A 5% drop in defections does not result in 80%+ increase in profits
By Professor Byron Sharp
Some of the most popular modern marketing myths come from Frederick Reichheld. In particular a famous article with Earl Sasser, where on the very first page they write:
“Companies can boost profits by almost 100% by retaining just 5% more of their customers”.
This has been quoted extensively. Even academics, who should know better, quote it in textbooks and in articles in scholarly journals.
And yet it is a grossly (and rather obviously) misleading line. Reichheld and Sasser’s article does not empirically show that lower defection rates cause massive increases in firm profits. Their misleading assertion is not even based on any research.
I will explain how they fooled so many. But before I start, stop and have a commonsense think about the famous quote. Could a company really be expected to double profits by just retaining 5% more customers? If you were the financial officer and were presented this as a business case (ie for a CRM or loyalty program investment) surely you would think this supposed fact to be fantastic…. as in fantasy, the sort of wishful thinking that only business consultants talk about (yes Frederick Reichheld is a consultant). Surely it just couldn’t be true ?…. and it isn’t.
So you might ask how could they have arrived at such a conclusion (and got to publish it in Harvard Business Review) ? What empirical research they did do ? And the answer is none.
What Reichheld & Sasser actually did was merely a “thought experiment”. They simply said suppose a credit card company lost 10% of its customers each year, then the average customer life would be 10 years. Now if that credit card company were able to reduce annual customer defection ratesto 5% then the average time a customer stayed would double to 20 years. And given that a customer delivers some profits each year now that they stay for more years they must, in total, give more.
So let me repeat, Reichheld & Sasser did no research that revealed that companies that reduced defection rates increased profits (that could be attributed to the defection increase). No, they simply argued by (fantastic) logic.
And then they presented their tautalogical findings in a very misleading manner:
1) Their 5% drop in defection is actually a drop of 5 percentage points, ie from 10% to 5%. note reader: that’s a 50% decrease, a halving of customer defection!
2) And their thought experiment wasn’t about company profitability, it was about ‘customer profitability’ which is quite a different thing. Essentially all they revealed is that if a customer stays (buys) for longer, then they give you more money (over this longer period). It’s called addition (we all learnt it at primary school) – 20 years is more than 10. R&S present a simple (and valueless) tautology – a bit like saying that if you won the lottery then you’d be richer… no kidding.
As Reichheld and Sassers’ article was about profitability one would expect that they would have included some assumptions about costs, and in effect they did. They simply assumed that the halving of defection is achieved at zero costs!
Oh and that customer acquisition continues at its normal rate too.
Wonderfully unrealistic assumptions.
And finally they assume that halving customer defection is perfectly possible (and easy). Indeed their article was titled “zero defections….”. But can companies radically alter their rate of customer defection? In the fantasy world of Reichheld and Sasser they never stopped to ask this real world question.
In summary the notion that reducing customer defections is cheap or that it will lead to fantastic profit increases is pure fantasy.