The loyalty business model is a business model used in strategic management in which company resources are employed so as to increase the loyalty of customers and other stakeholders in the expectation that corporate objectives will be met or surpassed. A typical example of this typle of model is: quality of product or service leads to customer satisfaction, which leads to customer loyalty, which leads to profitability.

The service quality model

A model by Kay Storbacka, Tore Strandvik, and Christian Gronroos (1994) is more detailed but arrives at the same conclusion. In it customer satisfaction is based firstly on a recent experience of the product or service. This assessment depends on prior expectations of overall quality compared to the actual performance received. If the recent experience exceeds prior expectations, customer satisfaction will likely be high. Customer satisfaction can also be high even with mediocre performance quality if the customer's expectations are low, or if the performance provides value (that is, it is priced low to reflect the medocre quality). Likewize a customer can be dissatisfied with the service encounter and still perceive the overall quality to be good. This occurs when a quality service is priced very high and the transaction provides little value for money.

The model then looks at the strength of the business relationship and proposes that this is determined by the level of satisfaction with recent experience, overall perceptions of quality, customer commitment to the relationship, and bonds between the parties. Customers are said to have a "zone of tolerance" corresponding to a range of service quality between "barely adequate" and "exceptional". A single disappointing experience may not significantly reduce the strength of the business relationship if the customer's overall perception of quality remains high, if switching costs are high, if there are few satisfactory alternatives, if they are commited to the relationship, and there are bonds keeping them in the relationship. The existence of bonds act as an exit barrier. There are several types including: legal bonds (contracts), technological bonds (shared technology), economic bonds (dependence), knowledge bonds, social bonds, cultural or ethnic bonds, idiological bonds, psychological bonds, geographical bonds, time bonds, and planning bonds.

The model then examines the link between relationship strength and customer loyalty. Customer loyalty is determined by three factors: relationship strength, perceived alternatives, and critical episodes. The relationship can terminate if: the customer moves away from the company's service area, the customer no longer has a need for the company's products or services, more suitable alternative providers become available, relationship strength has weakened, or the company handles a critical episode poorly.

The final link in the model is the effect of customer loyalty on profitability. The fundamental assumption of all the loyalty models is that keeping existing customers is less expensive than acquiring new ones. It is claimed by Reichheld and Sasser (1990) that a 5% improvement in customer retention can cause an increase in profitability of between 25 and 85 percent (in terms of net present value) depending on the industry. However Carrol (Carrol, P. and Reichheld, F. 1992) disputes these calculations, claiming they result from faulty cross-sectional analysis.

According to Buchanan and Gilles (1990), the increased profitability associated with customer retention efforts occurs beceause:

• The cost of acquisition occur only at the beginning of a relationship, so the longer the relationship, the lower the amortized cost.
• Account maintenance costs decline as a percentage of total costs (or as a percentage of revenue).
• Long term customers tend to be less inclined to switch, and also tend to be less price sensitive. This can result in stable unit sales volume and increases in dollar-sales volume.
• Long term customers may initiate free word of mouth promotions and referrals.
• Long term customers are more likely to purchase ancillary products and high margin supplimental products.
• Customers that stay with you tend to be satisfied with the relationship and are less likely to switch to competitors, making market entry or competitors' market share gains difficult.
• Regular customers tend to be less expensive to service because they are familiar with the process, require less "education", and are consistent in their order placement.
• Increased customer retention and loyalty makes the employees' jobs easier and more satisfying. In turn, happy employees feeds back into better customer satisfaction in a virtuous circle.

For this final link to hold, the relationship must be profitable. Striving to maintain the loyalty of unprofitable customers is not a viable business model. That is why it is important to for marketres to assess the profitability of each of its clients (or types of clients), and terminate those relationships that are not profitable. In order to do this, each customer's "relationship costs" are compared to their "relationship revenue". A useful calculation is the patronage concentration ratio. These calculations are hindered by the difficulty of allocating costs to individual relationships and the ambiguity regarding relationship cost drivers.

Expanded models

Schlesinger and Heskett (1991) added employee loyalty to the basic customer loyalty model. They developed the concepts of "cycle of success" and "cycle of failure". In the cycle of success, an investment in your employees’ ability to provide superior service to customers can be seen as a virtuous circle. Effort spent in selecting and training employees and creating a corporate culture in which they are empowered can lead to increased employee satisfaction and employee competence. This will likely result in superior service delivery and customer satisfaction. This in turn will create customer loyalty, improved sales levels, and higher profit margins. Some of these profits can be reinvested in employee development thereby initiating another iteration of a virtuous cycle.

Fredrick Reichheld (1996) expanded the loyalty business model beyond customers and employees. He looked at the benefits of obtaining the loyalty of suppliers, employees, bankers, customers, distributors, shareholders, and the board of directors.

References

• Buchanan, R. and Gilles, C. (1990) "Value managed relationship: The key to customer retention and profitability", European Management Journal, vol 8, no 4, 1990.
• Carrol, P. and Reichheld, F. (1992) "The fallacy of customer retention", Journal of Retail Banking, vol 13, no 4, 1992.
• Dawkins, P. and Reichheld, F. (1990) "Customer retention as a competitive wapon", Directors and Boards, vol 14, no 4, 1990.
• Fornell, C. and Wernerfet, B. (1987) "Defensive marketing strategy by customer complaint management : a theoretical analysis", Journal of Marketing
• Reichheld, F. (1996) The Loyalty Effect, Harvard Business School Press, Boston, 1996.
• Reichheld, F. and Sasser, W. (1990)"Zero defects: quality comes to services", Harvard Business Review, Sept-Oct, 1990, pp 105-111.
• Schlesinger, L. and Heskett, J. (1991) "Breaking the cycle of failure in service", Sloan Management Review, spring, 1991, pp. 17-28.
• Storbacka, K. Strandvik, T. and Gronroos, C. (1994) "Managing customer relationships for profit", International Journal of Service Industry Management, vol 5, no 5, 1994, pp 21-28.