acquisition – Sycamore Story

Right after my article on customer retention vs. acquisition (which was triggered by several live tweets I saw from certain loyalty conference) I saw the story of Sycamore networks,

Sycamore Networks: From $45 Billion to Zilch

The fifteen year old company known for its high flying stock from the 2000 bubble days ended the day with the decision to close down and liquidate remaining assets.

What went wrong? According to the WSJ article

analysts say the company’s demise also reflects strategic missteps—sticking with its initial product line as the market declined

It had one product that was relevant only to its original customers and failed to see how the market was evolving or where the new needs are arising.

They never kept pace with market development and never got customers.

In other words Sycamore failed to acquire new markets and in that process lost existing customers as well.

Engineers had figured out how to send much higher quantities of information by routing pulses of light down fiber-optic cables rather than relying on electrical signals sent across copper wires. Sycamore’s niche was to help network operators manage those pulses of light more efficiently.

Sycamore was loyal to its product and happy with its original customers. Even there it seemed to have failed to ask, “what job customers were hiring its product for” (i.e., the real need).

This is one just story and likely suffers from hindsight bias and selective recall. So do all the positive stories you hear about customer retention and loyalty. But one thing you need to care and apply diligently is the need for actionable business strategy rooted in data.

If your strategy is wrong it does not matter what rating your customers say on a 0 to 10 scale.








It costs 6-7 times more to acquire new customers over retaining existing ones …

No my account was not hacked (not yet, at least). I deliberately let this commonly repeated statement be the title without qualifying it.  Of course statements like these, (this particular one made famous by Loyalty Effect) cannot stand by themselves regardless of how popular the Guru who said this is.

Let us look at this closely

  1. Let us assume this statement is true. So shall we fire our sales team, shut down all marketing spend, stop product innovations and get rid of business development?  After all this statement indicates new customers are far more expensive. Then why bother?
  2. Let us take it to the extreme. Shall we stop after the first customer?
  3. Extending this even further, say you acquired the first customer at a cost of $1 and second at the cost of $7. Then by this logic does it cost $49, $343 etc to acquire third and fourth customer?
  4. What if you are essentially in a transactional business where you really need new customers every day because the current ones won’t be there tomorrow?
  5. How do you know it is 6-7 times or only 6-7 times? What are the data and metrics used? Was it based on experimental study?
  6. How generally applicable is this to your businesses – small and large, early stage vs. mature? Is the cost the same to all businesses?
  7. What about profits from new customers, is that 6-7 times as well?

You can see how ridiculous the statement sounds now. Here is a further breakdown of problem with this retention vs. acquisition costs statement.

First it is framed around cost and does not base it on marginal benefit and opportunity cost. I also doubt that the proponents know how cost accounting is done and most likely are allocating all kinds of fixed cost share to new customers. You need to have a costing system that can correctly capture only truly incremental costs for both acquiring and retaining. Simply distributing all costs to all customers won’t cut it.

Second it suffers from sunk cost bias. The fact that you spent some money to acquire a customer in the past does not matter in the decision to do everything to retain them. If you cannot recover the acquisition cost it is sunk. You should only look at future unearned marginal profit from each customer – existing or new. At decision time of spending capital on retention vs. acquisition you need to compute the opportunity cost and truly incremental profit from each path, not encumbered by the money you have already spent on existing customers.

Third, if the cost of acquisition is indeed high don’t you think you have a marketing problem? Is it likely that you are targeting wrong customers in wrong places with wrong product, versions, messaging and prices and hence wrong low value customers are self-selecting themselves to your service? Don’t you want to spend your resources fixing this strategic problem vs. worrying about retention?

Lastly the Innovator’s Dilemma.  What if the current customers are NOT the representation of future?  By choosing to focus your resources on them instead of new customers do you lose sight of new market opportunities, how the customer needs are evolving and how their choices for the job to be done are impacted by market trends and innovations?

Does the retention vs. acquisition pronouncement sound as profound as it did before?  I hope not.

How do you make business decisions?

Point of all the discounting is to earn shoppers’ loyalty for future

The title is a quote from one of the retail managers we will meet later in the article. Write down whether or not you agree with this quote before reading further.

If you look at it carefully, it is not difficult to see that retailers should have no pricing power. After all they are just the channels.

They do not know why the end customers are buying the products (What job is the customer hiring the product for?.

They do not make the products and do not take the risk of investing in R&D, design, supply chain etc.

They do not build the product brands and take the marketing investment.

But they do add one important value – connecting the producers with their target customers and enabling customers get the products they want, providing convenience, service, experience and information to make informed decision. So they get their a share of the value from the producers in the form of low prices they pay to producers or taking a cut of list price (think 30% fee by Apple or Amazon for Apps).

They can choose to share some of this value with end customers in the form of price discounts. They can choose all of the value and more for certain products in the hope of making up for it from selling other products at fuller prices (Loss Leaders).

some we won’t make money on, some we do

What we see with Black Friday deals is even deeper discounting and far too many loss leaders.

Black in Black Friday is supposed to mean ‘turning profitable for the year’ for the retailers. How can the retailers expect to make profit with deep discounts? Best Buy’s chief of retail operations had this to say about his store’s policy of deep discounting:

the point of all the discounting is to earn shoppers’ loyalty for future purposes

Let us stop and take a careful look at this. The only reason we see mob scenes on Black Friday is the deep discounts. Given that customers are willing to shop anywhere and if needed stay in long lines just for lower prices, how can you expect any loyalty?

If they were attracted by deep discount, and ONLY deep discount, to come to Best Buy, what makes you think they will remain loyal when some other store offers same or deeper discount in the future?

This brings us back to second part of the question we did not address on value add – what unique value does the retailer, the channel, add to end customers? When they have no products, no brand power or a compelling unique value to offer and compete only on price, they should not be rationalizing their discounting with hopes of future loyalty.

The deal seeking Black Friday shoppers, having scores their 60-inch flat screen TVs have moved on. Nothing other than even more discounting will bring them back.

The Point of all the discounting is not to earn shopper’s loyalty but a reality forced by the channel’s lack of value add to its end customers.

5% Increase in Loyalty

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.

No Single Metric – Proof By Contradiction

There is significant interest among businesses – enterprises and startups alike – to look for a single metric, one magic number that will point to overall success, profitability etc. When a metric is pitched, if it is reasonably popular, seemingly rigorous yet very simple to understand and comes from a firm or person with a pedigree or position, the metric will find almost religious acceptance.

Can there really be one metric that predicts profitability? I used statistical biases to explain why there cannot be just one metric, now let me make another attempt with Proof by Contradiction.

Let us assume there is indeed a single metric, let us call it X. If by a logical sequence of arguments, I  show you that there  is in fact one more metric  it will be  a contradiction to the assumption, proving it is false.

If X is a predictor of profitability, then improving it is good for the business.  There are three cases:

  1. There are no  levers to move X
  2. There is exactly one lever that businesses can pull to move X
  3. There are more than one levers to pull

The first case is not possible, after all no one will pitch a metric that cannot be controlled and managed. Granted, this is not really part of proof by contradiction but I am simply eliminating this branch of the decision tree.

In the second case, if there is exactly one lever that businesses can pull to move the metric, then by extension that becomes the predictor of profitability and not X.  This is a contradiction.

In the third case, if there are more than one lever to pull, that means the whole set of those affect profitability and not X. This is again a contradiction of the assumption that there is a single metric.

What do you say?

Futility of Chasing Zero Defections

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:

  1. A focus group  of parents and a number of one on one in-depth interviews
  2. A survey of parents in the city and quantitative analysis

Here are some high frequency reasons parents cited:

  1. It was the beginning of the economic downturn, people were worried or lost one of their income streams. Private school was no longer affordable.
  2. Their second child was starting day-care and it was not anymore possible to pay fees to two children.
  3. Parents moved just a few miles and found it hard to schlep the child to the school and get to their work.
  4. 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.
  5. 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:

  1. Businesses fail, move, change direction
  2. Business got acquired and the acquiring company has a preferred vendor
  3. Economic shocks
  4. Technology shifts
  5. Price issues
  6. Changing in their needs as they grow
  7. Variety seeking – simply interested in trying new products
  8. 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.

[tweetmeme source=”pricingright”] So why should businesses focus their resources on loyalty when the reasons customers switch are completely out of their control?