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The Mismanagement of Customer Loyalty - Not All Customers Are Created Equal

In this Harvard Business Review excerpt, Werner Reinartz and V. Kumar report that there is little correlation between customer longevity and company profits. Long-time customers have expectations for (and often receive) more attentive service, greater discounts, and tend to be resistant to cost-cutting changes, such as moving from phone to Web communications. The authors suggest measurement tools to evaluate customer behaviors and strategic management tips to make customers more profitable.

As valuable as segmentation is, even more valuable is correct identification at the individual level. Knowing that 60 percent of your loyal customers are profitable is useless if you don't know which ones to court with what level of service. At the corporate service provider, for example, we were able to predict how profitable and how loyal any particular customer would be with 30 percent more accuracy than we obtained using traditional methods like RFM [recency, frequency, and monetary value]. That kind of misinformation carries a high price. Our mail-order company, for instance, was sending mailings to people it should have ignored, ignoring people it should have been cultivating, and sending the wrong material to people.

From measurement to management
So what is the next step? After analyzing your customers' profitability and the projected duration of their relationships, you can place each of them into one of four categories, as shown in the matrix "Choosing a Loyalty Strategy" [see sidebar]. Now, what kind of relationship management strategies should you apply to the different segments? For the customers who have no loyalty and bring in no profits—we call them "strangers"—the answer is simple: Identify early and don't invest anything. But for customers in the other three quadrants, the choice of strategy will make a material difference to the segment's profitability.

We've found that the challenge in managing customers who are profitable but disloyal—the "butterflies"—is to milk them for as much as you can for the short time they are buying from you. A softly-softly approach is more appropriate for profitable customers who are likely to be loyal—your "true friends." As for highly loyal but not very profitable customers—the "barnacles"—the emphasis has to be on finding out whether they have the potential to spend more than they currently do.

Turning true friends into true believers. Profitable, loyal customers are usually satisfied with existing arrangements. At the mail-order company, for instance, we found that they tended to return goods at a relatively high rate, reflecting their comfort in engaging with the company's processes. They are also steady purchasers, buying regularly, but not intensively, over time.

In managing these true friends, the greatest trap is overkill. At the catalog company, for instance, we found that intensifying the level of contact through, for example, increased mailings, was more likely to put off loyal and profitable customers than to increase sales. People flooded with mail may throw everything out without looking at it. Sent less mail, however, they are more likely to look at what they get. Indeed, the mail-order company found that its profitable, loyal customers were not among those who received the most mailings.

What's more, companies need to concentrate on finding ways to bring to the fore their true friends' feelings of loyalty, because "true believers" are the most valuable customers of all. At the grocery retailer, for example, we found that customers who scored high on both actual and attitudinal measures of loyalty generated 120 percent more profit than those whose loyalty was observed through transactions alone. It wasn't just a business-to-consumer phenomenon, either: Those of the corporate service provider's customers who exhibited loyalty in both thought and deed were 50 percent more profitable than those who expressed their loyalty through action alone.

Knowing that 60 percent of your loyal customers are profitable is useless if you don't know which ones to court with what level of service.
— Werner Reinartz and V. Kumar

Companies can do several things to make loyal customers feel rewarded for their loyalty. The French grocery chain lets loyal customers opt in to e-mailings of special recipes, price promotions, and the like. It also grants them preferred access to company-sponsored seasonal events. For instance, they get exclusive early access to semiannual, weeklong wine festivals in which they get to buy many of the better wines, which are available only in limited quantities. Such measures are already having an appreciable impact on the purchasing volumes and profitability of loyal customers.

Enjoying butterflies. The next most valuable group comprises customers who are profitable but transient, and some industries are full of these kinds of purchasers. For instance, many of the direct brokerage company's most valuable customers were what it called "movers," investors who trade shares often and in large amounts. Aware of their value as customers, these people enjoy hunting out the best deals, and they avoid building a stable relationship with any single provider.

The classic mistake made in managing these accounts is continuing to invest in them after their activity drops off. Any such efforts are almost invariably wasted; our research shows that attempts to convert butterflies into loyal customers are seldom successful—the conversion rate was 10 percent or lower for each of the four companies we studied. Instead of treating butterflies as potential true believers, therefore, managers should look for ways to enjoy them while they can and find the right moment to cease investing in them. In practice, this usually means a short-term hard sell through promotions and mailing blitzes that include special offers on other products, an approach that might well irritate loyal customers. The corporate service provider, for instance, telephones those it has identified as butterflies four or five times shortly after their most recent purchase and follows up with just one direct mailing six to twelve months later, depending on the product category. If these communications bear no fruit, the company drops contact altogether.

Smoothing barnacles. These customers are the most problematic. They do not generate satisfactory returns on investments made in account maintenance and marketing because the size and volume of their transactions are too low. Like barnacles on the hull of a cargo ship, they only create additional drag. Properly managed, though, they can sometimes become profitable.

The first step is to determine whether the problem is a small wallet (the customers aren't valuable to begin with and are not worth chasing) or a small share of the wallet (they could spend more and should be chased). Thanks to modern information technology, which makes it possible to record the spending patterns of individuals, this is much less of a challenge than it once was. Our French grocery chain, in fact, does it rather well. By looking closely at POS data on the type and amount of products that individuals purchase (say, baby or pet food), the company derives amazingly reliable estimates of the size and share of the individual customers' wallets it has already captured in each product category. Then, a company can easily distinguish which loyal customers are potentially profitable and offer them products associated with those already purchased, as well as certain other items in seemingly unrelated categories. For instance, our corporate service provider might sell add-on software or memory upgrades for previously sold systems. Our mail-order company might send a do-it-yourself catalog to a customer who had previously bought a kitchen appliance.

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When profitability and loyalty are considered at the same time, it becomes clear that different customers need to be treated in different ways.

good fit between company's offerings and customers' needs
High profit potential
aim to achieve transactional satisfaction, not attitudinal loyalty
Milk the accounts only as long as they are active
Key challenge is to cease investing soon enough
True friends
good fit between company's offerings and customers' needs
High profit potential
communicate consistently but not too often
Build both attitudinal and behavioral loyalty
Delight these customers to nurture, defend, and retain them
little fit between company's offerings and customers' needs
lowest profit potential
make no investment in these relationships
Make profit on every transaction
little fit between company's offerings and customers' needs
lowest profit potential
measure both the size and share of wallet
If share of wallet is low, focus on up- and cross-selling
If size of wallet is small, impose strict cost controls
Short-term customersLong-term customers

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There is no one right way to make loyalty profitable. Different approaches will be more suitable to different businesses, depending on the profiles of their customers and the complexity of their distribution channels. But whatever the context, we believe that no company should ever take for granted the idea that managing customers for loyalty is the same as managing them for profits. The only way to strengthen the link between profits and loyalty is to manage both at the same time. Fortunately, technology is making that task easier every day, allowing companies to record and analyze the often complex, and sometimes even perverse, behavior of their customers.

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Excerpted with permission from "The Mismanagement of Customer Loyalty," Harvard Business Review, Vol. 80, No. 7, July 2002.

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Werner Reinartz is an assistant professor of marketing at INSEAD in Fontainbleau, France.

V. Kumar is the ING Chair Professor at the University of Connecticut's School of Business Administration and executive director of the School's ING Center for Financial Services.

Related stories in HBS Working Knowledge:
What's a Customer Worth?

The Economics of E-Loyalty

Three Common Myths About Customers That Undermine Results

A Toolkit for Customer Innovation

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Choosing a Loyalty Strategy