The Real Value of Customer Loyalty

It's a marketing truism: Higher buying rates and lower service costs make long-term customers more valuable. That, of course, influences what companies spend on customer acquisition and retention. But according to an August 2001 working paper titled “Customers as Assets,” by Sunil Gupta and Donald R. Lehmann of Columbia Business School, Columbia University, customer-lifetime-value metrics can and should inform many business decisions in the marketing realm and beyond. In fact, looking at management decisions through the lens of customer value can generate surprising new perspectives — and often overturn conventional wisdom.

According to the paper's authors, any calculation of customer-lifetime value (LV) must take three factors into account: margin (the annual revenue that customers generate minus the operating expenses a company incurs in serving them), retention rate (the percentage of customers expected to keep doing business with the company) and discount rate (the current cost of capital). The resulting dollar figure can yield a variety of insights.

Firing Customers. Many companies use revenue growth and market share as key measures of success. But the LV perspective shows that this growth may come at a significant cost. Specifically, the cost to generate revenue and growth varies dramatically across customers. To illustrate, after a number of natural disasters struck Florida, several insurance companies realized that in their zeal to grow, they had acquired too many customers in disaster-prone areas.

Clearly, if such companies hope to protect their long-term financial health, they must make unprofitable customers profitable — or “fire” them. Getting rid of customers runs counter to many managers' intuition and training. However, the LV model suggests that revenue growth and market share, per se, may actually be the wrong metrics by which to gauge success.

Serving Customers. According to this study, an enterprise should not raise its customer-service level across the board. Instead, it should provide better service for customers with higher LV — another policy that may contrast with conventional wisdom in many managers' minds. For instance, discount brokerage Charles Schwab answers its best customers' phone calls within 15 seconds. Its other customers may wait for as long as 10 minutes to have their calls answered. Such service discrimination may generate a backlash from some customers, but if companies make their policy clear, customers might accept the adage “You get what you pay for.” The key point is that the policy lets companies protect their long-term profitability.

Segmenting Customers.