David vs. Goliath I: Challenging Fred Reichheld on the Economics of Loyalty

10
410 views

Share on LinkedIn



Before I take out my slingshot, let me say that I think of Fred Reichheld as the dean of the school of customer loyalty. His Loyalty Effect is a true classic. He is one of the field’s defining figures and certainly its best known. No one has done as much to bring the issue of customer loyalty into the boardroom and the lexicon of corporate America.



And this is not (whew!) another rant about the evils or laurels of NPS.
I am a staunch defender of the economic value of loyalty. Loyalty is expressed by customer behavior that, in turn, drives value to a company. For any given customer, they express their loyalty to a company by continuing to be a customer, perhaps buying  more (or more expensive) products and services, giving the company a larger share of their spend, recommending the company to others and so on. The same customer expresses their disloyalty by doing the converse of these things. Consequently, for any given customer, their lifetime value to a company is significantly greater if they behave loyally than if they behave disloyaly. The dean (if I may speak for him) and I are in agreement on these points, and GfK’s LoyaltyPlusSM has validated this over and over again.  
 
Fred (whom I have never met, but he can call me Howard, so we’re even) also asserts, however, that loyal customers will pay more than non-loyal customers. His classic graph of “Why Loyal Customers Are More Profitable” (The Loyalty Effect, p.39) indicates that there is a price premium a firm can capture from loyal customers. He is not saying that Nordstrom’s can charge more than Macy’s which can charge more than Wal*Mart for the same products, that a devotee of a neighborhood bookstore will be willing to pay more for book from their favorite haunt despite the fact they can buy it for less online, or that people will pay more for better value/products/service/experience. Fred implies that a company can boost the lifetime value of a loyal customer by charging loyal customers more (that is, capture a price premium) than it charges less-loyal customers for the same products or services. This is where we part company.
 
I have seen a total of 1 (that’s ONE, uno) instance in which a firm actually was sufficiently confident about its ability to identify a small (very small) segment of customers it considered so loyal that they could charge them a small (very small) premium above its regular interest rate. The company in question is a bank that charged customers identified as its most loyal 7 basis points (that’s 1/16% or 0.067%) more than its regular interest rate on mortgages. In other words, the bank truly captured a price premium from a subset of customers it was able to identify as extremely loyal. (They tested 1/8% as well, but found that even their most loyal customers balked at 0.125% more and took their business elsewhere.)
 
For this one small example, I can cite hundreds of instances of banks – including the same bank that commanded this tiny mortgage premium – charging loyal customers lower rates on loans and offering them bundled products that are, in effect, packaged discounts from regular prices. Perhaps Fred is right and everyone in business is wrong, but it seems to me that most companies look for every opportunity to “reward” their most loyal customers with coupons, points programs, special savings, extra services, freebies, bennies and an endless array of incentives, all of which translate into a discount of some sort, not a price premium.
 
I am not suggesting that providing such incentives to customers to be more loyal or rewarding their loyalty is a bad idea or that it in any way undermines the economic value of loyal customers. In fact, it may actually punctuate the point: even though a company may effectively charge its most loyal customers less than other customers by virtue of incentives and packages it gives to loyal customers, the economic value of loyal customers still is greater than the value of non-loyal customers. In the experience of this David staring up at Goliath, at least, however, I see virtually no evidence of price premiums captured from loyal customers and a sea of examples where loyal customers realize price discounts.
 
I have never heard Fred challenged on this point, which is often repeated as a biblical truth without comment – but never with real examples. (Discounts to lure new customers or get them to try a product are simply new customer acquisition costs, not an example of more loyal customers paying premiums over less loyal customers, BTW.) Am I a lone voice in the wind? I know no one likes to respond to posts, but as a community of researchers and practitioners in the arena of customer loyalty, this group should be hyper-aware of these issues and any examples of such loyalty price premiums – so “show me the money.” Take ten seconds and weigh in: either there is no real price premium from loyal customers (who, I think, actually often realize price discounts) or register your agreement with Fred that companies capture price premiums from loyal customers (but with specific examples of loyalty premiums, not simple “I like Fred” raves).
 
Fred and I agree that the economic case for loyalty is compelling, boosting customer lifetime value. But I say that loyalty has a positive payoff despite incentives that amount to effective discounts, not because of supposed price premiums.

10 COMMENTS

  1. Howard, thanks for another thought-provoking post.

    I remember Reichheld’s chart very well, and in fact used his argument years ago in speeches explaining “loyalty economics” and why loyal customers may not be so price sensitive.

    Some solid research is needed to confirm or dispute this conventional wisdom.

    My take is that genuinely loyal (emotionally committed and highly satisfied) are on the one hand less likely to shop around for a better deal. On the other hand, I’ve run surveys myself over the years that found loyal customers want some kind of recognition or tangible rewards. There goes the “loyalty premium.”

    Even if loyal customers pay about the same as others, it still is valuable to the company because you’re avoiding the acquisition costs to replace that customer. And loyal customers do buy more over time, don’t they? Or is that just another story that Reichheld told to sell everyone on loyalty?

    Bottom line: In this day and age where price comparisons are all too easy, I don’t want to be “rewarded” for my loyalty by paying more. I will, however, reward companies I like by not focusing so much on price, and sticking around to spend more. Seems like a reasonable deal to me.

  2. Thanks for your response, Bob. I completely agree that genuinely loyal customers are less likely to shop around. To a large extent, continuing to be a customer is the most fundamental form of "loyalty behavior.” The core foundation of a customer's lifetime value (LTV) stems from retention value, the value of the repeat purchase over time.

    But what Reichheld implies is that Company A is able to capture a price premium from Ms. Genuinely Loyal Customer relative to what the company realizes from Mr. Less Loyal Customer. His argument hinges on Company A employing differential pricing based on loyalty. The Reichheld chart directly implies that the same customer is paying higher prices to the same company over time because of the customer's loyalty to the company: this is the supposed loyalty premium with which I take extreme exception.

    Different companies charging different prices is a related but conceptually not the same issue. Let's say Company A is more expensive than Company B for ostensibly the same product or service. Both companies will have customers who run the gamut from completely loyal to ephemeral transactors. In this circumstance, to assert that Company A is capturing a price premium from its loyal customers doesn't seem to make sense, as Company A also is getting the same higher price from its less loyal customers and one-time buyers. Simultaneously, what about the loyal customers of Company B? Where is their price premium? In the Reichheld argument, both Company A and Company B should be able to capture price premiums from their respective loyal customers.

    As I mention, I am 100% on board with the overall economic argument in favor of customer loyalty driving value to a company. As you point out, loyal customers are repeat buyers and are more likely to buy more items over time and do save companies on acquisition costs for de novo customers. And, as you note, loyal customers are less likely to shop around. All of this contributes to a compelling argument that loyalty boosts the economic value (LTV) a company realizes from a customer: my point, however, is that this boost in value does not hinge on a supposed price premium; going one step further, I argue that this boost in value occurs despite effective price discounts most companies give to their most loyal customers.

  3. Howard – I agree with you that loyal customers do not generally represent an opportunity for a price premium…indeed, we often expect the reverse. However, companies that engender loyalty – through superior service or product – do clearly have permission to charge a premium.

    Bob’s comment about data vs. anecdote is well taken, but indulge me…I am fantastically loyal to USAA. I happily pay them somewhat more for insurance and other financial products than I might be able to find elsewhere, but I know that if there’s ever a problem, USAA will make it right.

    However – since I am a very loyal customer, even among USAA members, I expect that RELATIVE TO OTHER USAA CUSTOMERS, I will receive their best pricing on their products.

    So, there are two forces at play: Companies that engender loyalty (or brand engagement if you come at it from that angle) can charge a premium. But, loyal customers expect a discount.

  4. Mike, you are dead-on with the distinction you so clearly draw: companies can command a price premium for being "better” – better product/service/value/convenience/etc. But loyal customers – whether they are loyal to such a "better” supplier with higher prices or they are loyal to a low cost supplier – expect (and almost always get) "best” (i.e. lower prices) than other customers of the same firm.

  5. Actually, the research has already been done and reported in both the Journal of Marketing and the Harvard Business Review. Specifically:

    Werner Reinartz and V. Kumar (2000), “On the Profitability of Long-Term Customers in a Non-contractual Setting: An Empirical Investigation and Implications for Marketing,” Journal of Marketing, vol 64, no. 4 (October), 17-35.

    Werner Reinartz and V. Kumar (2002), “The Mismanagement of Customer Loyalty,” Harvard Business Review, vol. 80, no. 7 (July), 86-94.

    In no case did Reinartz and Kumar find that loyal customers paid higher prices. They did find that in one case loyal customers paid 5% to 7% less than “new” customers.

  6. Thanks for the specific citations, Tim.

    Given the frequency with which I've heard and read people citing Reichheld's claim of a loyalty price premium, I would have thought that someone, somewhere, at some time would have found at least one solid example to support the assertion. Not that one example proves the rule, but the silence is deafening.

  7. Another element of the lifetime value of loyal customers, not covered in any of the other responses, is cost to serve. Numerous studies have determined that loyal customers require fewer service and support resources than customers making higher demands and offering lower cross-sell and upsell opportunities.

  8. Thanks for raising the flip side of the issue: the cost to serve. This steals my thunder a bit, as I have a post in the next day or so that speaks to just that point. From your comments, Michael, I will expect you to disagree with what I have to say. I'll look forward to your response!

  9. Interesting thoughts Howard. One thing that occurs to me it that it’s often difficult for organisations to justify a price premium for some customers when the practice becomes transparent (as it increasingly does in these days of empowered consumers).

    I suspect there are lots of instances where loyal customers are less likely to shop around and therefore remain with relatively uncompetitive (and high margin) products. For instance, I’m certain that I could get a slightly better rate on some of my savings if I could be bothered to move them even within the same bank – I’m loyal and inert – and conscious of my inertia!

    There has also been a lot of consumer fuss (certainly here in the UK in the telecoms sector) about companies offering better deals to new customers than they do to existing [loyal] ones. In a strict sense, the actual product varies across customers, but in effect it’s a tactic that enables companies to charge a price premium.

    This is what economists call ‘price differentiation’ – finding ways to extract higher margins from some customer segments. For some accessible examples, see The Undercover Economist by Tim Harford (on coffee) or Super Freakonomics by Levitt and Dubner (on call girls, ahem).

  10. Thanks for the examples, Trevor. We won't ask about who did the field work in the latter instance!

    When on the selling side, companies often strive for price differentiation, typically hoping to "value price,” that is capture higher prices from those customers realizing greater value from what the company is selling. "Client-9″ (AKA Eliot Spitzer, former governor of New York caught using the services studied by Levitt and Dubner) apparently paid top price because of the extra value he attached to discretion. In reality, however, I think companies differentiate on pricing more based simply on their market strength rather than any particular customer strategy or the degree of loyalty of the customer.

    Discounts for prospects to convert them into new customers are not the same as a price premium for loyal customers. Equating "existing customers” with "loyal customers” is a bit of mix-and-match. The majority of customers (that is, "existing customer”) of most companies are not particularly loyal. A loyalty price premium, in my mind, explicitly indicates a situation in which an existing loyal customer is paying more for the same product or service than an existing customer who is less loyal. I just don't see this in the marketplace.

LEAVE A REPLY

Please enter your comment!
Please enter your name here