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CRM is often justi ed by citing references to reports like those of Bain & Company, which maintain that companies can boost customer net present value by as much as 95 percent if they can retain only 5 percent more of their customers. Numbers like these have often been used to persuade management that a CRM package could pay for itself very rapidly. The assertion that growth in net present value results from increased retention is central to Frederick Reichheld s excellent book The Loyalty Effect. Figure 2-1 shows Reichheld s increases in customer net present value in various industries as a result of a 5 percent increase in the retention rate. These numbers seem too good to be true. In fact, they are too good to be true. Let s see what the real numbers might actually be. Let s take one industry from the list as representative of the problem: life insurance. We will take a typical term life insurance policy of $500,000 for a 45-year-old nonsmoker that costs $1000 per year. For such policies, Figure 2-1 Reichheld 5 Percent Retention Gains
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95% 90% 85% 85% 84% 81% 75% 50% 45% 45% 40% 35%
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Advertising Agency Life Insurance Publishing Branch Bank Deposits Auto/Home Insurance Auto Service Credit Card Industrial Brokerage Industrial Laundry Industrial Distribution Office Building Management Software
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Impact of a 5-percentagepoint increase in retention rate on customer net present value 40% 60% 80% 100%
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Source: Frederick Reichheld, The Loyalty Effect (Boston: Harvard Business School Press, 1996), p. 36.
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Table 2-5 Life Insurance Net Present Value
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Year 1 Retention rate Customers Payments Revenue Commissions Claims Total costs Pro t Discount rate Net present value Cumulative NPV 50% 100,000 $1,000 $100,000,000 $ 20,000,000 $ 75,000,000 $ 95,000,000 $ 5,000,000 1.00 5,000,000 5,000,000 Year 2 60% 50,000 $1,000 $50,000,000 Year 3 65% 30,000 $1,000 $30,000,000 Year 4 70% 19,500 $1,000 $19,500,000 $ 97,500 $14,625,000 $14,722,500 $ 4,777,500 1.21 $ 3,943,929 $26,903,530 Year 5 75% 13,650 $1,000 $13,650,000 $ 68,250 $10,237,500 $10,305,750 $ 3,344,250 1.29 $ 2,589,822 $29,493,352
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$ 250,000 $ 150,000 $37,500,000 $22,500,000 $37,750,000 $22,650,000 $12,250,000 1.07 $11,491,557 $16,491,557 $ 7,350,000 1.14 $ 6,468,043 $22,959,601
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the rst-year retention rates are very low. Subsequent rates are much higher. Table 2-5 shows the net present value for such policyholders for the rst 5 years. This chart shows that the cumulative net present value (the present value of the pro ts) from 100,000 new policyholders will be $29.5 million over 5 years. Note that we are assuming that 50 percent of the policyholders drop their policies during the rst year. After that year, the retention rate increases. Of particular importance is the discount rate. This is the rate used to discount future pro ts and convert them into net present value pro ts. The formula for the discount rate is D (1 i * rf ) years to wait
In the third year (2 years to wait), for example, the formula is D This becomes D 1.14 (1 0.06 * 1.1)2
In this formula, i is the market rate of interest, gured at 6 percent, and rf is the risk factor, which is determined to be 1.2 for the rst year and 1.1 for subsequent years. The risk factor is a number that represents the
T h e M i r a g e of C R M
risk that you won t generate the sales and pro ts at all. A perfectly safe business has a risk factor of 1. The risk can come about because customers don t pay, because of heavy competition, because of product obsolescence, etc. Years to wait is the amount of time that the insurance company has to wait before the pro ts materialize. The rst year, we are assuming that the waiting time is zero, because we are asking the policyholders to pay in advance. The chart could be made more complicated by adding administrative costs, medical examinations, etc. Leaving these out, we have a relatively clear picture of the marginal pro ts that a life insurance company can expect to realize over 5 years from 100,000 policyholders. Using the Bain & Company gures, we should expect to see this $29.5 million 5-year pro t go up by 90 percent, to $56 million, if we were to increase the retention rate by 5 percent. But that is not what happens. Table 2-6 gives the pro ts over 5 years assuming that the retention rate is somehow increased by 5 percent. The cumulative net present value does go up, but only by about 15 percent, as Table 2-7 shows. Now, 15 percent is a good solid number, but it is not 90 percent. Unfortunately, the rate is probably much less than 15 percent, because we have not gured in the costs of getting the 5 percent increase in retention. Here is where CRM really has trouble. Table 2-6 New NPV
Year 1 Retention rate 55% Customers 100,000 Payments $1,000 Revenue $100,000,000 Commissions Claims Total costs Pro t Discount rate Net present value Cumulative NPV $20,000,000 $75,000,000 $95,000,000 $5,000,000 1.00 $5,000,000 $5,000,000 Year 2 65% 55,000 $1,000 $55,000,000 $ 275,000 $41,250,000 $41,525,000 $13,475,000 1.07 $12,640,713 $17,640,713 Year 3 70% 35,750 $1,000 $35,750,000 $ 178,750 $26,812,500 $26,991,250 $ 8,758,750 1.14 $ 7,707,752 $25,348,465 Year 4 75% 25,025 $1,000 $25,025,000 $ 125,125 $18,768,750 $18,893,875 $ 6,131,125 1.21 $ 5,061,375 $30,409,840 Year 5 80% 18,769 $1,000 $18,768,750 $ 93,844 $14,076,563 $14,170,406 $ 4,598,344 1.29 $ 3,561,005 $33,970,846
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