PROFITABLE CUSTOMER LOYALTY - COST JUSTIFICATION Chris Jacobs, Managing Director, Business Assyst Ltd Interest in customer loyalty systems has never been more avid. After a number of years when such systems always seemed to be on the brink of taking off - but never quite managed to reach expectations - recent year have seen a real and dramatic increase in their uptake. Putting aside the superficial reasons for installing a loyalty system, such as everyone else in the same sector appears to be ‘doing something’, or fear that the main competitor might steal a march by implementing a loyalty strategy, the key consideration is whether such a system can be cost justified. Will it measurably help the retailer in his bid to build long term profitable relationships with his customers? Can the investment required in a sophisticated customer loyalty system be justified on the basis of anticipated increased profits? This paper explores the issues which need to be addressed in order to cost justify the implementation of a customer loyalty system. The Driving Forces behind Customer Loyalty A key reason for the increased focus on customer loyalty has been the changing role of the manufacturers. In the past, loyalty has predominantly been focused on a brand name. Manufacturers invested large amounts of time, money and creative energy on promoting their products, whilst all the retailers had to do was have a store in the right location, stock the brand-leading products - and watch the customers stream through the doors. Nowadays life is tougher. The emphasis has switched, such that there is no longer such a comfortable relationship between the manufacturer and the retailer. Now, in fact, there is increased competition between the two parties, including such areas as the introduction of own-branded goods by an increasingly large number of retailers. In a bid to increase revenue, many retailers opted for quantity and opened new stores wherever there was a location and an apparent opportunity. In a marketplace saturated with ‘lookalike retailers’, the extended recession was the final straw. Retailers had to completely rethink their strategy for survival, let alone growth, and the customer won hands down. Today’s retail environment is one where the customer is king, once again. Retailers really have to sell to their customers. And they have to make every possible effort to ensure that once a customer, always a customer. Advances in technology have helped the cause of the beleaguered retailer. Customer loyalty systems make it much easier to recreate the type of close relationship used to such effect, prior to their demise, by the traditional corner shop and its regular shoppers. What is a loyal customer? No retailer can ever expect, or even desire, to achieve one hundred per cent loyalty. It is impractical to believe that a customer will, for example, always be able to shop in the same supermarket, fill up at the same garage or even like the latest season’s fashion offerings. In any case, competition is not only a fact of life, it can also been seen as desirable in that it gives a retailer the opportunity to demonstrate such ‘differentiators’ as a superior service or, perhaps, more flexible financing options. A loyal customer is one who visits a particular retailer more often than the competition. However, no comfort can be taken in achieving seven out of ten visits if the three visits to the competition incur most of the expenditure. This is often the case with some outlets which are treated as convenience stores for just a few everyday items, whilst the major purchases are made elsewhere. Off-licenses are classic example of this phenomenon: used at the last minute for a bottle of wine for a dinner party, but missing out on the bulk drinks purchasing, which is made from the local supermarket as part of the general food shopping trip. © Copyright Chris Jacobs 1 of 7 PROFITABLE CUSTOMER LOYALTY - COST JUSTIFICATION A retailer must seek to gain the highest proportion of the customer’s annual expenditure - and then, most importantly, retain this customer as long as possible to reap the maximum benefits. Measurement In order to justify a scheme and prove that it really is working, it is essential to have a number of metrics to measure the performance of the system. This includes such statistics as number of customers, frequency, average spend and total expenditure. In addition, it is also helpful to be able to gauge retention and awareness, although of course it is difficult to measure these objectively. First and foremost, retailers need to know how many customers they have - information which retailers generally do not have. EPOS systems supply masses of data on sales transactions, including the average spend. Yet in order to measure the level of customer loyalty, it is necessary to know the number of different customers visiting the store in order to make it possible to calculate the frequency of individuals and what they spend. This means that there is a need to identify individual shoppers and compare their purchasing profile with the remainder of shoppers. The challenge then is to start improving their spend. The overall objective of a customer loyalty system is to increase or improve on all the various measurements. Increasing any one of them will contribute a positive benefit in terms of increased profit. Improvements in all of them together will represent a very powerful formula for greater profitability. Tracking customers through a well-designed loyalty programme provides the means of measuring precisely each of the above metrics. The bottom line, however, is that the only metric which really matters is the measurement of real profit. Quite simply, there is no point in having a loyalty scheme unless it delivers increased profits. General Findings Perhaps now is the time to consider just how valuable a loyal customer can be to a retailing organisation. Analysis of the data collected from a number of different customer loyalty schemes indicates that their worth is, in fact, quite remarkable. The figures speak for themselves: Loyal customers: spend 30% to 50% more per transaction visit three times the average spend four times more per annum account for over 50% of sales Each scheme will produce different results, so each will obviously need to be analysed on a case by case basis. But if a retailer has the opportunity to achieve anything like these results - then it would be sheer lunacy not to try and tie in these most profitable of customers. It is unlikely that any retailer would be starting from a position of zero loyalty. Even without any sort of promotions or incentives, let alone loyalty schemes, all retailers have some degree of existing customer loyalty. The way to improve on profitability is to both increase the number of these loyal shoppers and to keep them for as long as possible. The importance of retention It is a widely accepted truism that it is far easier to sell to an existing customer than to recruit a new one. In fact, figures suggest that it costs in the region of five times more to sell to a new customer, which is in itself a daunting and expensive prospect. Keeping customers just that little bit longer can have a very significant effect: increasing retention from 80% to 90%, doubles the lifetime value of the customer base. © Copyright Chris Jacobs 2 of 7 PROFITABLE CUSTOMER LOYALTY - COST JUSTIFICATION Year 1 80% 90% 100 100 Year 2 80 90 Year 3 60 80 Year 4 40 70 Year 5 20 60 Year 6 0 50 The above figures, based for illustration on a starting point of one hundred customers, show that at 80% retention, twenty are lost each year. In the course of five years, they have all changed their allegiance to some other retailer. In practice, of course, it is hoped that they are replaced by other customers! If 10% more are retained each year, then only ten are lost each year and it takes ten years before all are lost. The lifetime value at 80% means that retention is 300 ‘customer years’; at 90% it has increased to 550 ‘customer years’, nearly doubling the value. The high street banks are only too well aware of the importance of retention. Never ones to miss a money-generating trick, they work hard to attract teenagers to open an account. Not surprisingly this yields very little in the early years but it certainly pays off, more than handsomely, over the next forty or so years! The next step in looking at cost justification for loyalty systems is to assess what increased retention actually means in profit terms. Customer Spend Patterns Let’s consider the customer profiles of three different types of retailers. Type A is low spend, high frequency, reasonable margin. A variety store or convenience outlet is a good example of this type. Type B is high spend, low frequency and good margin. Fashion stores fall into this category, although some experience higher frequency. Type C is high average spend, high frequency but low margin. This is a scenario recognised by many grocery chains. A Average Transaction value Frequency Margin Reward structure: 5% on total spend 80% redemption 100,000 customers In the above examples, 50% is assumed for the reward (although this will depend upon the margin available), with a redemption rate of 80%. This is high and in practice is likely to be lower. Profit improvements are clearly proportional for retailers with a larger customer base. £5 26 30% B £20 6 50% C £60 30 10% © Copyright Chris Jacobs 3 of 7 PROFITABLE CUSTOMER LOYALTY - COST JUSTIFICATION Retention Profitability The example below is based on the same types of retailers. A Lifetime value Revenue gain Increased margin Less reward Gross profit 60.9m 27.7m 8.3m (2.4m) 5.9m B 56.2m 25.6m 12.8m (2.2m) 10.6m C 842.6m 383.0m 38.3m (33.7m) 4.6m The gross profit, as a result of increasing the retention from 80% to 90% is calculated for each of the three types of retailers, based on their traditional customer spend patterns. Lifetime value is the value at 90% retention, excluding VAT. Revenue gain is the additional revenue gained, due to increasing retention from 80% to 90%. The increased margin is the profit on the incremental business. This is therefore bottom line profit, since all the overheads have already been covered. After allowing for a 5% reward (with an 80% redemption rate), a healthy profit increase is achieved for 100,000 customers. The percentage profit gain for Type C is low, indicating that care must always be taken in a low margin retailing environment. However, if Type C is a grocery chain, then the number of customers would be much higher, and it is also likely that the margin would in fact be better. Experience also indicates that the redemption rate in such a retail outlet would be less than 80%. The above illustration shows what can be achieved simply by keeping customers a little bit longer. This takes no account of new customers or any other gains which are made. Increased retention thus plays a significant role in increasing profitability. Yet increased retention is not achieved purely by the implementation of a reward scheme. A true relationship marketing programme must also be introduced to give the customer the necessary level of ‘personal attention’ demanded by a loyal shopper. An example of expenditure Using Type B retailers, the customer spend pattern is illustrated below: £ Average annual spend Loyalty uplift (30%) Increased margin Less reward (10% of uplift) Benefit 92.28 27.68 13.84 (2.77) 5.9m The spend pattern for Type B retail outlets is a frequency of six visits with an average spend of £20. The average annual spend is that of a non-loyal customer, with the loyal customer producing £27m additional revenue and an increase in margin of nearly £14. © Copyright Chris Jacobs 4 of 7 PROFITABLE CUSTOMER LOYALTY - COST JUSTIFICATION The reward in this case is higher at 10% instead of 5% (as in the previous example) but this is only given on the incremental sales. The customer has to prove his or her loyalty before enjoying a generous reward. This approach is better in that it avoids giving a reward for purchases that would have been made anyway. For 100,000 customers using this example, the net benefit (before the costs of the loyalty scheme) would be £11m per annum. Obviously for higher average spends or higher frequencies, the gains could be much greater. Whilst detailed calculations would have to be carried out for each individual retailer’s situation, even this simple example shows that genuine gains can be made. The costs of installing a loyalty scheme It is extremely difficult to generalise as far as the costs of a loyalty scheme are concerned, partly because of the many different ways in which they can be implemented. The type of scheme is likely to be dictated by the nature of the retailing business. Costs areas, which need to be considered, are likely to include: set up (design, literature, advertising, etc) capital (cards, hardware, software, etc) administration relationship marketing reward The important point is to design a scheme which will appeal to the targeted customer base. This makes the choice of technology and the set-up a key decision. The reward structure has to be calculated to the minutest of detail to make the scheme profitable. The database is probably the most important element of any loyalty scheme. It is this which provides the opportunity to learn about the customer base and establish a relationship marketing programme. Key objectives and benefits of customer loyalty systems These are many, but some of those to be borne in mind are: increased turnover and profit higher customer retention increased frequency of visits cross-selling opportunities long term relationships improved product awareness reduction in the need for mark-downs improved effectiveness of direct marketing developing advocacy A successful, well-designed, well-planned and well-implemented loyalty system will change the behaviour and buying patterns of customers. © Copyright Chris Jacobs 5 of 7 PROFITABLE CUSTOMER LOYALTY - COST JUSTIFICATION Getting approval This is always a difficult step and will involve a board decision to commit to spending the money. It is never easy - and shouldn’t be so. Finance departments are inherently more easily persuaded by plans to cut costs rather than schemes to increase revenue. The first stage is to have a thorough understanding of the business and purchase patterns in order to deliver a well-reasoned plan. However this is something of a Catch 22 situation in that without a scheme in place, this data is virtually non-existent. Customer surveys and research will help build a picture, but it is essential to know where the gains are likely to be made in order to design the scheme accordingly. Areas to be addressed when seeking to get approval for a scheme include the following: analysing the business examining the purchase patterns profiling the customers isolating the potential for gain doing the calculations designing a test programme running the test and measuring the results The best way to test any theories about customer loyalty and its benefits, is to run a pilot, the results from which can be extrapolated to forecast the full potential of a roll-out scheme. Pilot test The criteria for putting together a pilot test include the following: close match to final scheme cross section of customer sample size (larger for small gains) control group period (longer for low frequency) measure frequently - not just at the end Obviously the pilot sites need to be a good representation of all the stores and the customer base. The size of the test will depend upon frequency of purchase and the size of the expected gains. Thus there is no point in running a test for three months if the annual frequency is six. If the percentage gain is low, then the sample size needs to be fairly large and the period needs to be longer to reduce the margin for error. It is necessary to measure the difference in the control group with the difference in the test group because there will obviously be other factors which affect spending. Success criteria need to be set at the start of the pilot and measured frequently (often weekly) thereafter. Only then, if it is going well, should the national roll out be brought forward. If the scheme appears not be working well, it can be stopped before too much investment is wasted. It is a major boost if it works, but an expensive price reduction exercise if it doesn’t! And finally, there is no excuse for sitting back and watching a pilot happen. The programme won’t run itself - it needs to be driven to give you the results you need to obtain approval. © Copyright Chris Jacobs 6 of 7 PROFITABLE CUSTOMER LOYALTY - COST JUSTIFICATION - Why do it? A loyalty scheme will not work if the retailer doesn’t have an attractive, sustainable proposition in the first place. It most certainly cannot be used to try and disguise a bad product or poor levels of service. The retailing house must be well and truly in order before a loyalty system can be contemplated. The reasons for implementing a loyalty system are that you can benefit from knowing your customers, you can engender loyalty if you have a sustainable attractive reward scheme and you can use it to overcome (or at least challenge) threats from the competition. But the real reason for putting in a customer loyalty system is in the numbers. If the numbers add up, then the case is proven. It’s as simple as that. Contact Details Chris Jacobs Business Assyst Limited 11 Southern Haye Hartley Wintney Hampshire RG27 8TZ United Kingdom Telephone: 0845 838 7592 (UK only) Outside UK +44 (0) 1252 843543 Mobile: +44 (0) 7799 606064 Email: Chris.Jacobs@businessassyst.com © Copyright Chris Jacobs 7 of 7
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