Tuesday, June 10, 2008

The Economics of Improved Customer Retention

This blog will answer the third question posed in the first blog in this series about relating customer retention to market share. In the two preceding blogs I answered the first two questions relating to the short term impact of improved customer retention and combating improved customer retention by competitors. The value of this blog is the presentation of a methodology for translating improvements in customer retention to market share and then into budget impact. I have found that management can be very supportive of programs when the programs are self funding. Thus, if it can be shown to management that a specific customer retention program creates additional revenue that exceeds the cost of the retention program, there is a high likelihood that it will be approved.

Perhaps the easiest way to describe the process of translating improved customer retention into budget impact is by outlining the process step-by-step.

Step 1 - Define the customer retention improvement program elements

It is easy to say you have a customer retention improvement program. It is quite another matter to demonstrate to a critical management team that the program actually works. I hope you will recall an earlier blog of mine that described customers as either “nice” customers or other customers. The point was that “nice” customers can be fatal to your business because they take whatever you give them and if they don’t like it they just go away without telling you why. They are too “nice” to want to tell you that you did not provide them with the level of service they needed or expected. It will be very difficult to develop a customer retention program that will be able to measure any impact on the “nice” customers.

On the other hand, you may recall a more recent blog where I mentioned that one of the most important measurement systems you have is the one that tracks the effectiveness of complaint resolution. This measurement indicates how well you resolve customer complaints (from those customers willing to complain; that is, those who are NOT “nice” customers). These customers are the best candidates for customer retention. There have been numerous studies (some by me for specific clients) that indicate a customer who complains and whose complaint is resolved quickly and satisfactorily are more satisfied (and loyal) than customers who do not experience any problems. Thus, the complaint resolution system is a critical element in any program to improve customer retention. For more detail on other elements to improve customer retention, refer to my previous series of blogs on customer retention.

Step 2 - Define the measurement for customer retention

A good measure of the health of a service organization is customer retention. Those service organizations with a high percentage of service contracts or loyal customers find it easy to measure customer retention by simply examining the percent of service contracts renewed or the frequency of purchase. For those organizations without a large contract base or a small customer base, the measurement of customer retention is a little more difficult - but NOT impossible. In each of my series of blogs I have stressed the importance of staying close to your customers. If you have been following my advice you know who your customers are and how they are doing (with respect to the products and services you offer). For those in this category, the measurement of customer retention is simple.

If you are the category of those who have “too many” customers to stay close to, this measurement is going to be very difficult. In the course of my consulting practice I have found many companies who think they know their customers until it comes time to contact them. For these companies the customer data base turns out to contain 5% to 15% of names who are no longer customers (gone out of business, switched to a competitor, moved to a new location, etc.). There will be a great deal more effort required by companies in this category to get a reasonable estimate of their customer retention. (This is the subject for another entire blog).

From the queuing analysis, the decision of exactly how many additional personnel to add must be made. With the results from the complaint system, consider the situation where the addition of two additional personnel to the phone system would have provided wait times acceptable to half of those that defected. Thus, the implication is that 15 rather than 30 would have defected if the additional personnel were available. When this is translated back into the retention calculation, the implication is that the defection rate would have been 8% rather than the 10% calculated.

To put the improved customer retention program into economic perspective, the new retention rate now needs to be translated into improved market share which is the next step.

Step 3 - Translate new retention rate into new market share

The calculations that were presented in the second blog in this series will be used for this example. In the second blog, I posed a manufacturer with a 90% retention rate (as noted above) and provided a table which indicated the rate of growth of market share when the customer retention rate improved by 2%. The table from that blog is reproduced below for convenience.
Months Manufacturer
1 0.353
2 0.360
3 0.366
4 0.372
5 0.376
6 0.380
7 0.384
8 0.387
9 0.389
10 0.391
11 0.393
12 0.395
13 0.396

The chart indicates that as soon as the new personnel are in place and customer defections resulting from waiting too long on the phone are addressed, market share should steadily increase to a new steady state of 39.6% which is approximately 4% higher than before the initiation of the new retention program.

Step 4 - Translate new market share into revenue

For the case where the service market is $100 million per year, the increase in revenue to the manufacturer as a result of the improved customer retention is shown in the following table.
current mkt improved mkt Incremental
revenue revenue 1/12 of annual increase
1 $35.3 million $36.0 million $58,000
2 $35.3 million $36.6 million $108,000
3 $35.3 million $37.2 million $158,000
4 $35.3 million $37.6 million $192,000
5 $35.3 million $38.0 million $225,000
6 $35.3 million $38.4 million $258,000
7 $35.3 million $38.7 million $283,000
8 $35.3 million $38.9 million $300,000
9 $35.3 million $39.1 million $317,000
10 $35.3 million $39.3 million $333,000
11 $35.3 million $39.5 million $350,000
12 $35.3 million $39.6 million $358,000

The total incremental revenue for the 12 month period is $2,940,000 (the sum of the incremental revenues for the twelve months). Even if this were a $10,000,000 service market, the incremental revenues would be $294,000 for the year.

The question you might ask is why not just compute the incremental revenue from saving the 15 customers. For this example ($100 million market with about 35% market share and each customer contributing about the same revenue) the computed savings is only about $700,000. The key point is that the direct computation only considers the customers measured whereas the proposed analysis looks at these customers as representative of the entire market and provides the extrapolation for entire market. The proposed method indicates a return more than 4 times greater than the direct computation.

Step 5 - Compute the bottom line impact

The last step is to translate the number of additional personnel into a budget impact which will show the cost of hiring, training, additional phone lines (if required), and on-going expenses for maintaining a larger staff and compute the return on the investment to the company. Once again, assume the following costs are associated with each of the items listed:
Start-up Costs (one time costs)
I. Hiring costs for two incremental personnel $10,000
2. Training for two personnel 5,000
3. Additional phone system hardware 1,000
4. Additional furniture, etc. 5.000
Total Start-up costs = $21,000
On-going Costs (recurring costs)
1. Personnel (2 @$30,000/year) $60,000
2. Benefits (35%) 21,000
3. G&A (7%) 4,200
4. Phone lines 12.000
Total On-going costs = $97,000/year

Thus, the total cost for the first year is $118,000 and $97,000 for each succeeding year (plus inflation). These costs will begin to be incurred before the incremental market share (and revenue) begin and will show reduced profits until the personnel are in place and the impact of their presence is detected by the customers. However, based on the magnitude of the impact, the costs will be recovered well within the first year for the $100 million market and will be recovered within two years for the smaller $10 million market.

The one caveat to this analysis is that it has been made under the assumption that the competition is not also improving their customer retention levels at the same time. Of course, the calculations will be different for every combination of retention rate and market size; however, this methodology will work as long as the short term (1 year) size of the market is relatively stable.

One final caution: When markets are very unstable (rapidly growing or declining) this methodology is only a rough approximation at best.


Tom Lutzenberger said...

It's nice to finally find a blog that covers the theory of customer retention and related metrics. We've reviewed your post and general blog at our own blog dedicated to customer retention at http://retentionofcustomers.com/wordpress/?p=221 .

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