4.2 The Relationship Between Customer Retention and Profitability This section first reviews the possible benefits of customer retention in terms of its contribution to a firm’s CE, and then concludes with some insights on how the shape of the response functions affects these benefits. 4.2.1 The benefits of customer retention The literature on CRM has argued that there are several benefits attached to long-life customers (e.g., Reichheld and Sasser, 1990, Reichheld and Teal, 1996), which are basically contained in the following five propositions: It is cheaper to retain customers than to acquire them The costs of serving long-life customers are less than those of serving new customers Long-life customers increase the reputation of the company and attract new customers through word-of-mouth (WOM) Long-life customers are less price sensitive than new customers and therefore pay higher prices Long-life customers are more likely to buy more from the company, so that the company can increase their share-of-wallet through up-selling and cross-selling These five propositions can be summarized in two: Customer lifetime is positively related to profitability. Profits for retained customers increase over time. Despite the apparent intuition of these propositions, little empirical evidence has been published. An exception is the work of Reinartz and Kumar (2000) where it is shown that long-life customers are not necessarily profitable in a noncontractual setting. They use three years of data of a catalog company, and estimate the probability of each customer being “alive,” using the NBD/Pareto model suggested by Schmittlein et al. (1987) and Schmittlein and Peterson (1994). They calculate the CLV of each customer and finally compare it to their estimated duration to test Propositions 2, 4, 6 and 7. Reinartz and Kumar (2002, 2003) extend their findings to the customer base of four different companies. They find that some of the long-life customers are much less profitable than transactional customers. Moreover, they find that (i) in none of the four companies, long-life customers were cheaper to serve, and (ii) in one company, long-life customers paid lower prices and no significant difference was found for the other firms. They argue that the violation of the previous propositions will be more likely to happen in noncontractual situations, in which there is a significant cost to entice customers to repeat buying.   Table 4.1 The relationship between customer retention and profitability Proposition Arguments in favor Arguments against P1: It is cheaper to retain customers than to acquire them Whenever there are switching costs, the company that already has a relationship with a customer has an advantage over its competitor. Recognizing the CLV of a customer might lead the company to offer lower prices in order to acquire a customer for the first time. There must be an interval in which the return on CE from acquisition spending is higher than the return on CE from retention spending. For instance, when the firm is in its early stage and needs to grow fast to reach a critical mass of customers. P2: The costs of serving long-life customers are less than those of serving new customers Customers learn over time and have less questions or problems. Higher marketing efficiency. Reward programs may be expensive and increase the costs of serving long-life customers. Long-life customers may require better service in reward for their loyalty.         P3: Long-life customers increase the reputation of the company and attract new customers through word-of-mouth (WOM) Long-life customers are usually more satisfied and hence generate referrals. The longer the relationship, the higher the probability of spreading WOM. Long-life customers might be heavy users and buy at the same time from different vendors. So their referrals are spread among different firms. Some customers even with low satisfaction levels tend to exhibit high levels of loyalty (e.g. if they have high switching costs).         P4: Long-life customers are less price sensitive and therefore pay higher prices Product preference: Because consumers value the product more than that of the competitors, they are willing to pay a price premium. Switching costs: retained customers are more likely to have high SC. SC could even increase over time. Long-life customers might be heavy users who have better price information about the competition.   Table 4.1 (Continued) Proposition Arguments in favor Arguments against P5: Long-life customers are more likely to buy more from the company, so that the company can increase their share-of-wallet through up-selling and cross-selling As they repeat with the firm, customers become aware of more products and, if satisfied, buy them. As the experience with that product category increases, consumers become aware of other players in the market and might start to buy from more than one vendor. P6: Customer lifetime is positively related with profitability If P1 - P5 are true, the higher the average retention, the higher the profitability for the company. Some transactional customers might buy more and at higher prices than long-life customers.       P7: Profits for retained customers increase over time Customers use the product slowly at first, then start to exhibit the effects described in P2 - P5 Reichheld and Sasser (1990) argue they found that trend in 100 analyzed firms in 24 industries. Not if the firm is spending too heavily on retention. The marginal benefit from customer retention might be lower than the cost of increasing retention. We provide in Table 4.1 both arguments in favor and against these propositions. We think Proposition 1 is too strong and only valid for certain situations. Propositions 2 to 5 can be very context specific. Propositions 2 and 4 have been shown not to be true for several firms in the published studies that have formally tested them (Reinartz and Kumar 2000, 2002, 2003). The same studies question Propositions 6 and 7. The bottom line is that a firm should expect heterogeneity in the customers’ behavior, and not necessarily all customers will exhibit these effects. Believing Propositions 1 to 7 as true in all scenarios might lead the firm to suboptimal spending decisions. Instead, continuous measurement and management of that heterogeneity is key for the long-run success of the firm. Models that find the optimal retention spending - especially under a limited budget - should correctly specify the acquisition and retention response functions, as we will show next. 4.2.2 The shape of the response functions The shape of the response functions helps resolve some of the contradictory findings explained above. These insights should be incorporated in models that capture the link between retention spending and CE. The relationship between retention spending and retention rate may follow a concave or an s-shaped pattern. The relationship between retention spending and retention rate cannot be linear, nor can it be convex since the function has to be bounded by 1.7 The simplest functional form is a concave one, with its origin at zero (see Blattberg and Deighton, 1996). Nevertheless, imposing this form might be too restrictive in some scenarios. First, it is more than likely that spending zero in retention will lead to positive retention rates. Second, a more complex functional form might be imposed (e.g., s-shaped). This could occur, for instance, when the likelihood of an individual continuing a relationship is significantly increased only after a certain spending threshold, or point of inflection. Or when the distribution of the switching costs is not uniformly distributed but denser in a certain interval. Hence, slightly increasing retention spending in that interval will increase the average retention rate significantly. There exists a point of diminishing returns from which further spending on retention would lower the firm’s customer equity. Previous literature recognizes that some customers may not be profitably served, and therefore the zero defections argument should be followed only for those customers that are profitable to the company (e.g., Reichheld and Sasser, 1990). This insight follows from the previous one in that, when the retention rate gets sufficiently high, further increases in retention become very expensive and there has to be a point from which the marginal cost of an increase in retention is higher than the marginal benefit. This can be seen for instance in Blattberg and Deighton’s (1996) work in which the model finds precisely the level of spending that maximizes the CLV of a customer. There exists at least one interval in which the return on customer equity from one dollar spent on increasing retention is lower than the return from the same dollar spent on acquisition. Intuitively, firms starting their businesses first need to acquire a customer base that is sufficiently large, if they want to become profitable (e.g., they need to cover their fixed costs). If the customer pool were still small, further investments in retention would derive less customer equity contribution than investments in acquisition. Similarly, when customer retention rates are very high, it might be more profitable to acquire customers with high CE potential than to retain customers with low interest in the firm. And this could happen even before reaching the point of diminishing returns. There might be intervals for intermediate retention spending where the CE elasticity of acquisition spending is higher than that of retention, especially if the relationship between spending and retention is s-shaped. This will also depend on how mature the market is, the number of competitors, product differentiation, and the magnitude and distribution of the switching costs. Previous Next