Calculating the economics of loyalty
This post originally appeared on Forbes.com.
Imagine that you run a chain of hotels. You know that amid all the guests who stay with you there is a group of star customers. They visit often. They never stay anywhere else when they’re in town. They spend a lot of money because they value the amenities and services your hotels offer. They talk your hotels up to their friends and colleagues.
Some of these customers even get to know the service staff and greet them by name. You love these people.
But now ask yourself: do you know how much more valuable these customers are than others? If you could turn another 10% or 20% of your client base into loyal, enthusiastic patrons like these, do you know how much more growth that would generate? Unless you can answer such questions, you can’t know how much to invest in creating and retaining this kind of high-value customer.
Here’s how you can figure out the answer.
The first step is to calculate the lifetime value of an average customer. (If you’re not sure how to do this, you can get a brief refresher course here.) The fundamental idea is to tally up all the cash flows attributable to the life of a typical customer relationship and put them in today’s dollars.
Then, using the average lifetime value as a baseline, you can tally up the differences in key areas for your group of loyal, enthusiastic customers. Here are a few variables to examine:
- Retention rate. Ask your star customers how long they’ve been customers, and use this average tenure to infer likely retention patterns. Chances are they’ll be staying with you over a longer timespan than the average customer.
- Pricing. Loyal customers are usually less price sensitive than others. They appreciate the overall quality and value they receive from your company. Examine the market basket of goods or services they purchase over a six-to-twelve-month period and then calculate the margin on each basket, keeping track of discounts and price concessions. Compare that margin with what you make on the average customer.
- Annual spending. Loyal customers increase the number of purchases they make more rapidly than others. Your share of their wallets increases as they upgrade to higher-priced products or services and respond with enthusiasm to new offerings.
- Cost efficiencies. Star customers complain less frequently and are responsible for fewer credit losses. Sales, marketing, advertising and other customer-acquisition costs are lower, due to the longer duration of their relationships and their higher propensity to respond to offers or seek out additional products and services.
- Word of mouth. You can also estimate the effect of positive word of mouth. Quantify (by survey if necessary) the proportion of new customers who selected your hotel because of reputation or referral. In general, between 80% and 90% of positive referrals come from your highest-value, most loyal customers.
This micro view of customer economics provides a foundation for cost-benefit analysis of investment decisions aimed at building stronger customer relationships. Once you know how much a truly loyal customer is worth to you, you can figure out how—and how much—to invest in turning more “regular” customers into stars.