Where the Money Really Comes From

Loyalty consultants typically claim that loyal customers bring in loads of extra money through numerous avenues. The most typically claimed benefits of loyalty are as follows:¹⁸

1. Lower costs to serve
2. Higher margins (i.e., less price sensitivity)
3. Word of mouth
4. Retention
5. Higher spend (i.e., higher share of wallet)

In fact, based on the charts consultants present of these supposed benefits, you would think that these claimed benefits bring in loads of extra money and that they were all basically equally important.¹⁹ Sadly, that is not the case. In fact, the first two supposed benefits aren't even true.

If managers want to make a positive return on their investments to enhance the customer experience, they first need a clear understanding of where the money really comes from. So let's begin by debunking two of the myths of loyalty: (1) loyal customers cost less to serve, and (2) loyal customers are less price sensitive.

We already debunked these myths in our earlier book, Loyalty Myths²⁰ (with Terry Vavra and Henri Wallard). Unfortunately, like a monster in a horror film, these myths are hard to kill despite evidence conclusively proving them to be false.

Myth: Loyal Customers Cost Less to Serve

The argument that loyal customers cost less to serve is this: “As the company gains experience with its customers, it can serve them more efficiently.”²¹

We will be the first to admit that this sounds completely plausible, which is why this myth is so tough to squash. The flaw in this theory is the belief that loyal customers behave the same as their less loyal counterparts do.

The fallacy of that is clear. Real loyalty requires different behaviors. And although there are lots of good customer behaviors for companies associated with loyalty, being easier to serve isn't one of them. Why? Companies may know more about their loyal customers, but loyal customers also know more about the companies. As a result, they may be more demanding of the company through better knowledge of the inner workings of the system. This allows them to seek recourse for what they believe to be inadequate treatment, and they are more likely to receive perks from the relationship, which cost money to administer and fulfill.

Moreover, research conclusively proves this to be the case. Eminent professors Werner Reinartz and V. Kumar conducted in-depth research into several firms to examine the impact of loyalty on the cost to serve customers. Their findings were published in both the Harvard Business Review and the Journal of Marketing.²² In no case could they find an example of loyal customers costing less to serve. In fact, when there was a cost difference for a company, the relationship was reversed: Loyal customers cost more to serve.

Myth: Loyal Customers Are Less Price Sensitive

Loyal customers are also widely reported to be less price sensitive—even willing to pay a premium to do business with the company. The argument goes like this: Loyal customers “will often pay a premium to continue to do business with you rather than switch to a competitor with whom they are neither familiar nor comfortable.”²³

That statement is probably true, but it is also totally misleading. The deception is in the qualifier “rather than switch to a competitor with whom they are neither familiar nor comfortable.” In other words, “I would be willing to pay more than go someplace I don't know or like.”

But is that the real choice customers face? Almost never! Given that multibrand loyalty is the norm in most industries, customers have somewhere else to go. And one of the easiest ways to get them to go there is to charge them a price premium.

The reality is that loyal customers know when prices are good or bad relative to the norm. That's one of the benefits to customers for their loyalty—they know a good deal when they see one. As a result, loyal customers tend to be more price sensitive, not less.

Let's return to the research of professors Reinartz and Kumar. In no case could the professors find an example of loyal customers paying a higher price for the same bundle of goods. If there was a price difference, the relationship was reversed—loyal customers paid less.²⁴

Moreover, we've taught our most loyal customers to be price sensitive. As an article in The Washington Post notes, “In a subtle shift of marketing tactics, some retailers have stepped up coupon offers directed at their most loyal customers in a bid to attract repeat visits from big spenders Eager to wean themselves from discounts for the masses, retailers hope more targeted coupons will limit big bargains to a pool of their best customers.”²⁴

Word of Mouth

There is no question that positive word of mouth is an important element for a firm's ability to attract new customers. In fact, for many entertainment-related industries (e.g., movies, television shows, nightclubs, etc.), positive customer “buzz” is essential to success.

The Internet and social networks in particular have heightened managers' attention to the potential power of word of mouth. With the help of technology, one person has now the potential to reach hundreds, thousands, and sometimes even millions of people. Moreover, referrals from individual customers tend to have more credibility with prospective customers than company-sponsored advertisements.

As a result, customers' willingness to recommend the brand has become one of the most important metrics that managers use to measure and manage customer loyalty (second only to customer satisfaction).²⁶ This in large part fueled the adoption of the NPS by many companies. For most businesses, however, the effect of word of mouth on customer acquisition is far less than managers tend to believe.

First, let's begin by examining the relationship between a customer's stated likelihood to recommend a product and the actual adoption of that product by members of his or her social network. Clearly, there is a seductive logic to the idea that customers' willingness to recommend a firm or brand to friends leads to increased sales. We can all think of times that we have tried a new restaurant, seen a new movie, or bought a new product based on the recommendation of friends and family. But does customers' willingness to recommend a firm or brand to friends in their social network really lead to a significant increase in sales? That's precisely the question we wanted to find out for ourselves.

Using data provided by a large U.S. telecommunications provider for 791 customers and their corresponding telephone network (11,552 individuals), we investigated the relationship between customers' willingness to recommend via word of mouth a new product they had purchased and the adoption of that same product by members of their social network.²⁷ What we found was surprising. A customer's willingness to recommend the product had no significant impact on a potential customer's likelihood to adopt the product.

To see if other factors played a role, we also examined two elements that research has shown influences the role of word of mouth on new product adoption: (1) how recently the product was adopted by the customer (new customers are shown to be more influential) and (2) the strength of the social connection (as measured by communication time). Interestingly, none of these variables demonstrated a statistically significant relationship with adoption of the product when examined individually.

Only by examining the interaction of these variables simultaneously (i.e., recommend intention, recency of adoption, and strength of social connection) was it possible to identify a relationship to product adoption. Specifically, we found that recommend intention predicts new product adoption only when two conditions are met: (1) recommending customers have recently adopted the service themselves (as opposed to being longer-term users of the product), and (2) potential customers are in frequent contact with recommending customers.

Our findings point to the difficulty in translating social networking, recommend intention, and product adoption into a coherent marketing effort. Our results indicate that measuring word of mouth intentions on their own may not be predictive in product adoption by other potential customers. So although knowing your customers' willingness to recommend your brand is important, it is clear that other factors must be taken into consideration and measured when using this particular metric.

Second, let's look at actual word of mouth (as opposed to intention to recommend) on customer acquisition and profitability. One of the primary drivers of word of mouth is customer satisfaction, with most positive or negative word of mouth occurring at the extremes (either very highly satisfied or dissatisfied).²⁸ Most of us inherently know this to be true.

What is surprising, however, is that positive word of mouth is three times more common than negative word of mouth.²⁹ Clearly, negative word of mouth is bad, but it doesn't reflect the majority of customers' discussions about the brands and companies they use.

The question of overriding importance to managers is, “How does this translate into new sales?” Research into word of mouth and customer acquisition finds some unusual things. For one thing, it doesn't have the effect you would expect. For example, given that the success of movies and television shows is in large part based on generating buzz among potential viewers, you would expect word of mouth to be critical to a show's success. Research, however, finds that word of mouth volume doesn't show a consistent relationship to television ratings.³⁰

Even more unexpected, research finds that word of mouth activities from loyal customers do not generate additional sales to new customers. Really! So the common argument that increasing customer loyalty results in increased customer acquisition from referrals isn't proving to be true. Instead, research finds that new customers generated by word of mouth come from referrals by nonloyal customers.³¹

If all this leaves you wondering how to make word of mouth pay off, you are not alone. What is clear is that the journey from customer willingness to recommend to gaining new profitable customers is not straightforward. Research by professors Kumar, Petersen, and Leone, reported in the Harvard Business Review, sums up the problem this way:³²

The number of both companies' customers who said they intended to recommend the firm to other people was high, but the percentage who actually did was far, far lower. While 68% of the financial services firm's customers expressed their intention to refer the company to other people, only 33% followed through. Fully 81% of the telecom's customers thought they'd recommend the company, but merely 30% actually did. What's more, very few of those referrals, in either case, actually generated customers (14% at the financial services firm; 12% at the telecom company). And, of those prospects that did become customers, only 11% of the financial services firm's—and a mere 8% of the telecom company's—became profitable new customers.

This is not to suggest that word of mouth referrals are not valuable. They are! They just aren't nearly as valuable as we've been led to believe.

Customer Retention

For virtually every business, success depends on the repeat business of loyal customers. In fact, it is this recognition that spawned managers' current focus on the customer.

In their seminal Harvard Business Review article, “Zero Defections: Quality Comes to Services,” consultant Fred Reichheld and esteemed Harvard Business School professor W. Earl Sasser, Jr., triggered a massive shift in companies' strategies by declaring that “reducing defections by 5 percent boosts profits 25 percent to 85 percent.”³³ Although these staggering rates of return haven't held up under more rigorous analysis,³⁴ customer retention is nonetheless one of the most important customer loyalty–related behaviors that drive a company's revenues. In fact, research conducted by professors Gupta, Lehmann, and Stuart finds that a 1 percent improvement in customer retention has a 5 percent impact on a firm's total market value. By contrast, a 1 percent improvement in customer acquisition costs corresponds to a 0.1 percent impact on firm value.³⁵

Share of Wallet

As we have argued throughout this book, for most firms, more customers change their spending patterns than do customers who completely defect. Therefore, efforts designed to manage customers' spending patterns with a firm tend to represent far greater opportunities to a firm than simply trying to maximize customer retention rates.

McKinsey & Company argues that focusing on customers' spending patterns to improve customers' share of wallet can have as much as 10 times greater value to a company than efforts to improve retention alone.³⁶ Our own research similarly supports the far greater impact of share of wallet relative to retention for industries in which customers tend to use multiple brands within the same category.³⁷

As this review of the economics of loyalty makes clear, loyal customers bring in greater revenue through three primary means: customer acquisition through word of mouth, improved customer retention rates, and improved share of category spending (i.e., share of wallet). Of these three, share of wallet presents by far the greatest opportunity to grow revenues.

The problem for managers has always been identifying what it takes to grow share of wallet, particularly given that the relationship between share of wallet and metrics such as satisfaction and NPS has been extraordinarily weak. The Wallet Allocation Rule solves this problem. For the first time, managers can easily and accurately determine what it really takes to drive share.

Step 1: Use the Wallet Allocation Rule to Link Satisfaction and Share of Wallet

With the Wallet Allocation Rule, step 1 is easy. To link satisfaction (or NPS) to share of wallet simply do the following:

• Survey customers and establish the brands (or stores or firms) that customers use in the category.
• Obtain satisfaction ratings for each brand the customer uses.
• Convert each customer's satisfaction ratings for the brands he or she uses into ranks.
• Use the Wallet Allocation Rule to transform these ranks into estimates of each customer's share of category spending.

Step 2: Align Share of Wallet and Revenue Objectives

Improving the share of category spending that customers allocate to your brand is the primary goal, but share of wallet must always be considered in tandem with the total revenue that customers spend in the category. Clearly, customers who buy only once in a category give 100 percent of their wallet share to a single brand.

The reality is that customers who spend more in the category are much more likely to divide their spending among multiple brands (see Figure 4.4).⁵³ The goal, of course, is not to get customers to spend less in the category to raise share of wallet. The goal is to get customers to allocate more of their purchases in the category with your brand.

Therefore, we need to understand share of wallet in the context of the revenue it represents. Not every customer is capable of being a high-revenue, high-share of wallet customer, nor does every customer want to be one. Some customers make purchases in the category so infrequently that unless these customers represent a significant portion of the customer base, servicing and marketing to such customers yields too little in return.

Therefore, at a minimum, we need to segment customers by the volume of business they conduct in the category. Because low-spending customers tend to be much less involved in the category, their needs tend to be very different from high-spenders.

Furthermore, high-revenue customers are almost always in the minority in terms of number of total customers. Strategies that neglect customer differentiation will inevitably tilt the scale toward break-even and unprofitable customers because they represent the majority.

High-category spending, high-share customers represent a company's core customers. The goal must be to create more of them. The only customer group with the necessary resources to move into this group is the high-category spending, low-share customers. The key to making this happen is to have a clear understanding of precisely why these customers choose to use competitors. Improvement efforts must then minimize customers' perceived needs to use the competition.

Step 3: Align Revenue and Profit Objectives

Understanding the relationship between share of wallet and revenue is not enough. As noted earlier, there are lots of ways to grow share while still losing money.

The seemingly logical answer to solve this problem is to ignore revenue and focus exclusively on return on investment (ROI). That, however, is typically not the best solution for a business either. Maximizing ROI often comes from defining the customer pool too narrowly to gain significant market share growth.

Instead the goal should be to maximize the return on each high-potential customer.⁵⁴ This shifts the focus from maximizing ROI to maximizing profits. Without overcomplicating this, the key is to determine what is required to address the overriding reasons your customers use competitors and the cost of doing so. These costs are then weighed against the expected financial return.