Managing Customer Retention

Customer Relationship Management - Managing Customer Retention CRM Seminar SS 04 Professor: Assistent: Handed in by: Dr. Andreas Meier Andreea Iona Eric Fehlmann Av. Général-Guisan 46 1700 Fribourg eric.fehlmann@unifr.ch

Customer Relationship Management - I - Managing Customer Retention Table of Contents 1 Introduction... 1 2 Myths about Customer Retention... 2 3 Determinants of Customer Retention... 3 3.1 The Customer Satisfaction Trap... 3 3.2 An Alternative Model of Customer Retention... 3 3.2.1 Customer expectations versus delivered quality... 4 3.2.2 Value... 4 3.2.3 Product Uniqueness and suitability... 5 3.2.4 Loyalty mechanisms... 5 3.2.5 Ease of purchase... 5 3.2.6 Customer service... 5 3.2.7 Ease of exit... 6 4 Customer Retention Strategy... 6 4.1 Changing Retention Rates... 6 4.2 The Acquisition-Retention Link... 7 4.3 Short-Term Losses for Long-Term Gains... 7 4.4 Retention Spending...7 5 Methods and Tools for Retention... 8 5.1 Databases and Data Sources for Retention... 8 5.2 Measures and Accounting for Retention... 9 5.3 Retention Measures... 10 5.4 Data Analysis Tools for Retention... 10 5.5 Targeting Defectors... 11 6 Conclusion... 11 7 Literature... 11

Customer Relationship Management - 1 - Managing Customer Retention 1 Introduction Customer relationship management makes available, through the internet, a quick and direct communication between an offerer and a customer. The aim is to raise a long lasting and profitable customer relation in order to increase the customer value, called customer equity. Besides technical issues as customer data warehouse (analytic CRM) and contact database (collaborative CRM), the main objective is to realize, with adequate methods and techniques, the strategic programs for the acquisition of customers, for the customer relation and for the Cross/Up-Selling. This paper aims to look at customer retention management specifically and show the determinants, strategies and methods of customer retention. 1 Defining Customer Retention One possible way to define customer retention is the following: The customer continues to purchase the product or service over a specified time period. Unfortunately, not all products are purchased frequently enough to make this definition applicable to many products. This forces us to consider an alternative definition for products with long purchase cycles: Products with short purchase cycles: the customer continues to purchase the product or service over a specified time period. Products with long purchase cycles: The customer indicates the intention to purchase the product or service at the next purchase occasion. But this again questions how to define long-purchase-cycle products. To simplify retention analysis we define long-purchase-cycle products as those with purchase cycles longer than one year. Sometimes, a customer s intention is not determined by revenue but by signalling the company through behaviour that they intend to continue their relationship with the firm. Therefore, the definition of retention must not mean that revenue from a customer shows whether or not the customer is retained. 1 IS Homepage

Customer Relationship Management - 2 - Managing Customer Retention Attrition and silent attrition are terms that need to be taken into account as well. Attrition is when the customer has decided to no longer use the product or service and has communicated to the firm that he or she is no longer a customer. It is important to mention that in most cases customers do not communicate to the firm that they are no longer their customers. In most cases silent attrition occurs, that is when the customer has decided to no longer purchase the product or service but has not indicated to the firm that he or she has defected. Silent attrition makes it very hard to determine if a customer is retained or not. Retention is no the same as loyalty or share of requirements. Retained customers do not need to be loyal. For an example: Assuming a customer invests some money through a traditional brokerage and some through an Internet brokerage might not be considered loyal to either, but this customer is retained by both. 2 Myths about Customer Retention Customer retention can be a critical factor to a firm s success, but is not the most important thing. There are two myths that need to be discussed, before looking at customer retention strategies: A firm should strive for 100 percent customer retention. Maximizing customer retention is synonymous with maximizing a firm s profits. The idea that a firm s maximum retention rate is not 100 percent may not seem logical at first, but factors both within the firm s control (such as price) and beyond (such as customers desire for newness) have an affect on a firm s customer retention potential, making the assumption of a maximum retention rate of 100 percent incorrect. Let us look at the airline industry to show why a firm should not strive for 100 percent (or at least some fixed number close to that) customer retention. It makes sense that airlines strive for 100 percent retention among their top customers, since they have an exceptionally high lifetime value. But striving for similar retention rates among very price conscious college students would simply not make sense. College students are no where close to being loyal,

Customer Relationship Management - 3 - Managing Customer Retention they simply seek the lowest fares and after college they usually relocate to other markets with different hub airlines, that is why college students generally do not have high retention rates. So, the question that arises is: should the airlines avoid adding these low-valued, pricesensitive customers who are incrementally profitable? Obviously not. By accepting retention rates lower than 100 percent, the airline can gain customer classes who have lower retention rates but add incremental profits. So it makes sense to treat some customers as transaction customers, but not relationship ones. Maximizing customer retention is not the same as maximizing a firm s profit. A possibility to increase retention rates is to offer lower prices to the best customers. If an airline charges this group too little, it leaves money on the table. It would rather lose some high-valued customers at the expense of its retention rate, because the profits gained by charging higher prices to the majority who are retained exceed the profits lost from the defectors. 3 Determinants of Customer Retention 3.1 The Customer Satisfaction Trap Firms often manage customer retention by managing customer satisfaction. In particular, they focus on achieving a certain level of satisfaction among all customers, which can lead to the customer satisfaction trap: increased customer satisfaction, but yet none of the benefits, such as increased sales, higher profitability or customer loyalty. There may be a correlation between satisfaction and retention, but customer satisfaction should not be the primary determinant of customer retention. 3.2 An Alternative Model of Customer Retention The customer retention process actually begins during acquisition, which creates customer expectations, including perceptions of product value and uniqueness. Initial product usage determines whether these expectations are met. Then other factors, such as ease of exit, ease of purchase, and customer service, come into play. All this together affects long-term

Customer Relationship Management - 4 - Managing Customer Retention customer behaviour and determines the relationship between seller and buyer. There are three general types of relationships: The highly loyal, committed customer. The customer who is willing to continue purchasing the product or service, but who is vulnerable to competitive offers The defector, who abandons the product In this model, there are seven determinants of customer retention: 1. Customer expectations versus the delivered quality of the product or service 2. Value 3. Product uniqueness and suitability 4. Loyalty mechanisms 5. Ease of purchase Availability Convenience 6. Customer service 7. Ease of exit (lock-out provisions) In the following these determinants are briefly explained and how each variable affects customer retention. 3.2.1 Customer expectations versus delivered quality Customers evaluate a product or service relative to their expectations. When customer expectations are too high and the delivered product does not meet those expectations, the customer will generally not repeat-purchase. So a crucial factor is the difference between the customer s expectations and the delivered quality of the product or service. Overly high expectations contribute to low retention. A firm goal must be to try to achieve a healthy balance between expectations and delivered quality.

Customer Relationship Management - 5 - Managing Customer Retention 3.2.2 Value We look at value as quality divided by price. A firm can provide greater value either by offering higher quality and matching the competition on price or by offering the same quality at a lower price. Unfortunately, firms often try to justify a higher price by arguing that they provide a greater quality. From a customer equity perspective, firms should trade off the potential price premium against the risk of customer defection and the resulting loss of substantial retention equity. 3.2.3 Product Uniqueness and suitability The more different or less substitutable a product is, the greater the retention rate. Obviously, the easier a customer has access to almost the identical product or services, the smaller the probability gets of the customer purchasing any particular one. 3.2.4 Loyalty mechanisms The airlines have used frequent-flyer programs to achieve a high degree of loyalty even though their services are very similar, close to identical. Retailers use frequent-shopper cards to promote customer loyalty. These mechanisms, which link usage and rewards, can be a very powerful generator of retention. 3.2.5 Ease of purchase If a product or services is very difficult to find or purchase, it has a negative affect on retention. For example, a customer will not regularly buy a specialty brand of stocking if it is not widely available, even if the product is highly differentiated. 3.2.6 Customer service Customer service plays an important role when it comes to customer retention. Defining customer service is not as easy for a company to do as it may seem, it has many components. Accounting provides customer services when it solves a customer s billing problems, logistics

Customer Relationship Management - 6 - Managing Customer Retention handles customer services problems when the product is not delivered, and engineering provides customer service when it shows a customer how to utilize the equipment more efficiently or how to increase production-line speed through a minor product modification. Some companies have customer service representatives who are responsible for handling all customer problems. Other companies decentralize the process. For the customer equityoriented manager, evaluating the range of service options comes down to three questions: What customers will this service approach retain, and for how long? What is the potential asset value of those customers? Does the retention equity created exceed the service cost? 3.2.7 Ease of exit Exit barriers offer one strategy for increasing retention. This can be a product-design characteristics that make it difficult to change suppliers, or product-learning curves that make it costly to switch to competing products. 4 Customer Retention Strategy 4.1 Changing Retention Rates By increasing spending on retention programs or by improving the effectiveness of current retention programs, retention rates can be changed. If a firm wants to attain a certain retention level, it can either move along the lower curve by spending more, or it can shift that curve higher by implementing some type of management-process change. The latter approach increases retention without increasing current spending. Unfortunately, this is very difficult to do; although it may be the preferable option, it is not always feasible. Both approaches are useful and commonly applied. Improving retention programs has the advantage of being a one-time investment, but a firm can have trouble identifying the

Customer Relationship Management - 7 - Managing Customer Retention necessary changes. Increasing spending can help a firm to attain its optimal retentionspending rate, but carries the risk of inefficient overspending. 4.2 The Acquisition-Retention Link Just as expectations set during acquisition affect retention, so do customer retention strategies have implications for acquisition. However, very few firms know that or give much thought to it. Instead of trying to understand the relationship between acquisition and retention, many firms simply focus on managing customer satisfaction. 4.3 Short-Term Losses for Long-Term Gains A firm may not want to retain all its customers, but the retention of desirable customers is an important goal. It may be in the firm s best interest to make suboptimal profits in the short run in order to nurture the customer-firm relationship and maximize customer equity over the total customer life cycle. Besides recency, frequency and monetary value data on past purchases, managers should look at the following: How buying patterns change over time How much customers purchase in a product category What customers purchase in complementary categories How customers respond to various promotions The level of customers disposable income (for consumer markets) 4.4 Retention Spending Firms need to understand when to increase or decrease their retention expenditures, since expenditures on retention reach a point of diminishing returns. If the overall defection rate is already low, then a firm s retention expenditures should decrease. How should a firm price its best customers? The answer depends on a number of factors, the two most crucial of which are the following:

Customer Relationship Management - 8 - Managing Customer Retention Whether customer price sensitivity increases or decreases as a function of the number of purchases made The extent of word of mouth among customers If price sensitivity decreases as the number of a customer s purchases increases, then the firm should increase the price to this customer over time. In general, a firm s best customers are less price sensitive because of their greater preference for the product, because they do not search for alternatives. This concept contradicts most customer retention literature, because it means that a firm intentionally will lose some customers as a result of its pricing strategy. New customers often get discounts for trying a product, which makes their prices lower than the current list price. A firm rarely lowers prices for existing customers, who end up paying more than the newest customers do. Ironically, this is an excellent pricing strategy in most situations. The exception to this rule is when there is substantial word of mouth among customers. In cases in which pricing and promotion data are widely known, firms may be forced to charge best customers the lowest price or risk losing them. 5 Methods and Tools for Retention 5.1 Databases and Data Sources for Retention To manage the retention process, a firm needs to understand what influences repeatpurchasing decisions. Retention databases benefit from having a large set of data and measures that allow analysts to tap a wide range of theoretical constructs when modelling retention behaviour. One of the most potent tools is a database that tracks customers interactions with the firms. Companies tend to collect very little customer interaction data. Consider a hypothetical frequent flyer who spends an average of $100,000 per year with an airline and has had several negative experiences. Several of the customer s flights were significantly delayed or cancelled. The customer then had poor service from a flight attendant and responded to the

Customer Relationship Management - 9 - Managing Customer Retention airline with a negative letter. In the end, the customer found an alternative airline for most flights. Should the airline have been able to detect such problems and possibly avoid the defection? Clearly, the answer is yes, although it requires sophisticated database management to do so. This airline could assign a customer retention specialist to be responsible for regularly obtaining all information on cancelled or delayed flights from the operations department. This person then could match the information to individual customers by linking the frequent-flyer database to the operations database. Next, the retention specialist could append information from the customer complaint database. Once all three databases have been linked, the specialist could analyze the data to identify flyers whose travel patterns have changed or who are at risk for defection. This system also would make it possible for the specialist to recognize sources of customer dissatisfaction. After identifying them, the firm could develop communications, pricing and promotional strategies to overcome the problems. Interaction should include the source of interaction, the cause of the interaction, and the outcome of the interaction. Gathering this information is not simple, because many interactions come from different functional areas within the firm. 5.2 Measures and Accounting for Retention Customer equity is the sum of the acquisition equity, retention equity, and add-on selling equity. The net profits generated during the retention phase of the customer-firm relationship are what we call a firm s retention equity. Using a Survival Model to Compute Retention Equity A survival model calculates the probability distribution associated with how long a customer survives as a customer, and gives the probability that a customer will survive to a specific point in time. This probability, when combined with relevant revenue and cost data, makes it possible to compute the customer s retention value. Using an RFM Model to Compute Retention Equity

Customer Relationship Management - 10 - Managing Customer Retention An RFM Model tracks customers through their purchase histories and groups customers into cells with similar purchase sizes, frequencies, and timing. It then predicts future customer behaviour by cell. Once analysts predict future purchase levels, they can compare them with costs to calculate retention equity. No matter which method a firm uses, computing retention equity is a challenging task. Many firms undertake the task and obviously recognize that the resulting understanding of customer equity compensates for the effort more than enough. 5.3 Retention Measures Typical defection and retention rates are average rates, influenced equally by the retention rate of newer customers and the retention rate of customers who have had longer relationships with the firm. Management that is evaluated and compensated based on retention and defection rates has a tendency to avoid increasing acquisition rates, because it recognizes that retention rates likely will decline. Companies should also measure the ratio of lost customers to new customers. 5.4 Data Analysis Tools for Retention Decile Analysis This method determines the relative profitability and sales of different customer segments. It also shows which individual customers are most valuable. Deciles are 10 percent groupings computed by ranking each customer according to his or her purchases, or according to any other variable of interest, such as profitability, and grouping the customers into 10 percent segments. RFM Analysis Computing Current Customer Status. The purpose of an RFM matrix is to display how customers are distributed by purchase recency, frequency and value.

Customer Relationship Management - 11 - Managing Customer Retention Computing Purchasing Probabilities. An RFM matrix can be used to predict future purchase rates. The RFM framework is an effective method for summarizing and interpreting complex purchase data. 5.5 Targeting Defectors The RS Matrix The basic idea is that a customer s sales rate and recency tell us something about whether the customer will repurchase. A Defector is someone who was a regular customer but now no longer is. Statistical Models Statistical modelling is a more sophisticated way to predict defectors. 6 Conclusion The goal of customer retention management is not to strive for zero defections. Instead, a firm should manage its retention rate and choose retention strategies and tactics that best support its main focus: optimizing customer equity Customer retention does not occur without incurring some costs. Companies can maximize customer equity by matching those costs to the retention values of individual customers rather than by acting on the myopic view that retention is free. Managers should have the goal to maximize customer equity, not retention. And they should always keep in mind that retention generally comes at a cost. 7 Literature Blattberg R.C. et al. 2001, Harvard School Press: Managing Customer Retention, p.67-93 IS Homepage: http://diuf.unifr.ch/is