Traditional service companies know that customer loyalty has a powerful impact on the bottom line. But what about service firms in the new economy, where customers can defect at the click of a mouse? Bain & Co.'s Frederick F. Reichheld (HBS MBA '78) first demonstrated the value of customer retention in the Harvard Business Review a decade ago. Now Reichheld and his colleague Phil Schefter (HBS MBA '89) have completed a study of customer loyalty and the Web—with some surprising results. They explain in this excerpt from their new HBR article "E-Loyalty: Your Secret Weapon on the Web."

by Frederick F. Reichheld and Phil Schefter

Ten years ago, Bain & Company, working with Earl Sasser of Harvard Business School, analyzed the costs and revenues derived from serving customers over their entire purchasing life cycle, and we published the results in this magazine. (See "Zero Defections: Quality Comes to Services, " Harvard Business Review, September-October 1990.) We showed that in industry after industry, the high cost of acquiring customers renders many customer relationships unprofitable during their early years. Only in later years, when the cost of serving loyal customers falls and the volume of their purchases rises, do relationships generate big returns. The bottom line: increasing customer retention rates by 5% increases profits by 25% to 95%. Those numbers startled many executives, and the article set off a rush to craft retention strategies, many of which continue to pay large dividends.

When we applied the same methodology to analyzing customer life-cycle economics in several e-commerce sectors—including books, apparel, groceries, and consumer electronics—we found classic loyalty economics at work. In fact, the general pattern—early losses, followed by rising profits—is actually exaggerated on the Internet. (See the exhibit) At the beginning of a relationship, the outlays needed to acquire a customer are often considerably higher in e-commerce than in traditional retail channels. In apparel e-tailing, for example, new customers cost 20% to 40% more for pure-play Internet companies than for traditional retailers with both physical and on-line stores. That means that the losses in the early stages of relationships are larger.

In future years, though, profit growth accelerates at an even faster rate. In apparel e-tailing, repeat customers spend more than twice as much in months 24-30 of their relationships than they do in the first six months. And since it is relatively easy for Web stores to extend their range of products, they can sell more and more kinds of goods to loyal customers, broadening as well as deepening relationships over time. The evidence indicates, in fact, that Web customers tend to consolidate their purchases with one primary supplier, to the extent that purchasing from the supplier's site becomes part of their daily routine. This phenomenon is particularly apparent in the business-to-business sector. For example, W.W. Grainger, the largest industrial supply company in the United States, discovered that longtime customers, whose volume of purchases through Grainger's traditional branches had stabilized, increased their purchases substantially when they began using Grainger's Web site. Sales to these customers increased at triple the rate of similar customers who used only the physical outlets. [For more on Grainger, see "How Grainger Helps Customers Make Sense of Complexity" below.]

In addition to purchasing more, loyal customers also frequently refer new customers to a supplier, providing another rich source of profits. Referrals are lucrative in traditional commerce as well but, again, the Internet amplifies the effect, since word of mouse spreads even faster than word of mouth. On-line customers can, for example, use e-mail to broadcast a recommendation for a favorite Web site to dozens of friends and family members. Many e-tailers are now automating the referral process, letting customers send recommendations to acquaintances while still at the e-tailers' sites. Because referred customers cost so little to acquire, they begin to generate profits much earlier in their life cycles.

EBay is one e-commerce leader that is reaping the economic benefits of referrals from loyal customers. More than half its customers are referrals. "If you just do the math off our quarterly financial filings, " CEO Meg Whitman recently told the Wall Street Journal, "you see that we're spending less than $10 to acquire each new customer. The reason is that we are being driven by word of mouth." EBay has even found that the costs of supporting referred customers are considerably lower than for those brought in through advertising or other marketing efforts. Referred customers tend to use the people who referred them for advice and guidance rather than calling eBay's technical support desk. In effect, loyal customers not only take over the function of advertising and sales, they even staff the company's help desk—for free!

The combination of all these economic factors means that the value of loyalty is often greater on the Internet than in the physical world. For all companies doing business on the Web, the implication is clear: you cannot generate superior long-term profits unless you achieve superior customer loyalty.

Source: hbswk.hbs.edu