The Loyalty Effect


CRM is often justified by citing references to reports like those of Bain & Company, which maintain that companies can boost customer net present value by as much as 95 percent if they can retain only 5 percent more of their customers. Numbers like these have often been used to persuade management that a CRM package could pay for itself very rapidly. The assertion that growth in net present value results from increased retention is central to Frederick Reichheld’s excellent book The Loyalty Effect. Figure 2-1 shows Reichheld’s increases in customer net present value in various industries as a result of a 5 percent increase in the retention rate.

click to expand
Figure 2-1: Reichheld 5 Percent Retention Gains
Source: Frederick Reichheld, The Loyalty Effect (Boston: Harvard Business School Press, 1996), p. 36.

These numbers seem too good to be true. In fact, they are too good to be true. Let’s see what the real numbers might actually be. Let’s take one industry from the list as representative of the problem: life insurance. We will take a typical term life insurance policy of $500,000 for a 45-year-old nonsmoker that costs $1000 per year. For such policies, the first-year retention rates are very low. Subsequent rates are much higher. Table 2-5 shows the net present value for such policyholders for the first 5 years.

Table 2-5 : Life Insurance Net Present Value

Year 1

Year 2

Year 3

Year 4

Year 5

Retention rate

50%

60%

65%

70%

75%

Customers

100,000

50,000

30,000

19,500

13,650

Payments

$1,000

$1,000

$1,000

$1,000

$1,000

Revenue

$100,000,000

$50,000,000

$30,000,000

$19,500,000

$13,650,000

Commissions

$ 20,000,000

$ 250,000

$ 150,000

$ 97,500

$ 68,250

Claims

$ 75,000,000

$37,500,000

$22,500,000

$14,625,000

$10,237,500

Total costs

$ 95,000,000

$37,750,000

$22,650,000

$14,722,500

$10,305,750

Profit

$ 5,000,000

$12,250,000

$ 7,350,000

$ 4,777,500

$ 3,344,250

Discount rate

1.00

1.07

1.14

1.21

1.29

Net present value

$ 5,000,000

$11,491,557

$ 6,468,043

$ 3,943,929

$ 2,589,822

Cumulative NPV

$ 5,000,000

$16,491,557

$22,959,601

$26,903,530

$29,493,352

This chart shows that the cumulative net present value (the present value of the profits) from 100,000 new policyholders will be $29.5 million over 5 years. Note that we are assuming that 50 percent of the policyholders drop their policies during the first year. After that year, the retention rate increases. Of particular importance is the discount rate. This is the rate used to discount future profits and convert them into net present value profits. The formula for the discount rate is

D = (1 + i * rf) years to wait

In the third year (2 years to wait), for example, the formula is

D = (1 + 0.06 * 1.1)2

This becomes

D = 1.14

In this formula, i is the market rate of interest, figured at 6 percent, and rf is the risk factor, which is determined to be 1.2 for the first year and 1.1 for subsequent years. The risk factor is a number that represents the risk that you won’t generate the sales and profits at all. A perfectly safe business has a risk factor of 1. The risk can come about because customers don’t pay, because of heavy competition, because of product obsolescence, etc. Years to wait is the amount of time that the insurance company has to wait before the profits materialize. The first year, we are assuming that the waiting time is zero, because we are asking the policyholders to pay in advance. The chart could be made more complicated by adding administrative costs, medical examinations, etc. Leaving these out, we have a relatively clear picture of the marginal profits that a life insurance company can expect to realize over 5 years from 100,000 policyholders.

Using the Bain & Company figures, we should expect to see this $29.5 million 5-year profit go up by 90 percent, to $56 million, if we were to increase the retention rate by 5 percent. But that is not what happens. Table 2-6 gives the profits over 5 years assuming that the retention rate is somehow increased by 5 percent.

Table 2-6: New NPV

Year 1

Year 2

Year 3

Year 4

Year 5

Retention rate

55%

65%

70%

75%

80%

Customers

100,000

55,000

35,750

25,025

18,769

Payments

$1,000

$1,000

$1,000

$1,000

$1,000

Revenue

$100,000,000

$55,000,000

$35,750,000

$25,025,000

$18,768,750

Commissions

$20,000,000

$ 275,000

$ 178,750

$ 125,125

$ 93,844

Claims

$75,000,000

$41,250,000

$26,812,500

$18,768,750

$14,076,563

Total costs

$95,000,000

$41,525,000

$26,991,250

$18,893,875

$14,170,406

Profit

$5,000,000

$13,475,000

$ 8,758,750

$ 6,131,125

$ 4,598,344

Discount rate

1.00

1.07

1.14

1.21

1.29

Net present value

$5,000,000

$12,640,713

$ 7,707,752

$ 5,061,375

$ 3,561,005

Cumulative NPV

$5,000,000

$17,640,713

$25,348,465

$30,409,840

$33,970,846

The cumulative net present value does go up, but only by about 15 percent, as Table 2-7 shows.

Table 2-7 : Gains from 5 Percent Increase

Present 5-year NPV

$29,493,352

New 5-year NPV

$33,970,846

Increase

$ 4,477,494

Percent increase

15%

Now, 15 percent is a good solid number, but it is not 90 percent. Unfortunately, the rate is probably much less than 15 percent, because we have not figured in the costs of getting the 5 percent increase in retention. Here is where CRM really has trouble.

How does Reichheld suggest that the 5 percent increase be brought about? He has some very ingenious and valid ideas. The book is filled with excellent suggestions. Here are only a few of them:

  • Improve employee loyalty by increasing the employee retention rate (since retained employees help to retain customers).

  • Recruit the right sort of customers to begin with (some customers are inherently loyal, and others are inherently disloyal).

  • Change the commission system to reward retention as much as or more than acquisition.

Nowhere in Reichheld’s book does he suggest building a huge data warehouse and purchasing CRM software to go with it. If we had done this, we would have had to factor into Tables 2-6 and 2-7 the cost of the CRM needed to produce the 5 percent increase in the retention rate. The 15 percent growth in net present value might disappear or even become negative if we were to do so.

So, unfortunately, CRM proponents have been using numbers from Reichheld’s book to justify their programs without any solid justification in the book whatsoever.




The Customer Loyalty Solution. What Works (and What Doesn't in Customer Loyalty Programs)
The Customer Loyalty Solution : What Works (and What Doesnt) in Customer Loyalty Programs
ISBN: 0071363661
EAN: 2147483647
Year: 2002
Pages: 226

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