Retaining Current Customers
It is widely known, that the cost of acquiring new customers is about five time the cost of retaining current customers. While money has to be spent in acquiring new customers, a company gains from old loyal customers as they:
- purchase the services of the company repetitively,
- are cheaper to serve as they do not have to be educated for repeated service deliveries and play their roles accurately,
- are willing to pay a increased price for the same service as they are satisfied with it,
- purchase other services from the same company, and,
- refer the company to other people, who in-turn purchase from and add to the revenues of the company.
A customer can be retained when he/she becomes loyal to the company. A customer becomes loyal to the company when he/she is satisfied with the quality of service delivered by the company and receives true economic value (TEV) from the company. Professors Sunil Gupta and Valerie Zeithaml have written in 2006 that both customer satisfaction, and resulting customer retention, enhances financial performance of a firm. For instance 1% increase in the American Customer Satisfaction Index can lead to a $240 to $275 million improvement in firm value.
We may note that not all customers are profitable for a company. It has been found that the top 20% of the customers generate 220% of the profits while non-profitable customers eat away a lot of the generated profit as shown in Figure 37-1 and Figure 37-2. So, we would be interested in identifying our profitable customers and nurture them, while negotiating low-cost services or higher prices with non-profitable customers. In one company, researchers found that the single largest customers also accounted for the heaviest investments from the company to serve them and were therefore, eating into the company’s profits. Company personnel then negotiated with their largest customer for higher prices while streamlining the services offered to the customer. We would then be wondering how we can calculate the value of a customer to our company. The model used to do that is called customer lifetime value (CLV) as described in the following section.
Figure : Customer Profitability Ranked from Most to Least Profitable Customers
Figure : Whale Curve showing Customer Profitability
Customer Lifetime Value
Professors Sunil Gupta and Donald R. Lehman have shown in 2003 that the customer lifetime value can be calculated using the following formula:
CLV = mr(1+i-r)
m is the constant margin received from the customer,
r is retention rate, i.e. the probability that the customer will make a repurchase, and
i is the prevailing interest rate
The margin and retention rates are calculated from an analysis of previous shopping data of the customers. It is clear from the above formula that the value of a customer retained with the company is directly proportional to the retention rate. Many research studies have found that making investment on customer retention is more important than investments on improving the margin or investing in customer acquisition, although this is dependent on the life cycle of the service industry. For instance, studies have found that it is five times more costly to acquire new customers than to retain current customers. Hence, it is important to retain current customers of a company and try to make them loyal to the company.