After spending $1 billion of investor capital on winning customer’s “loyalty” Uber decided to stop the customer acquisition war with Didi in China. Didi and Uber are now collaborating in China. But what was the logic behind subsidising customers with these amounts of money in first place?
Of course Uber is not in the business of welfare. So, they were expecting to recoup the money at some stage. The idea is based on the customer lifetime value. Companies accept to make an initial loss on the customer relationship to turn it into profit in the later months or years. The profits increase with the duration the customer stays with you (i.e. their loyalty).
Customer lifetime value is a long-term asset
Since the early 2000s Bain consultancy’s Frederick F. Reichheld and a number of Business Schools professors have researched the relationship between a number of significant customer metrics. The results are eye-opening. And they are relevant for offline as well as online businesses.
In a widely-noticed study Bain consultancy study shows that it takes:
- An average of 1-4 years until companies recoup customer acquisition costs (advertising, promotions, etc).
- Apparel companies, for example, tend to be on the faster end with approximately 1.1 years.
- Whereas electronics companies are at the long end with around 4 years.
Only after this time, your company starts making profits. Pity if the customer leaves you before it happens. Then the game starts from the beginning. Electronics companies lose 60% (!) of their customers before they break even.
“We showed that in industry after industry, the high cost of acquiring customers renders many customer relationships unprofitable during their early years. Only in later years, when the cost of serving loyal customers falls and the volume of their purchases rises, do relationships generate big returns…. In apparel [online retail], repeat customers spend more than twice as much in months 24-30 of their relationships than they do in the first six months.” Frederick F. Reichheld and Phil Schefter, Harvard Business School.
The study has shown that reducing defections by 5% (of your total customers) boosts profits 25% to 85%.
What does a reduction of 1% defections mean for your company?
Can you buy loyalty?
Uber was of course not aiming to buy loyalty through their discounts. They really wanted to use the first-mover advantages in the market to make use of the first-mover advantage.
But their investors were getting increasingly unhappy with the subsidies to drivers and customers. And rightly so.
The success of these incentives can be doubted. William Bao Bean, an investment partner at SOSV notes “And they’ve trained Chinese consumers to not be loyal, but instead to go anywhere to seek out bargains.”
A better strategy is for customer retention to outweigh customer acquisition. This is especially true for established companies who have already built a customer base. But it has also been a great growth strategy for Zappos as we will see in a minute.
How to increase customer lifetime value?
There are a many ways to gain customer loyalty. They really fall into three board categories:
- Pro-active: Constantly aim to delight customers and find ways to increase loyalty.
- Active: Establish means to stay in touch with your customer & to measure their behaviours, e.g. through loyalty programs.
- Reactive: Retain customers through high switching barriers/costs where possible.
Your customers will sense which of the above categories your company falls into. In fact, they may be doing this faster than you are hoping for.
Let’s have a look at all three approaches.
1. Customer loyalty: The pro-active way
These companies put in the work to delight customers whenever they have the opportunity. They offer excellent customer service across all touchpoints. They don’t necessarily look for an immediate return (as in the same quarter). The online retailer Zappos is a rockstar in the customer service space. And they know that loyalty pays off in the long run.
Zappos CEO and Co-founder Tony Hsieh makes clear that “The payoff is not in the current quarter or the current year, the payoff is probably going to be two or three years down the line. So it’s about how long-term you are thinking.”
Online retail is not like hospitality or traditional retail. You don’t have face to face contact with the customer. That should normally make it much more difficult to give the customer a memorable experience. Zappos has put in significant efforts from their call centre KPIs, to hiring practices, training programs and individual incentives to provide outstanding customer experience.
“A lot of people may think it’s strange that an internet company would be so focused on the telephone when only about 5% of our sales happen through that channel. But we’ve found that on average, our customers call us at least once at some point, and if we handle the interaction well, we have an opportunity to create an emotional impact and a lasting memory.” Tony Hsieh
2. Customer loyalty: The active way
Many loyalty programs have been created after the importance of customer retention became more obvious. The majority of those falls into loyalty cards where the customer gets some sort of benefits in exchange for having their purchasing behaviours tracked and accepting to receive more advertising.
I consider these as active approaches. They ultimately help to market more efficiently. When TV ads or billboards target a very broad range of people – most of which are not your customer and never will be – loyalty programs put the promotions to those people who have previously purchased from your company. This should give you more bang for your advertising/promotion bucks.
With the advent of big data & analytics, these approaches can give a good return for the expenses of having a loyalty program. They can be pretty powerful. Does anyone remember one father finding out about his daughter’s pregnancy after complaining to a retailer that they are sending her baby product ads. The retailer had noticed the increased purchase of larger sizes of unscented lotion and other typical products that they correlate with second-trimester pregnancy.
Here is the thing: In a recent Harvard Business Review article marketing professor Niraj Dawar (Ivey Business School, Canada) recommends:
“The questions that need to be asked of big data are:
- not just what will trigger the next purchase, but what will get this customer to remain loyal;
- not just what price the customer is willing to pay for the next transaction, but what will be the customer’s lifetime value; and
- not just what will get customers to switch in from a competitor, but what will prevent them from switching out when a competitor offers a better price.”
You see the shift to loyalty here and not “just” to increase the efficiency of your advertising dollars.
3. Customer loyalty: The reactive way
Well, we also have to talk about the laggards. Those that think customer retention starts the moment that the customers want to leave your company. Many utilities companies (electricity, gas, water, etc), insurers and others start worrying about the customer when the call to quit.
These companies build barriers to leave and/or have a “customer recovery” department that tries to sway you to stay after you just told them you will quit. This is like ignoring your partner until she files a divorce application and suddenly start to give attention in a panic mode. Guys, do we think there could be a better way?
Funny enough, many of these providers try to expand into other markets. Health insurers start selling health-related products, say glasses. Electricity companies offer solar related products including installation thereof. Ignoring the customer from the moment they have signed up may not have been the best way to build loyalty. Trying to sell additional products to these people is like getting your partner to be happy about you buying yourself a new sports car after having ignored her a long time. How well is that going to work?
Don’t understand me wrong, I am sure there are immense opportunities for these companies to expand into other markets. But given it can take 12-36 to build trust, it needs to start much earlier and not the moment that you are trying to sell more to your customers. It might also lead you to the wrong conclusions, namely that your offering is the problem when in fact it is the lack of trust (it does not mean mistrust – just healthy cautiousness). The wrong conclusions will then lead to wrong decisions.
There are still few individuals that argue that there is no real correlation between customer service and customer retention. In the early days of online shopping, it was assumed that loyalty is a phenomenon of the past given people can switch at the speed of a mouse click. But it turned out that people are reluctant to give their credit card information to those they do not trust in first place. Surprise!
You (or your decision makers) may think to wait until enough evidence has been found for your industry. But you might find out only after your competition has demonstrated this tactic applies to your industry as well. I argue it applies to any industry where the customers are humans. Let me know if you disagree, I would be very interested in dissenting views.
Delight the customer
Fred Reichheld goes a step further and has done so from the very first days of online shopping. Namely, that the customer service, your reputation and exceeding customer expectations go a long way to build loyalty and get the extra revenue in the later years of the relationship.
For the vast amount of companies that are on level 2 with a good loyalty program, there are great opportunities to take the next step. With their approach Zappos has achieved an astounding 75% repeat sales rate – how is that for loyalty?
Within 10 years of their start-up, they achieved a market capitalisation of over $1 billion and were acquired by Amazon for $2 billion. An astounding feat that I will be elaborating on more in an article soon.
Engaged customers generate 70% more revenue
Customer retention has a direct impact on profitability. Research by John Fleming and Jim Asplund indicates that engaged customers generate 1.7 times more revenue than normal customers while having engaged employees and engaged customers return a revenue gain of 3.4 times the norm.
There are a lot of insights that can support your innovation ideas in this field, so get your thinking started now.
Customer lifetime value calculation
There are many pages listing how to calculate the customer lifetime value. Most of them are flawed in that they don’t even discount future revenues by the cost of capital. I recommend if the Harvard Business School tool (download here).
It would be better to use the methodology applied within your company. The cost of capital (CAC) might be called also WACC (weighted average cost of capital) in your company. For established companies, this should be around 10%-13% (yes even in today’s near zero interest rate times).
For some start-ups that get tons of venture capital (like Uber) CAC might be much lower, for others, it might be much higher (up to 25%).
If you are struggling with the numbers but really want to understand how it works, just contact me. The math involved is not as complicated as many seem to think. And it would be sad if that would hold you back from elaborating the impact of your innovation ideas.
Take action now & boost your innovation skills:
Even a 5-minute brainstorm will help trigger your subconscious thinking and broaden your horizon for bigger, better ideas over time. Copy & paste to your note taking software and jot down what comes into your mind.
- Try to find out the repeat customer rates for (a) your company (b) in your industry.
- Try to find out your company’s customer lifetime value after 1 year, 2, 3, 5 years – this data should exist in your company.
- Which of the 3 categories listed in the article does your company fall into? What are a few ideas to improve customer lifetime value proactively?
On a parting thought
Zappos has used customer loyalty as a growth strategy. But Uber and other startups want to turbo-charge their growth. A crucial objective for them is to have the highest possible valuation at their initial public offering (IPO). In some cases, this leads to strange ideas.
This article by Murat Uenlue is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License.
For most companies, the best strategy will be to increase customer lifetime value through proactive measures. This will come at lower costs and deliver sustainable returns. If you liked this, please share.