The True Value of a Lost Customer

Overlooking important social effects can lead companies to underestimate the value of their customers. That's the message of new research on lost customer value by John E. Hogan and Katherine N. Lemon, both assistant professors of marketing at the Carroll School of Management, Boston College, and Barak Libai, a senior lecturer in marketing at the Leon Recanati Graduate School of Business Administration, Tel Aviv University. In a report for the Marketing Science Institute, they offer a simple method for quantifying these effects.

Over the past 10 years, marketers have become increasingly sophisticated at using data on purchasing behavior and costs to determine each customer's worth. However, traditional models, by and large, have missed a crucial point: By focusing only on the purchasing behavior of individuals, they capture only part of what customers do. People don't just buy products and services, explains co-author Hogan; they also use them, talk about them, and serve as role models for potential purchasers. Taken together, these activities can significantly enhance the value of an individual to a firm.

While academics have long been aware of these social effects, the difficulty lies in figuring out how to measure their impact on profitability. To simplify their analysis, Hogan and his colleagues focus on how social interactions influence sales for whole product categories (ignoring brand-level effects). This makes it possible to distinguish between two types of lost customers: those who defect to another company and those who give up altogether on the product category, which they term “disadoption.”When a customer defects, the abandoned firm simply loses the value of potential purchases. However, when a customer disadopts, an entire category also loses a walking, talking billboard that could potentially encourage other consumers to try the product.

Traditional customer profitability models capture the impact of defection, but quantifying the financial effects of disadoption requires a different approach: The authors build on the Bass model of new product growth, which has come into use widely since its introduction in 1969. The basic Bass model relies on two parameters to explain how sales evolve. The first is the effect of “external” influences, such as mass media, on the rate of new product adoption; the second is the impact of “internal” or social influences, such as network effects, imitation and word-of-mouth. These parameters can be calculated for specific cases on the basis of past sales data, or they can be estimated by correlating them to similar product categories.

After calibrating the Bass model for a product category, marketers can forecast revenues and profits for an individual company by estimating its share of category sales. This information allows them to measure the value of a lost customer by determining the difference between the present value of profits before and after the customer dis-adopts. Moreover, this method enables managers to separate lost customer value into its two components. After subtracting the direct effect — the present value of the profits forgone because the lost customer no longer purchases from the firm — they're left with the indirect effect, or the profits forgone because the loss of a customer diminishes future sales growth. The greater the influence that social effects have on adoption decisions, the larger the indirect effect becomes. Similarly, the earlier a customer gives up on a product, the more value the company will lose.

Using data from the online banking industry, the authors show that the indirect effect of disadoption can be more than 75% of the total loss. As the potential market becomes saturated, the direct effect remains the same, but the indirect effect tapers off, reaching zero after about 10 years. As a result, innovators — the first to adopt the service — are worth 50% more to the firm than early adopters and four times as much as the last ones to sign on.

This finding should prompt companies to reevaluate how they allocate their marketing dollars between acquiring and retaining customers, particularly early in the product life cycle. “Traditionally firms want to spend to get market share, but you also need to spend to retain both innovators and early adopters,” says co-author Katherine Lemon. She explains that in addition to suffering from the loss of their own customers, firms lose value when their competitors' customers disadopt due to the resulting slowdown in overall category sales.

How important are these issues likely to be for the typical firm? The answer depends on the ratio of disadopters to defectors in the mix of lost customers. Generally, analysts expect this number to be high in markets for new, technology-intensive products and low in well-established categories. However, as a growing number of companies in mature industries are taking advantage of new technologies, the problem of disadoption becomes much more a general concern.

Report No. 02-108, “What Is the True Value of a Lost Customer?” is available from the Marketing Science Institute at www.msi.org, and will be published in the February 2003 issue of the Journal of Service Research.