Economics assessment one and two

assessment_2_required_material.pdf

Home >Business & Finance homework help >Economics homework help >Economics assessment one and two

P l e a s e n o t e t h a t g ra y a re a s re f l e c t a r t w o rk t h a t h a s b e e n i n t e n t i o n a l l y re m o v e d . T h e s u b s t a n t i v e c o n t e n t o f t h e a r t i c l e a p p e a rs a s o ri g i n a l l y p u b l i s h e d .

The Microeconomics of Customer Relationships

W I N T E R 2 0 0 6 V O L . 4 7 N O. 2

R E P R I N T N U M B E R 4 7 2 1 5

Fred Reichheld

effrey R. Immelt, chairman and CEO of General Electric Company, recently

announced the extraordinary goal of boosting GE’s organic growth rate

from 5% a year to 8% — a 60% increase for a company that is already the ninth

largest (by revenue) in the world. As part of the strategy for reaching this ambi-

tious target, Immelt has encouraged many of GE’s divisions to apply a simple

customer-relationship metric known as “net-promoter score.”1 The ideas

behind NPS, which have been around for a couple of years,2 are simple. A com-

pany asks its customers just one question — “How likely is it that you would

recommend us to a friend or colleague?” — and then scores the results on a

zero-to-10 scale with 10 representing “extremely likely” and zero representing

“not at all likely.” Customer responses tend to cluster in three groups, each of

which is associated with a set of behaviors. One group is made up of customers

who give the company a nine or 10 rating. They are known as “promoters”

because they behave almost as if they were adjuncts to the organization’s sales

force. They report by far the highest repurchase rates, account for more than

80% of referrals and are the source of most of a company’s positive word-of-

mouth. A second segment rates the company seven or eight and might be

dubbed the “passively satisfied” or passives. Their repurchase and referral rates

are considerably lower than those of promoters, often by 50% or more. Finally,

those who give a company ratings from zero to six are known as “detractors.”

Detractors are the least likely to repurchase or refer, and they account for more

than 80% of negative word-of-mouth. A company’s NPS is simply the percent-

age of promoters minus the percentage of detractors, a metric that turns out to

correlate well with increases in a company’s growth rate.

New studies show that NPS is correlated with growth rates in most compet-

itive industry. Researchers from Bain & Company have found that, on average,

a 12-point increase in NPS corresponds to a doubling of a company’s growth

rate, though the variation from one industry to another is substantial. More

recently, a careful study of four U.K. industries by researchers associated with

the London School of Economics and The Listening Company found that a

seven-point increase in NPS correlated on average with a one percentage point

increase in growth rate.3 To be sure, whether the correlations imply causality is

WINTER 2006 MIT SLOAN MANAGEMENT REVIEW 73Illustration: © Brian Stauffer/theispot.com

The Microeconomics of Customer Relationships

Fred Reichheld, a director emeritus and Bain fellow at Bain & Company, is the author of The Loyalty Effect (1996) and Loyalty Rules! (2001), both published by Harvard Business School Press. His new book, The Ultimate Question, from which this article is adapted, will be published by Harvard Business School Press in March 2006. Con- tact him at [email protected].

Using net-promoter

score, a metric that,

in most industries,

correlates well with a

company’s growth rate,

managers can evaluate

how investments aimed

at improving the customer

experience actually affect

the bottom line.

Fred Reichheld

74 MIT SLOAN MANAGEMENT REVIEW WINTER 2006

still open to debate, but the logical connection is strong4 and it

raises interesting and hitherto unexplored questions. Why is the

connection as strong as it is? How does the quality of customer

relationships affect the economics of a business? Can the micro-

economics of NPS itself ultimately be quantified and managed?

How does a company raise its NPS — and on which customers

should it focus its efforts? This article examines these questions.

Unraveling the Mystery The key to answering many of these questions is to quantify the

value of a promoter or a detractor. This is no idle exercise; it is the

best way of understanding in numerical terms why and how cus-

tomer relationships matter to a company’s financial perform-

ance. Most organizations are able to produce the data required,

but even if your company doesn’t have exact figures, you can still

learn much by using reasonable estimates.

The first step is to calculate the lifetime value of an average

customer. The fundamental task is to tally up all the cash flows

that will be generated over the life of a typical customer rela-

tionship and then to convert this total into current dollars,

using a reasonable discount rate. The next step is to go beyond

this well-worn calculation and to understand that the lifetime

value of an average customer by itself isn’t very useful. In fact,

promoters and detractors exhibit dramatically different behav-

iors and produce dramatically different economic results. The

following list describes several factors that distinguish promot-

ers and detractors, and offers tips for estimating their eco-

nomic effects on a business. (See “The Value of Promoters and

Detractors,” p. 75.)

Retention rate. The lifetime value of a customer is obviously

dependent on how long the customer stays with a company. That,

in turn, depends on how likely it is that the customer will defect

to the competition. 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 on the basis of their response to the

“would recommend” question, a company can determine true

retention patterns over time and quantify their impact. In fact, a

company can estimate the average tenure of its current popula-

tion of detractors and promoters even before gathering the time-

series data. All that’s required is to ask customers, on the same

survey with the “would recommend” question, how long they

have been customers and then to use this average tenure to infer

likely retention patterns.

Margins. The lifetime value of a customer is based on the market

basket of goods and services bought by the average customer. But

here, too, promoters and detractors are very different. Promoters

are usually less price-sensitive than other customers because they

believe they are getting good value overall from the company. The

opposite is true for detractors: They are more price-sensitive. A

company needs to examine the market basket of goods or services

purchased by promoters and detractors over a six- to 12-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 because they tend to consolidate more of their

category purchases with their favorite supplier. A company’s

share of wallet increases as promoters upgrade to higher-priced

products and respond to cross-selling efforts. Promoters’ interest

in new product offerings and brand extensions far exceeds that of

detractors or passives. A company can gather annual spending

data for a sample of customers in each category then adjust the

lifetime-value calculations accordingly.

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 detractors exact revenge.) Customer-acquisition costs are

lower for promoters due to both the longer duration of their rela-

tionships and their role in generating referrals. Companies can

calculate or estimate all of these costs then assign them appropri-

ately to promoters or detractors.

To study the connections among survey questions, cus-

tomer behaviors and growth, my colleagues and I teamed

up with Satmetrix Systems Inc. (a company on whose board

I serve). First we administered the Loyalty Acid Test — a sur-

vey designed to assess relationships between companies

and their customers — to thousands of customers in six

industries. Then we gathered purchase-history and referral

data from each of our respondents. That data allowed us to

determine which of the questions on the test had the

strongest correlation with repeat purchases and referrals.

We found that the “would recommend” question described

in the body of this article was the single best gauge of cus-

tomer behavior for nearly every industry.

Next, we gathered tens of thousands of responses to

this question from customers in many different industries.

We could then calculate net-promoter scores — the per-

centage of promoters minus the percentage of detractors

— for these industries and for the leading companies in

each industry. Comparing NPS to growth rates, we found

strong correlations between a company’s relations with its

customers and its rate of growth — correlations that have

since been confirmed by other investigators.

About the Research

WINTER 2006 MIT SLOAN MANAGEMENT REVIEW 75

Word-of-mouth. This component of customer relationships

merits detailed consideration both because it is so important and

because it seems to be the one that stumps most analysts. Word-of-

mouth has always been important to companies; it used to be said

that a happy customer tells a friend while an unhappy customer

tells 10 friends. Today, customers can post their experiences on the

Internet; happy or unhappy, they all have a global public-address

system at their disposal. Companies are thus more dependent than

ever on cultivating positive word-of-mouth and on nipping nega-

tive word-of-mouth in the bud.

Word-of-mouth, too, is subject to numerical calculation. A

company can begin by quantifying — by survey if necessary — the

proportion of new customers who selected their organization

because of reputation or referral. Since promoters account for 80%

to 90% of positive referrals, most of the lifetime value of these new

customers (including any savings in sales or marketing expense)

should be allocated to promoters. It’s worth noting 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% of a

company’s 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. This number can be accurately

determined only through customer interviews, but for an initial

estimate it’s safe to assume that each negative comment neutral-

izes from three to 10 positives. 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 partic-

ular dentist from a trusted friend or colleague, how many positive

comments will you need to hear before you select that dentist?

Though all this calculation may sound complex, it doesn’t need

to be. Using only publicly available data, for example, a small team

in 2003 calculated the value of promoters and detractors to Dell

Inc., which has the highest NPS in the Wintel personal-computer

business. Securities analysts estimated at the time that each of

Dell’s 8 million consumer customers was worth $210 to the com-

pany. Surveying a sample of these customers, the team was able to

use the responses to quantify the factors mentioned above and

allocate them accordingly. The 60% of Dell’s customers who were

promoters, the researchers calculated, were worth $118 more than

the average, or $328. The 15% who were detractors were worth

$267 less than the average, or -$57 apiece, meaning that each one

actually destroyed that much value. The difference between pro-

moters and detractors was an astonishing $385.

Converting just half of those detractors into average customers

— not an unrealistic target, given that other companies with high

NPS typically generate only 3% to 8% detractors — would add

more than $160 million annually to Dell’s bottom line (600,000

detractors at $267 improvement per conversion). Converting

some of the detractors into promoters would add even more. This

simple math could help Dell managers place the right level of pri-

ority on reducing detractors and increasing promoters. Using this

data, Dell, or any other company, can evaluate major investments

aimed at improving the customer experience because these pro-

posals can be subjected to the same rigorous economic analysis

already applied to other investments.

Increasing NPS Strategically The precise economics of increasing NPS — whether, for exam-

ple, it is more cost-effective to try converting detractors to pas-

sives or passives to promoters — will vary from one company to

another, which is why actually doing the calculations for your

own customers is critically important. But a useful way of figur-

ing out strategic priorities is to map your customer base on the

promoter-passive-detractor scale and then to divide each cate-

gory into high-profit and low-profit customers. (Your cost of

capital is a good dividing line between high profit and low

Negative Word- of-Mouth

Cost to Serve

Annual Spend

Margins

Retention

-200

-100

100

200

Detractor

Promoter

Average Customer

(Base)

Retention

Average Customer

(Base)

Positive Word- of-Mouth

Annual Spend

Cost to Serve

Margins

$ Customer Value (Net Present Value) 300

Calculation and interpretation of net-promoter scores allows

companies to identify the customers who help their business

and those who harm it. By quantifying the value of promoters

or detractors in comparison with average customers, man-

agers can more effectively evaluate investments aimed at

improving the customer experience.

The Value of Promoters and Detractors

76 MIT SLOAN MANAGEMENT REVIEW WINTER 2006

profit.) The result will be a grid in which circles represent the

approximate size of the various customers (or customer seg-

ments). (See “The Customer Grid.”)

Sometimes just looking at this grid can spark targeted action.

When a division of GE analyzed its accounts on the grid, managers

quickly developed specific strategies for each sector. Customers in

the top left, for example, were profitable but angry — and the divi-

sion promptly dispatched a cross-functional team to visit each one,

to probe for the causes of their dissatisfaction and to develop solu-

tions. A consumer-oriented company can’t visit each customer, but

it might ask every member of its senior team to contact a sample

of these customers to find out why they’re so upset.

In general, though, you should use the grid strategically. It can

help you determine which customer segments to focus on, where

to allocate resources and how to design appropriate propositions

for each. The grid can also allow you to visualize and manage what

may be the quintessential business process: creating more prof-

itable-promoter customers. There are three broad priorities for

moving more customers into this category.

Invest in your core. Take a good look at those customers in the

upper right of the grid. They love doing business with you. They

generate high margins. By definition, these people or businesses

constitute your company’s core clientele. They may be even more

profitable than you think they are: Remember how much addi-

tional benefit promoters bring you through referrals and positive

word-of-mouth. These are the customers that should drive your

strategic priorities.

But how do most companies treat these customers?

At best, companies take this sector for granted. At worst,

they milk it to fund solutions for other customers —

those who are less happy or less profitable. Systematic

underinvestment in the profitable-promoter sector

explains why so many companies experience “core

meltdowns” and compromise their growth. Think back

to American Express in the 1980s, for example. The

company took the healthy profits it was earning from its

core travel-card business and financed an expansion

into a broad array of financial services. Even within the

card division, margins from high-volume customers

went toward the acquisition of new customers rather

than toward enhancing the experience of those core

customers. For instance, the company’s rewards pro-

grams — miles or other benefits earned by charging on

the American Express card — were narrow and over-

cautious; their purpose was primarily to limit defec-

tions to competitors’ cards. The result of all these moves

wasn’t hard to predict. Visa and MasterCard issuers ate

into American Express’s share of wallet for its most

profitable customers. American Express’s growth and

profits tailed off accordingly.

Over time, however, American Express learned how to design

compelling value propositions for its core customers. It transformed

its earlier Membership Miles program into Membership Rewards,

one of the most generous awards programs in the industry. Rather

than offering the program only to card members who signed up for

it and paid a fee, as before, the company launched products that

included the program as a core benefit. American Express created

partnership programs with travel-related companies such as Delta

Air Lines and Starwood Hotels, so that frequent travelers could earn

bonus points; it also created a partnership with Costco, designed to

appeal both to consumers and to the small-business owners who are

among Costco’s prime customers. A special card called Rewards Plus

Gold — offered primarily as an upgrade to high-value core cus-

tomers — gave card members additional points and free extra cards

and turned out to be immensely popular. Thanks largely to word-

of-mouth, the Rewards Plus Gold card soon grew to significant size

and became one of the most profitable products in American

Express’s portfolio.

Address the detractors. If upper-right customers are your top

long-term priority, the upper left should be next. In fact, some-

times the actions required here may be quite urgent. Customers

in this sector don’t like doing business with you and are spread-

ing negative word-of-mouth. They may defect at the first

opportunity. Yet because they are profitable, you can afford to

invest in solving their problems, hopefully even converting

them into promoters.

High

Low

Profitability

Low High Net-Promoter Score

Detractor PromoterPassive

A B C

F E D

Circles on the grid represent the approximate size of various customers

(or segments), helping to clarify which customers are the most profitable

to focus on and what strategies are most appropriate for each segment.

The Customer Grid

WINTER 2006 MIT SLOAN MANAGEMENT REVIEW 77

Sometimes all you have to do is talk to them, identify their con-

cerns and solve their problems on the spot with a rebate or an apol-

ogy. More often, these customers are offended by company policies

that need to be changed. For example, a mobile-phone provider

found that many accounts in this sector of its grid had accepted

long-term contracts at fixed prices. Now these prices were not com-

petitive, yet the customers were locked in — and they were furious.

But this was a problem that could be easily fixed: The company sim-

ply contacted the customers before their contracts expired and

offered far more favorable terms on a renewal. The fix cost money

to be sure. But holding customers hostage to deals they resent, with

all the resulting negative word-of-mouth, undoubtedly would have

been more costly in the long run.

The customers in the lower left — detractors who do not gener-

ate much profit — may be a slightly lower priority but only slightly.

For one thing, most companies will find that they have many

accounts in this sector. For another, whatever profits are generated

in this sector are too low; they are actually destroying shareholder

value. Indeed, given the negative economics of detractors, whatever

profits you think you are earning are probably greatly overstated.

These customers are hammering your reputation and turning off

other prospects by voicing their grievances. They are taking out

their frustrations on your frontline employees. They are filing a dis-

proportionate number of complaints and lawsuits.

The rule for these customers must be: up or out. Since there is

little profit to invest in fixing their problems, you must either dis-

cover a more efficient way to serve them or find a way to move

them to the competition. Sometimes, of course, they were merely

sold the wrong product or service initially, and all that’s necessary

is to get them into the right package. And sometimes you can fig-

ure out lower-cost processes for serving them, just as banks have

converted unprofitable branch customers into profitable ATM

and online customers. Otherwise there is little to do except guide

them to an alternative supplier.

Find additional promoters. How can you economically increase

the population of customers in the upper-right sector? The two

choices are to move the promoters in the lower right up by

increasing their profitability or to move the passives from the

upper middle (who are already profitable) over into the promoter

category.

Take the move-the-promoters-up option first. It’s tempting to

raise prices for these customers, thus immediately boosting their

profitability, and in some cases that may be the right tactic. But

beware! These referral-generating, positive-word-of-mouth–giv-

ing, faithful customers are probably far more valuable to you

than profit calculations alone can show. You don’t want to milk

their good will. Since they already love you, it might be better to

78 MIT SLOAN MANAGEMENT REVIEW WINTER 2006

find opportunities to cross-sell goods or services, or look for

other ways to encourage them to give you more business. This is

essentially what Amazon.com has done with its personal recom-

mendations and incentives such as premium shipping.

Of course, these customers may not be good candidates for

change, given their age or income levels. In that case you must

look for investment opportunities that can move passive cus-

tomers from the upper middle (and maybe even the lower mid-

dle) into profitable-promoter status. There’s no shortcut here.

You’ll have to learn why these customers aren’t enthusiastic

about your company. You’ll have to figure out what would truly

delight them, and whether the required investments would make

economic sense. And if you decide to make those investments,

you’ll have to track customer migration on the grid to determine

whether they are really paying off. Otherwise you will simply be

stealing resources that could be invested in your core customers

whose referrals will almost always represent the best source of

new promoters.

Again, American Express offers examples of both of these

strategies. The company has found, for instance, that many loyal

users of one level of card are prime candidates for an upgrade

— that is, moving from the green card to gold, from gold to

platinum, and from platinum to the premium card known as

the Centurion card. American Express has found that the prof-

itability of customers who upgrade increases as much as four-

fold — even more for some customer segments. Upgrades are

available even for specialized cards such as the Delta SkyMiles

card, and the effects are similar. Thus the Platinum Delta

SkyMiles card has a higher annual fee but provides additional

benefits; it gives the card member an incentive to use the card