The neglected moneymaker: Customer retention

A lot of companies focus on competition, innovation and cost-cutting to drive cash flow. But according to Ruth Bolton, marketing professor at the W. P. Carey School of Business, successful firms understand that cash flow is derived from customers. When customers are more satisfied and loyal, they buy more and remain customers longer. "That delivers more profitability to the bottom line," she says.

Readers took notice when the New York Times recently announced that consumer electronics retailer Circuit City was laying off 3,400 top-earning sales people to replace them with people who would earn less. One wrote in to say that the store's "cold-hearted calculation of a worker's worth" left out a critical thing: "how much it costs to hire and train new workers."

The reader who penned those words, also said: "I simply won't shop in places where the sales associates don't know the product, especially for technical gadgets and consumer electronics." Matossian concluded that, perhaps, if Circuit City tried a "win-win model — like personal service to counteract online sales — they would build customer loyalty.

But you have to build worker loyalty first." Apparently, Matossian thinks Circuit City's move to improve financial performance by cutting skilled workers and replacing them with newer ones was ill conceived. And, maybe it was. "A lot of business people are focused on competition, innovation, cost cutting — things like that," explained Ruth Bolton, a marketing professor at the W. P. Carey School of Business.

"You have to think of cash flows as being derived from customers, not products. If you focus on cash flows coming from customers — and what things influence those customers who bring in the cash flows — you can figure out where to put your dollars in the most profitable way." That was the message Bolton brought to practitioners who attended the 21st Annual Services Leadership Institute held in late March at the W. P. Carey School's Center for Services Leadership.

Billed as an exclusive "mini-MBA" program on competing through excellence in services, the three-day conference covered how companies can meet — and exceed — customer expectations. Bolton told the group why they should. When customers are more satisfied and loyal, they buy more and remain customers longer, she said.

"That delivers more profitability to the bottom line." According to Bolton, profits don't necessarily come from acquiring new customers, which can be a pricey process. "Profitability comes from keeping customers," she added. That's because loyal customers cross-buy products with higher margins, react less to price increases, and bring their friends in the door.

Missing the link

Bolton began her presentation with a quiz to see just how many people in her audience had misconceptions about customer relationships with a company. Most did. One question she posed to her audience was "True or false: satisfying customers should be our first priority." "That's obviously a false statement," she said. "You could satisfy customers by giving your product away free. Part of satisfaction relates to price. There's a cost-benefit tradeoff."

That is, it's only profitable to satisfy customers if they're willing to pay for what you're offering. Bolton also asked session attendees to consider how a 5-percent increase in customer retention could affect profitability. She did that, she later explained, because business people don't understand the widespread effects of retention.

"Most people think 80-percent retention is really good," she said. "It's actually really bad. It means that your customers are in a leaky bucket. You're spending money advertising and doing other things to bring customers in, but they're just going out the bottom of that bucket." Rather than be complacent about a 20-percent customer-churn rate, Bolton invited conference attendees to look at the lifetime value of customers and manage the relationship to nurture lifetime duration.

As an example, she found in the audience that ever-present java junkie who visits Starbuck's with circadian regularity. "There's always someone in a group who buys a $4.50 latte every day," she later explained. That cup of coffee translates into an investment of $22 a week, $1,144 a year and $5,720 in five years.

"You bought a family vacation at Starbucks," she told conference goers. And, she pointed out, if the same person quit drinking coffee at Starbucks and saved the money for 15 years, he could buy an SUV. Bolton went on to explain that many recent studies show that profitability and shareholder value can be linked to market orientation.

One factor of market orientation is customer-focus, and companies that have it tend to practice relationship marketing rather than transactional marketing. "Relationship marketing is any activity that enhances a relationship. It's distinguished from transactional marketing, where all you care about is an initial sale," Bolton explained.

Climbing the pyramid

Relationship marketing involves identifying which customers are your most profitable ones and what makes them choose you in the first place. It can also mean anticipating what new products and services your customers will want next. Bolton used a "customer pyramid" to illustrate how companies might segment customers.

At the top of the pyramid are the most profitable customers, the ones who spend more with a company over time, cost less to support and spread positive word-of-mouth advertising, thereby generating referral business. Some managers like to call such customers the "platinum tier." Just below those platinum customers are the "gold" level customers, those who buy a lot, but aren't quite as loyal and may be less profitable because they need discounts as a purchase enticement.

"Iron customers," the next tier down on the pyramid, may provide a company volume but not as much value. Their spending levels, loyalty and profitability don't warrant special treatment. And, naturally, most firms have some "lead-tier" customers — the ones that cost money to serve because they demand attention without high-volume buys.

These customers may even cost companies money through their complaints and negative publicity. Although companies need all those tiers, Bolton encouraged her listeners to figure out which level of customer brings in the lion's share of profits and how to solidify relationships with that top-tier group.

At one major U.S. bank, managers discovered that the top customers — about 20 percent of the entire customer base — brought in 82 percent of retail profits, following the classic 80/20 rule, Bolton said, Segmenting customers showed bank managers that those highly profitable customers were mostly female, upper income, and older than the "iron" tier of customers.

After surveying all bank customers, managers also found that the more profitable customers viewed service quality as reliability and "nice personal treatment" delivered by tellers and others with "a good attitude." Less profitable customers only cared about the speed of service.

The bank implemented service improvements aimed at enhancing attitudes and reliability, thereby winning impressive approval from top-level customers. Those buyers became 10 times more profitable than they'd been before. That's certainly one reason to focus on keeping those customers. Bolton's presentation offered other reasons, as well.

Serve long and prosper

There is some simple math involved in calculating the value of customer retention. First, if you only retain 80 percent of your customers, "it implies that in roughly five years, you'll have no customers left," Bolton said. Plus, there's per-customer revenue growth to consider. "In some industries, you earn more money from customers the longer they stay with you," she added.

If customers trust a company, they generally buy more from it. In addition, long-established customers may become easier and more profitable to serve. Bolton said this was especially true in business-to-business settings, where there may be specifications to meet or detailed processes to follow. And, there are no customer-acquisition costs to factor in with repeat buyers.

Also, there's a price premium with these people. "Loyal customers tend to be less sensitive to price," Bolton says. How does a firm gain loyal customers? By raising satisfaction. Bolton's own research has found that a 10 percent increase in customer satisfaction translates into an 8 percent increase in lifetime duration and a corresponding 8 percent increase in lifetime revenues.

Considering the value of loyal customers, it's no wonder customer satisfaction is such a good predictor of firm success. One study analyzed companies in the Business Week 1000 firms to compare firm value to satisfaction indices as measured by the Ann Arbor-based University of Michigan's American Customer Satisfaction Index (ACSI).

"Firm value rose $275 for each 1 percent increase in customer satisfaction," Bolton recalled. Perhaps the managers at Circuit City should take a look at that study. That company's reason for laying off higher-earning employees was "to improve financial performance," according to the March 28 news release. It's interesting to note that when the ASCI came out earlier this year, Circuit City ranked lowest in satisfaction among all businesses in its category, which is "specialty stores."

Writing for Forbes.com, Tom Van Riper suggested this sorry position might be the result of "Circuit City's inability to keep up with rival Best Buy's famed 'geek squad,' the popular customer service group." All this harkens back to the lessons in Bolton's presentation: Satisfaction builds loyalty. Loyalty builds profits. "You have to remember that revenues come from customers," Bolton said. "You may not have the same products in five years, but if you still have the same customers, you still have cash flows."

Bottom Line

• Cash flows come from customers, not products. If your product line changes but customers remain, so do your revenues.
• Customer satisfaction is an important predictor of customer loyalty and firm health.
• When customers stay with companies longer, those customers are more profitable because they buy more, complain less, are easier to serve and are less sensitive to price increases.
• Although few companies focus on customer retention, it leads to greater profitability, and even a small increase in retention can pay off substantially.