The Microeconomics of Customer Relationships

MBA 6008-Global Economic Environment

Capella University

Theresa Patterson

November 27, 2011

Holding on to the customers that are the most profitable is just plain good business. The retaining of current customers is less expensive than acquiring new ones. Current customers represent the path for growth, only if you know how to expand a relationship with them. Jeffery R. Immelt chairman and CEO of General Electric Company recently announced an extraordinary goal to increase the organic rate of G E from 5% a year to 8%. This 60% increase would be tremendous for a company of this magnitude, who already has the ninth largest revenue in the world.
The strategy for reaching this target encourages many of G E divisions to apply a simply customer-relationship metric known as “net-promoter score.” The idea of the NPS is relatively simply. A company begins by asking its customers just one question, “How likely is it you would recommend us to a friend or colleague?” The Company then proceeds to score the results on a zero-to-10 scale with 10 representing “extremely likely” and zero representing “not likely.” The Customers responses are then clustered in groups of threes. These groups are associated with a set of behaviors. One group is of customers who gave the company a rating of nine or ten. This group is known as “promoters” for they behave as if they were joined to the company’s sale team. Their repurchase rate are the highest and account for 80% of referrals by word of mouth. The next group rates the company with seven or eight and is considered as the “passively satisfied” or passives. Passives referral rates and repurchases are lower than the promoters by 50% or more. Last are those who gave the company ratings from zero to six. They are the “detractors” which are least likely to repurchase or refer, and account for more than 80% of negative word-of-mouth.
NPS for a company are the percentage of promoters minus the percentage of detractors, a metric that has a relationship with increases in a company’s growth rate. Many new studies have shown that NPS correlate with growth rates in competitive industries. Bain & Company researchers have found that NPS on the average increases by 12-points which double a company’s growth rate in which the variation from one company to another is substantial. Researchers associated with the London School of Economics and The Listening Company found a seven-point increase in NPS on the average increase with one percentage point growth rate increase.
Whether the correlation implies causality, to be sure is still open to debate, but a logical connection is strong and raises questions in general. Why is the connection strong? How does the quality of customer relationship affect the economics of business? To answer these questions and many others is to size up the importance of a promoter or detractor. We begin by calculating the lifetime value of the average customer. This task tallies up the cash flow that generates over the life of a typical customer relationship and then converts this total into current dollars, using a discount rate.
The next process is to go beyond this calculation and understand that the lifetime value of the average customer isn’t very useful by itself. Due to this fact we must understand that promoters and detractors display different behaviors and yield different economic results. The use of calculations and interpretations of net promoter scores permit companies to identify customers who help and harm their business. Managers can effectively evaluate investments that improve customer experience by quantifying the value of promoters or detractors in comparison with the average customer.
Factors such as retention rate, margins annual spend, cost efficiencies, and word of mouth distinguish promoters and detractors. The lifetime value of a customer is based on how long the customer stays with accompany. Detractors defect at a higher rate than promoters, which means a shorter and less profitable relationship with a company. By tagging a customer as promoters or detractors on the basis of their given response to the “would recommend” question, can determine true retention patterns overtime and quantify their impact.
The lifetime value of a customer is also based on the market basket of services bought by an average customer. Promoters in this case are not as price sensitive and believe they are getting tremendous value from the company. On the other hand detractors are more price sensitive and cautious of their spending. Companies will have to examine the goods and services purchased by the promoters and detractors for six to 12 month period to calculate the margin and keep track of discounts and price concessions.
A company’s share of wallet will increases as promoters upgrade and move toward high end products that are geared to cross-selling efforts. Promoters are more interested in new products and brand extensions which exceed that of the detractors and passives. A company may wish to gather annual spending data from sample customers in each category to adjust their lifetime-value calculations as needed. Acquisition costs for customer are lower for promoters while credit losses are higher for detractors. Detractors complain more frequently and consume more resources from customer resources. Companies calculate this cost and appropriately assign to detractors or promoters.
Word-of-mouth is very important to companies. This customer relationship component merits detailed consideration due to importance and has been said that a happy customer tells a friend while an unhappy customer tells 10 friends. Happy or unhappy customers can post their experience on the Internet for they all have a global public address system at their disposal. Word of mouth is subject to numerical calculations. A company can quantify a portion of new customers through surveys of those who selected the organization because of reputation or referral.
The lifetime value of new customers should be allocated to promoters since they account for 80% to 90% of positive referrals. Detractors are responsible for 80% to 90% of a company’s negative word-of-mouth this cost should be allocated to them. The easiest way to determine the estimated cost is based on how many positive comments are neutralized by negative comments and how many potential referrals have been lost. This number can be determined accurately through customer interviews, but for initial estimates we must assume each negative comment neutralizes from three to ten positives.
The precise way of increasing NPS economically is to try and convert detractors to passives or passives to promoters. A useful way to figure out these strategic priorities is to map customer base on the promoter-passive-detractor scale and then divide each category into high and low profit customers. This will result in a grid where circles represent the approximate size of various customers. The grid should be used strategically for it can determine which customer segments to focus on and where to allocate resources and how to design proposition for each. To move more customers into this category you must: Invest in your core, Address the detractors, and Find additional promoters.
The value of NPS allows experimentation. A company that produces NPS data regularly with sufficient granularity can track and assess their strategic and tactical moves month in and month out. Current customers represent the path for growth only if companies expand relationships with them. CEO Immelt has tapped a guide for the success of a customer metric where versatility of NPS is rooted in its simplicity: “In a company of our size and complexity, it becomes critically important to focus on one number that is practical to measure. It is vital that this metric reliable links to profits and growth.”

Reference
The Microeconomics of Customer Relationships Reichheld, Fred. MIT Sloan Management Review 47.2 (Winter 2006): 73.