Understanding Customer Economics

Customer Experience
Customer Experience
Five factors that distinguish customer types and how companies can estimate their potential economic effect on their business.

Customers who talk about a business to friends or associates generally fall into two camps: those who speak positively about a business, and those who speak negatively about it. Those positive and negative sentiments can lead to an increase or decrease in customer value-among existing customers, as well as among the prospects in a customer's network. In other words, it's possible to quantify the value of customers who promote a brand versus those who advise against it.

"To answer the question, companies need to understand the economic value of better customer relationships," write Fred Reichheld and Rob Markey in The Ultimate Question 2.0: How Net Promoter Companies Thrive in a Customer-Driven World. "They must be able to answer questions such as these: What would it be worth to turn a detractor into a passive or a promoter? What would it be worth to raise our relative NPS by 10 points? Where and when would this improvement show up in our financials?"

The following excerpt from The Ultimate Question 2.0 outlines five elements of customer behaviors and influencersand how they impact a business's bottom line:

Let's start by examining individual customer economics. The value of a promoter or a detractor can be quantified. Indeed, given the vital role that promoters play in building a business, the value of improvements in NPS must be quantified and put into financial terms. You may not have all the data you need at your fingertips, but most companies can produce it. Remember, of course, that this quantification is still an emerging science-even after years of experience, most practitioners are still developing a more complete picture of the economic benefits and better ways to calculate them. So don't let the perfect be the enemy of the good. If exact figures aren't available, use reasonable estimates-and keep innovating.

The first step is to calculate the lifetime value of your average customer. The fundamental approach is to tally up all the cash flows that occur over the life of a typical customer relationship and put them into today's dollars. You don't need a graduate degree in finance to understand that a dollar today does not have the same value as a dollar tomorrow, so you will need to convert future cash flows into today's dollars using a reasonable discount rate. Then, using the lifetime value of an average customer as a baseline, tally up the differences in lifetime value for promoters, passives, and detractors. They often exhibit dramatically different behaviors and produce significantly different economic results. The following list describes several factors that distinguish the categories and offers some tips for estimating their economic effects on your business.

  • Retention rate. Detractors generally defect at higher rates than promoters, which means that they have shorter and less profitable relationships with a company. By tagging customers as promoters or detractors based on their response to the "would recommend" question, you can determine actual retention patterns over time and quantify their impact. You can estimate the average tenure of your current population of detractors and promoters even before gathering the time-series data. Just ask them on the survey with the "would recommend" question how long they've been customers, and then use this average tenure to infer likely retention patterns.
  • Pricing. Promoters are usually less price sensitive than other customers. Typically, they did not initially choose to do business with you primarily on the basis of price, and they appreciate the overall quality and value they receive from your company. They want your business to prosper. The opposite is true for detractors: they're often more price sensitive to begin with, and they have no interest in helping keep your business healthy. You'll need to examine the market basket of goods or services purchased by promoters and detractors over a six- to twelve-month period and then calculate the margin on each basket, keeping track of discounts and price concessions.
  • Annual spend. Promoters increase their purchases more rapidly than detractors. The reason is that they tend to consolidate more of their category purchases with their favorite supplier. Your share of wallet increases as promoters upgrade to higher-priced products or services and respond with enthusiasm to new product or service offerings. Promoter's interest in new offerings and brand extensions far exceeds that of detractors or passives.
  • Cost efficiencies. Detractors complain more frequently, thereby consuming customer-service resources. Some companies also find that credit losses are higher for detractors. (Perhaps that is how some detractors exact revenge.) Similarly, in some businesses, most of the legal expenses should be attributed to detractors, since lawsuits by promoters are rare. Sales, marketing, advertising, and other customer-acquisition costs are also lower for promoters, due to the longer duration of their relationships and their higher propensity to respond to offers or seek out additional products and services. Average order size is often larger for promoters; their purchase patterns can be more predictable (and can sometimes be adjusted to help smooth your production process), resulting in lower administrative and inventory costs. Finally, perhaps the biggest productivity boosters that should be allocated to promoters-albeit the ones most difficult to quantify-are the positive energy and morale boost in the frontline employees who receive positive feedback. That produces another round of productivity improvement and cost savings from lower employee turnover.
  • Word of mouth. This component of NPS merits a somewhat more detailed consideration because it is so important and because it seems to be the one that stumps most analysts. Begin by quantifying (by survey if necessary) the proportion of new customers who selected your firm because of reputation of referral. For those customers who cite more than one reason for selecting your company, estimate the importance of the referral or reference in their decision. The lifetime value of these new customers, including any savings in sales or marketing expense, should be allocated to promoters. (Between 80 and 90 percent of positive referrals come from promoters.) Keep in mind that referred customers usually have superior economics themselves; they also have a higher propensity to become promoters, which accelerates the positive spiral of referrals.

Detractors, meanwhile, are responsible for 80 to 90 percent of the negative word of mouth, and the cost of this drag on growth should be allocated to them. Perhaps the easiest way to estimate the cost is to determine how many positive comments are neutralized by one negative comment and how many potential referrals have therefore been lost. For example, consider the process you might go through in searching for a dentist when you move to a new town. If you hear one negative comment about a particular dentist from a trusted friend or colleague, how many positive comments will you need to hear before you select that dentist?

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Reprinted by permission of Harvard Business Review Press. Excerpted from The Ultimate Question 2.0. How Net Promoter Companies Thrive in a Customer-Driven World, by Fred Reichheld with Rob Markey. Copyright 2011 Bain & Company. All rights reserved.