E-Loyalty: Your Secret Weapon on the Web

July 2000

by Frederick F. Reichheld and Phil Schefter

Loyalty may not be the first idea that pops into your head when you think about electronic commerce. After all, what relevance could such a quaint, old-fashioned notion hold for a world in which customers defect at the click of a mouse and impersonal shopping bots scour databases for ever better deals? What good is a small-town virtue amid the faceless anonymity of the Internet’s global marketplace? Loyalty must be on a fast track toward extinction, right?

Not at all. Chief executives at the cutting edge of e-commerce—from Dell Computer’s Michael Dell to eBay’s Meg Whitman, from Vanguard’s Jack Brennan to Grainger’s Richard Keyser—care deeply about customer retention and consider it vital to the success of their on-line operations. They know that loyalty is an economic necessity: acquiring customers on the Internet is enormously expensive, and unless those customers stick around and make lots of repeat purchases over the years, profits will remain elusive. They also know it’s a competitive necessity: in every industry, some company will figure out how to harness the potential of the Web to create exceptional value for customers, and that company is going to lock in many profitable relationships at the expense of slow-footed rivals. Without the glue of loyalty, even the best-designed e-business model will collapse.

Over the past two years, we have been studying e-loyalty with our colleagues at Bain & Company. We have analyzed the strategies and practices of many leading Internet companies, evaluated the designs and workings of their Web sites, and surveyed thousands of their customers. What we’ve uncovered may come as a surprise. Contrary to the common view that Web customers are fickle by nature and will flock to the next new idea, the Web is actually a very sticky space in both the business-to-consumer and the business-to-business spheres. Most of today’s on-line customers exhibit a clear proclivity toward loyalty, and Web technologies, used correctly, reinforce that inherent loyalty. If executives don’t quickly gain the loyalty of their most profitable existing customers and acquire the right new customers, they will face a dismal future catering to the whims of only the most price-sensitive buyers.

We’ve heard new-economy pundits argue that the Internet has overturned all the old rules of business. But when it comes to customer loyalty, the old rules are as vital as ever. Loyalty is still about earning the trust of the right kinds of customers—customers for whom you can deliver such a consistently superior experience that they will want to do all their business with you. The Web does, however, raise new questions and open new opportunities: it places the old rules in a new context. Our goal in this article is to describe that context and its implications.

The Economics of E-Loyalty

Ten years ago, Bain & Company, working with Earl Sasser of Harvard Business School, analyzed the costs and revenues derived from serving customers over their entire purchasing life cycle, and we published the results in this magazine. (See “Zero Defections: Quality Comes to Services” in the September–October 1990 issue.) We showed that in industry after industry, the high cost of acquiring customers renders many customer relationships unprofitable during their early years. Only in later years, when the cost of serving loyal customers falls and the volume of their purchases rises, do relationships generate big returns. The bottom line: increasing customer retention rates by 5%increases profits by 25% to 95%. Those numbers startled many executives, and the article set off a rush to craft retention strategies, many of which continue to pay large dividends.

When we applied the same methodology to analyzing customer life-cycle economics in several e-commerce sectors—including books, apparel, groceries, and consumer electronics—we found classic loyalty economics at work. In fact, the general pattern—early losses, followed by rising profits—is actually exaggerated on the Internet. (See the exhibit “Customer Life-Cycle Economics in E-Commerce.”) At the beginning of a relationship, the outlays needed to acquire a customer are often considerably higher in e-commerce than in traditional retail channels. In apparel e- ailing, for example, new customers cost 20% to 40% more for pure-play Internet companies than for traditional retailers with both physical and on-line stores. That means that the losses in the early stages of relationships are larger.

In future years, though, profit growth accelerates at an even faster rate. In apparel e-tailing, repeat customers spend more than twice as much in months 24–30 of their relationships than they do in the first six months. And since it is relatively easy for Web stores to extend their range of products, they can sell more and more kinds of goods to loyal customers, broadening as well as deepening relationships over time. The evidence indicates, in fact, that Web customers tend to consolidate their purchases with one primary supplier, to the extent that purchasing from the supplier’s site becomes part of their daily routine. This phenomenon is particularly apparent in the business-to-business sector. For example, W.W. Grainger, the largest industrial supply company in the United States, discovered that long-time customers, whose volume of purchases through Grainger’s traditional branches had stabilized, increased their purchases substantially when they began using Grainger’s Web site. Sales to these customers increased at triple the rate of similar customers who used only the physical outlets.

In addition to purchasing more, loyal customers also frequently refer new customers to a supplier, providing another rich source of profits. Referrals are lucrative in traditional commerce as well but, again, the Internet amplifies the effect, since word of mouse spreads even faster than word of mouth. On-line customers can, for example, use e-mail to broadcast a recommendation for a favorite Web site to dozens of friends and family members. Many e-tailers are now automating the referral process, letting customers send recommendations to acquaintances while still at the e-tailers’ sites. Because referred customers cost so little to acquire, they begin to generate profits much earlier in their life cycles.

Frederick F. Reichheld is a director emeritus of Bain & Company and a Bain Fellow. He is the author of The Loyalty Effect (Harvard Business School Press, 1996) and the forthcoming Building Loyalty in the Age of the Internet (Harvard Business School Press, 2001).Phil Schefter is a vice president in Bain’s Boston office and a leader in the firm’s e-commerce practice.