14 The loyalty effect — the relationship between loyalty and profits In the early 1990s loyalty w ef the fundamental drivers af company profitability. It is no less applicable to the new e-commerce businesses. In the first of a two-part article the authors review the basic aspects of the loyalty effect. The second part will examine how e-loyalty is helping businesses at the cutting edge of to succeed. Frederick F. Reichheld, Partner, Ps Bain & Company, Inc. gy 7 Robert G. Markey Jr, Partner, Bain @ Company, Inc. Christopher Hopton, Partner, Bain ea & Company, Ine. Loyalty versus chaos Chaos seems ro have got a leg up in its battle against ‘order’ and today's marketplace is reeling The advantages of market share, cost position and service quality no longer guarantee success. General Motors, instead of eeaping the spoils of market share leadership, is struggling to reverse its downward spiral, A low cost manufacturer like Caterpillar suddenly finds itself at a cost disadvantage in key iarkets. And a service quality ‘Blue Chip’ like Delta Airlines is downgraded to junk bond status. Companies such as Wang and IBM are profiled as case studies of ‘Excellence’ one day, then as man- agement turnarounds the next The Baldrige Award is trumpeted on the front pages of US newspapers as the competitive saviour in the crusade to reassert America’s ‘Quality’ leader ship. Then, a Baldrige winner files for bankruptcy and the award is hidden back on the fifth page of the Wall Sreet Jounal, One day, marker share and experience are the essential strategic assets; now, they are irrelevant compared to time, the new com: petitive frontier. Forget about ‘Total Quality,’ now all you have to do is re-engineer all your core busi ness processes Business thinkers careen from guardrail to guardrail, One professor claims that strong leader- ship is really the keys another concludes that empowered, learning organisations will triumph. Is ir truly chitos? Is success really so complicated, tran- sitory and fragile? Or is the business world rational? We just don't yet understand some of the natural forces which govern it From an evolutionary perspective, management science is still in its infancy. Today's large corpora: tions are relatively recent descendants of the indus- trial revolution. Unlike well-evolved institutions which transcend the lifespan of their individual members, the average Fortune 500 company expires in 40 years. Most are outlived by the majority of their employees. The study of this struggle for sur- vival is relatively immature since business schools are inventions of the twentieth century. Harvard, for instani began its search for Veritas almost three centuries before its Business School hegan its search for profits. 1 Eoropean Business Journal 2000THE LOYALTY EFFECT. So it would not be surprising if there are some basic flaws in our mental models of business. Management lags far behind more mature sciences such as physics and medicine, Until the forces gov- ering cause and effect in a business are better understood, we are doomed to rhetoric, confusion and inconsistency. The earth has always been central co human: ity’ survival. Ic is no surprise chat ancient civilisa- tions placed our home at the centre of the universe. Taday, most executives view profitability as the most important factor in the survival of their business. Is it possible that modern theories in managerial science, like ancient theories in nat- tural science, are built around an equally false cen- tre? ‘We encountered evidence which supports this hypothesis when we stuclied the linkage between customer retention and profits. Seemingly insignif- icant changes in customer retention cat al of our clients’ businesses resulted in eye-popping improvements in profits. Then, we studied « wide array of industries, and found that a 5 percentage point shift in customer rerention consistently resulted in 25-100% profit swings. These almost unbelievable results indicate that there must be powerful forces at work. What are they? How does retention drive such swings in profits? Whar drives customer retention? Why do companies with high customer retention also have high employee and investor retention? The answers t these questions have not only given us important new tools to improve a company’s per- formamee, they have changed our understanding of the nature of business Ar the core of any successful entesprise, enabling its very existence, is its value creation process. Vi creation generates the energy which holds the busi- ness together. The economic ‘physics’ which govern the interrelationships and energy states of the ele- mentary particles in a business system (its cus tomers, employees and investors) we have come to: call che forces of loyalty These forces are measurable in cash flow terms because of the linkages between loyalty, value and profiss. Loyalty is inextricably linked to the creation of value. As a first oxder effect, loyalty reliably measures whether superior value has been delivered (they come back for more). Next, loyaley initiates a series of second order economic effects which cascade through ® busi- ness system as follows L. Revenues and market share grow as the best customers are swept into the company’s book of business, building repeat sales and referrals 2. Costs shrink as the expense of acquiring and serving new customers and replacing ok! ones declines. Employee retention increases because job pride and job satisfaction inerease, in tum creating a loop that reinforces customer retention through: familiarity andl better service to the customers Increased productivity results from increasing employee tenure. As costs go down and revenues go up, profits (the third order effect) increase. This provides the resources to invest in superior employee compensa- tion (further reinforcing retention) and in new activities or features that enhance customer value, thus further increasing both customer and employ ce retention. Profits are important, not just as an end in themselves, but because they allow the company to improve value and provide incentives for employees, customers and investors te renvain loyal to the company: The loyalty base The loyalty-Kased model effectively explains suc- cess and failure in the husiness world, In most industries which we have studied, the companies with che highest retention rates (evidence of super- ior customer value) also carn the best profits Relative retention explains profits better than mat- ket share, scale, cost position or any af the vi ables usually associated with competitive advantage. It also explains why traditional man- agement techniques often backlire in chaotic ways, Consider how a traditional company would respond to a slowdown in its revenue growch, tt might hire more salesmen, raise commissions £0 entice more aggressive selling, drop price to new customers, or add new products. The result: more inexperienced salesmen (low productivity/high cost), bringing in the wrong kind of customer (price shopper/disloyal), with escalating costs of product line complexity The traditional company attacks cost by redesigning processes, laying off employees and so forth, often demoralising its employees, thus lower- ing customer service, This decreases customer retention which makes costs skyrocket! Cost reductions passed on co the customer in lowerEUROPEAN BUSINESS JOURNAL prices can inerease value. Cost reductions taken only for the benefit of the shareholder (the vast majority) usually destroy value. While Loyalty-Based Management® tech- niques may seem intuitive, they represented a rac cal departure from traditional business thinking. As we leamed more about the forces of loyalty, we came to view business strategy ina new light. Tes objective is to bring together a well-matched set of customers, employees and investors who will remain together long enough so they can learn to be very effective at mutually creating and consum- ing value. This shift for business is as fundamental as the Copernican shift to a sun-centred solar sys- tem was for astronomy. Creating customer value becomes the centre of business straregy — nor ma’ imising profits or shareholder value. Loyalty also illuminates the physics which gov- ern a business system. Just ay friction steals the energy from a mechanical system, defection robs the energy and knowledge from a business system. Without knowing it, managers have engineered enormous friction into their businesses in the name of ‘maximising shareholder value’, In fact, this friction destroys value for all the participants ing shareholders The opportunity for reducing friction in most businesses ts immense. Shareholders now churn their holdings based on short-term speculation the rate of 50% per year. Employees change jobs with increasing frequency; 15-25% turnover is common. And customers defect at the alarming rate of 10-30% per year. With this much frietion, it is no wonder that productivity and economic growth are languishing. Business is being conduct cd among strangers, trust is low and energy is sapped. Fundamental changes are required in business practives ranging from refined customer-targeting to revised hiring strategies. New measures and incentives are required. Much more work needs to he done to develop the best method for allocating value among the stakeholders soa business ca prosper and energy can he focused to sustain the value creation process. in a business inch You are what you measure What a business measures shapes employee think- ing, communicates company values and channels organisational learning, Measures, by establishing the fecdback loops that are the foundation of leam- ang, define whar an organisation is and whar it will 136, become. Deciding what to measure and how mea- sures are linked tw incentives are among the most important decisions a senior manager must make, However, mast executives make do with inherit ed and outdated measurement systems that warp and distort their business strategies. Measurement, systems are often vestiges of past accounting tradi- ons and regulacory requirements having little to clo with netalising the comporate vision, Asa result, a CEO functions like a pilot flying an aeroplane with nothing bur an air speed indica- tor to tell him how he is doing. Without an altime- ter or compass, most planes would crash; and without the right measurements, most organisa tions face a similar fate. Wich almost total reliance ‘on measures of current period profits, today’s man agers are flying blind. Because CEOs generally rel- ash the all-absorbing job of the pilot, few have the nv and energy 10 adress their true strategie job = the design of the plane and its instrumentation They fool themselves into believing that if they simply create and communicate a vision, the organisation can keep the craft on course. For example, the CEO of a leading intemation: al company became convinced that his organis tion had to improve service quality and increase focus. He saw that the competitive battle- as shifting from technology to service. In every speech, he emphasised these themes. In every interview with journalists, he focused on this vision and its compelling logic. At shareholder meetings, he articulated the importance of service quality and customer focus. As patt of every strnte- tic plan review, he insisted that each division spe cify the initiatives they were taking 1 increase ‘ice quality and customer focus. After three years, to be certain that is vision was having impact, he polled his senior managers. On a confidential basis, they were asked to weight their top priorities. The result: Their number one priority, by far, was hitting the annual profit plan. Service quality and customer focus did not even make it into the cop three. In explanation, one of his managers said, ‘Everybody knows what drives annual bonuses and how our careers are measured = irs the annual profit budget.” The problem, as we saw it: Measures for service quality and customer focus had not been tied into the annual plan numbers. As a result, there was disconnect hetween the vision and the reality. The auto industry has tried to bridge this gap by mea- suring cuscomer satisfaction and linking it to man- agement bonuses and dealer incentives. However,THE LOYALTY EFFECT the link between satisfaction scores and profits is umclear. Satisfaction scores for the industry have ballooned up to 90% or more as managers have learned how to game the system; meanwhile, repurchase rates huive remained mired helow 50%, The irony of this situation is that most man agers in the car industry clearly understand the economic value of customer repurchase: loyalty. However, most of them measure customer satisfac- tion (pethaps because it is easier?) rather than repurchase rates. Their historic measurement systems track cars hy their government-required vehicle identification number = not by customers. Have regulators had more impact on measures than managers? The satisfaction trap The simple truth is thar satisfaction surveys alone don’t yield the information companies need to have about delivering value to customers. There is more and more evidence that people in the field are responding to the corporate obsession with sat- isfaction by creating higher scores in ways that don't necessarily improve customer val For example, at one Toyota dealership a recent- ly-hired salesman pleaded with a customer eo fill out the satisfaction questionnaire with favourable responses. He explained that, ‘Both my wife and [ just lost our jobs at a local computer company 30 my young family is depending on me and I'll lose my job here if Fdon't get high satisfaction scores.” These efforts may lead to increased scores, but they probably won't lead to inereased loyal Manipulating the system doesn’t wike place only at the grassroots level. Auto executives want to tour high marks in industry-wide satisfaction surveys in their advertising campaigns. Whe companies figured out how to manipulate the scores, the tempration was too much (0 resist. For example, companies found thar they could get con- sistently high scores by calling customers just after they have bought a car. This realisation gave rise rations that telephone cus- tomers after their purchase and ask them satisfac- tion-rclated questions. Customer feedback is often, to ‘boiler roars” ope ignored the caller's primary purpose is to inflate the satisfaction score Even when dealers legitimately try to imple- ment satisfaction surveys for the right reasons, they run up against some of the technology's inherent limitations. For instance, they are finding that an increasing number of customers are tired of being 137 sorveyed. A leading Cadillac dealer related this story: ‘One of my customers cornered me at a char- ity board meeting, and she told me, “I got a call after I picked up my car asking if | was satisfied with the sales experience. Then 1 got a call after the car was serviced, asking if T was satisfied with the service experience. Finally, sanother surveyor called several weeks later to check if my car was still running OK. So when | am going to get 2 call asking if [was satisfied with the satisfaction survey experience?” One of the leading auto companies admits that customers could yet is many vveys or calls during a year. Imagine how much thi costs the company, to say nothing of the customer's wasted time ‘companies serious about measuring the value they deliver to customers will not base their measurement system on satisfaction surveys. They will recognise thar satisfaction 18 an inherently unstable and temporary mental state, thar cus- tomer artinwles shift many times during the four years between auto purchases andl thac measuring genuine satisfaction is a tricky business. Instead, they will carefully track repurchase loyalty as a truer measure of how well their proxduct and ser- vice offerings stack up against che competition. When customers donot retum ro the dealer for their service needs (dealers now earn less than 40% of post-warranty service purchases), and when they replace theit present car with another brand, these are incontestable signals that customers are not satisfied with value received. Satisfaction surveys are simply a poor litmus test for satisfaction, Our research has shown that in business after business, 60-80% of customers who defect to a competitor said they were satisfied or very satisfied on the survey just prior to their defection. Clearly, broad-based satisfaction surveys cannot be the only tool used to manage defections, Far too many (the majority of) defectors slip through the cracks. Some companies have responded to this problem hy refining their saris: faction measures. Most of the auto companies have chosen this route, Their sitislaction survey tech- nology is state-of-the-art, bur they still see only 45% of their customers retuming when more than, 90% say they are satisfied. Even so, most auto com- panies are still investing more in the refinement of their satisfaction survey system than in developing, reliable loyalty measures, One exception is Lexus. Drive by a Lexus deal- evchip in the US and you will notice a satellite dish con top of the building. Inside rhe building is anEUROPEAN BUSINESS JOURNAL AS 400 computer that is, among other things, sending and receiving information on customer saute and service purchases to Lexus US headquar ters in Torrance, California. Since Lexus believe that the only meaningful measure of satisfaction is repurchase loyalty, they built a system that enables them to crack loyalty — of both auto purchases and follow-on service, Lexus can track which customers are coming back for more and which are not. They can analyse the differences between the dealers who are earning superior customer loyalty and chose who are not They can then use satisfaction research produc- tively to help them understand customer purchase decisions. Another advantage of watching what specific customers pay, not just what they say, is that this enables the tracking of liferime purchases, a critical ingredient in determining the lifetime value of spe- cific customers and customer segments. To be prof ‘table, investments made to increase satisfaction and value must focus on the customers with the highest porential value. Satisfaction research applied broadly across the entire customer base, while st ly correct, ensures thar scores will he influenced by the responses from unprofitable customers. For example, a bank branch manager might hear many complaints about long queues but the most profitable customers may not care. They rarely come into the branch, preferring to do busi- ness by phone, mail and ATM. Investing in more cashiers will inflate satisfaction scores, buc it may deflace profits by increasing costs and service levels in areas that the bank’s best customers don't value ‘One leading bank invested significant energy in the development of a satisfaction tracking system thar it used co compare performance across branch es. Along with other important measures such sts cost effectiveness and growth, the system was used to evaluate branch manager performance. Then the bank decided 10 measure customer retention, rates as well. They found that the branches wich the highest satisfaction scores did not have the best retention. This led some executives to call for the elimination of satisfaction measures and co focus more of the manager bonus on cost effective. ness. One trap embedded in satisfaction pro- grammes unlinked to loyalty and profits is that they may become discredited ata time when Improving value ro customers should be a critical objective. Lacking a reliable loyalty and cash flow based measurement system, many companies 18 default to cost reduction programmes and layoffs, Many of the relephone companies are groping for the right tools to manage their business in an increasingly competitive environment. Most of them have developed sarisfaction surveys to help focus their organisations on customer service, But few have yet built a system to analyse lifecycle pur- hayes and profits from various types of customers, ‘When this analysis is done, companies find that the best 10% of rheir customers are worth 5 ta 10 times as much as their average customers in terms of potential lifetime profits. If the telephone companies yo the route of the auto companies and ury to manage through increasingly refined cus tomer satisfaction systems, they will fall into the same satisfaction wap. Their organisations will concentrate on increasing broad measures of satis- faction, while competitors cherrypick the most profitable customers with focused marketing pro: grammes designed to deliver outstanding value to these segments. The diminished cash flows that result will make it more difficult to deliver good value even to the average customers. Companies must know how much they ean afford ro invest in increasing satisfaction for specific customers. To gauge the return on satisfaction- enhancing investments, the company must know customer lifecycle purchase patterns. Since lifecycle purchase patterns must be tracked co determine customer profitability, why not also use this infor mation as the basis for measuring and managing satisfaction! ‘The true mission of the firm is te create value for three key constituencies: customers, employees and investors, In order to prosper, each of these tlrce partnets must be satisfied with the value they receive from the business. There's nothing wrong with measuring satistaction. The problems begin when satisfaction scores hecome a goal unto thei selves, independent of customer loyalties, reward ing careers for employees and superior prodits ta investors. Customer repeat purchase loyalty must he the basic yardstick of success, Companies can avoid the satisfaction trap if they remember: It’s not how satisfied you keep your customers, it's how many satisfied customers you keep! In search of failure Most people understand intuitively that the great- est learning in life flows not from our successes, but from our mistakes. And systems experts wouldTHE LOYALTY EFFECT attest that when a component fails, it can cast a spotlight on the workings af an entire system, pin- pointing corrections that must be made. Warren Buifert, one of the most successful investors in the world, has concluded there is more to he gained by studying business failures than busines successes. He says, ‘In my business, we try to study where people go astray, and why things don’t work ... [We] stare out with failure, and then engineer its removal.’ Similarly, Japanese manufae- turers treat a defect as ‘a gift” and use failure analy- sis to continuously improve their operatio If failure analysis works so well, why don's more companies do it? Psychologically and culeurally, it’s difficult and sometimes threatening. Fatlures are often examined for assigning blame, rather than detecting — and eradicating ~ the systemic causes of poor performane: In the business arena, we have found that one of the most illuminating units of failure is customer defection. When desirable customers defcet, its a signal that something in the system is amiss. [na leaming organisation, the departure of such a cus- tomer prompts a search for the root causes ot th problem to learn more about what needs to be fixed in the business, and if possible, to re-establish the customer relationship on firmer ground. There is a strong temptation to rationalise, of course: ‘Well, he wasn't really a good customer ind we didn't wane him anyway.’ Rationalisation is but cone of the ways to fail at failure analysts The MicroScan division of Baxter Diagnostics, Inc. is a successful company that faced up squarely to its failings ~ and hay become even stronger and more profitable as a result. MicroScan is in the business of automated microbiology. Ir makes the sophisticated instruments used by medival labora- tories to identify microbes in patient cultures and determine which antibiotics will eliminate these “bugs’ most cost-effectivel A few years ago, MicraScan was neck-and-neck with Vitek Systems, Inc. in the race for market leadership. Both companies were growing rapidly, converting customers from manual testing methods and edging out other manufacturers of automated equipment. MicroSean had worked hard to improve quality and considered applying for the industry award. Bur first (perhaps because of 19 diagnosing bugs inside the human body), MicroScan understood the value of applying pow- erful diagnostic techniques to itself and decided to identify the bugs inside its own business system, The management team recognised that they could lear a lot by understanding why they were losing business. They analysed their customer hase, highlighting accounts that had been lost as well as those that remained active but showed a declining volume of testing. MicroScan inter- viewed every one of the lost customers and a large number of the ‘decliners’, probing deeply for the root causes underlying their change in behaviour, especially when they defected ro alternative testing methods. The picture that emerged was clear, instructive, and somewhat painful to behold. There were con: cerns about MicroScan's instrument features, their reliability, and the company’s responsiveness to customer problems. MicraScan managers overcame their natural feelings of denial and acted decisively con shat they hail learned They shifted R&D priorities to address specific shortcomings thar customers had identified, such as test accuracy and time-ra-resule. They accelerat- ed the development of a low-end model and Drought ir to marker in record time, having learned that their instrument line was unsuitable for many smaller laboratories. They also redesigned their customer service protocols to ensure immediate attention was given to equipment faults and deliv ery glitches. MicroScan’s willingness to learn from failure has paid off: Two years later, it has pulled away from Vitek 10 achieve clear market leadership and enjoys the bottom-line benelits that flow from it. Tracking and responding to customer defections has hecome a central part of MicroScan’s approach and a model for other Baxter divisions. A successful ozganisation must learn how 10 leam from its mistakes. The manager of a success- ful organisation does not pursue nebulons theories of excellence — nor does he wait for disaster before adjusting his strategy. He defines the right units of failure ~ such as customer defections ~ tracks them, analyses them and helps his people to learn from them. For he knows that the candles of failure will light the pathway to excellence.CONTRIBUTORS TO Brian Boyd is at Arizona State University: Mark Fox is at Indiana Universi ind Melinda Muth is with Deloitte Touche Tohmatsu, Sydney. David Norburn, calitor emeritus of the European Business Journal, is Dean of Imperial College Management School. Frederick E Reichheld, Robert G, Markey Jr and Christopher Hopton are with Bain & Company. Dermot Hodson is at South Bank University, London. Imelda Maher is at the London School of Economics, _ THIS ISSUE Peter Edmonds, Dermot Glynn and Claudia Oglialoro are with Europe Economics, Chancery 4 Chancery Lane, London WC2A Michael Kaser is Emeritus Fellow of St Antony's College, Oxford and Honorary Professor, Institute of German Studies, University of Birmingham, Liam Collins, a former intern at the European Commission, has taken a sabbatical to research the rise and fall of the International Ruhr Authority