Thursday, February 4, 2010

Measuring Customer Loyalty

There are some people who suggest that customer loyalty is an emotion that is most easily measured using a survey or interview of some form. There are others who say that loyalty shows up in the pocket book and that actions-speak-louder-than-words. One way to measure loyalty using the survey method that appears to be most popular these days is NPS. One of the ways to measure customer loyalty using the actions-speak-louder-than-words approach is RFM.

The term RFM stands for Recency, Frequency and Monetary value. The concept is baaed on a way of gathering the total value of a customer so that customers can be classified into groups which can then be assigned different levels of investment by the company to reward the various customer groups according to their "loyalty".

Recency is determined by reviewing past history for each customer and assign a score which is higher for the more recent purchase. There are several ways this score can scaled. One simple scale would be to give a maximum score if the most recent purchase was within 30 days, the second highest score would be for purchases within 90 days, etc. One concern is that high priced products often have longer periods of time between purchases (e.g.automobiles, tvs, washers and dryers) than clothing,or consumables such as ink cartridges and paper.

Frequency measures the number of purchases made in each of the time frames used to measure recency. Although the recency measure has a limited range of values (depending on the number of time periods used), the frequency measure has virtually no upper bound. Thus a customer could make a purchase every day and have a very high frequency rating or maybe as infrequently as once a year.

With the information of recency and frequency, a total score can be determined by adding the two scores together. In general, the more items a customer purchases and the more recent the purchase will yield a higher overall score which would lead a company to provide more lavish rewards to those customers. Many companies stop rating customers for loyalty when they have reached this point of adding the recency and frequency terms together to categorize their customers into different levels of loyalty. What has been ignored up to this point is the monetary value of these customers. When this term is omitted from the evaluation, the company can not differentiate between customers who provides a high level of profit and those who do not.

Monetary value is often measured in terms of revenue which is easily determined by reviewing the purchases. The monetary value is misleading when only the purchase prices are considered since different products will carry different profit margins. For that reason, the monetary value should be measured in terms of total profit margin rather than total revenue.

Some of the problems with RFM are:
1. A customer's history of purchasing may not be reflected in his future purchasing behavior.
2. A high frequency of buying low margin products can be misleading and score a low value customer high.
3. There are a number of ways to combine all three measurements.
4. The cost of servicing customers is usually not included in the measurement of profit margin.

The bottom line is that there is a need for a business measure of loyalty beyond feelings and emotion. Perhaps the best solution is to find some way to integrate the emotional measure with a business measure. This blog will continue to pursue other business measures of loyalty and report on those that appear to be rational, repeatable and consistent.


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