Loyalty seems to be dying in our society. Look at the way we treat friendships, community organizations, even marriage--you would think we were renting cars or motel rooms instead of making commitments. And it's not just our social lives that seem less permanent than they used to be. As pointed out in the Financial Times recently, business also seems to have entered the age of the one-night stand (1). The average U.S. company now loses one-half of its customers in five years, one-half of its employees in four, and one-half of its investors in less than one. Layoffs, stock market churn, fickle customers, executive job surfing--all signs seem to point toward opportunism and disloyalty as the governing principles in commerce as well as in society. Worse yet, a lot of business leaders accept this state of affairs with a shrug of the shoulders. Loyalty is not fashionable, lucrative, or relevant, they think; they have more urgent problems to worry about: growth, productivity, and profits, for example.
The problems that concern business leaders are certainly urgent. In recent decades, annual rates of real growth at large companies have run only 2-3%; productivity has risen at an average rate of little better than 1% per year over the past 10 years (despite trillions of dollars spent on productivity-enhancing technology), and profits as a percentage of sales have declined in every decade since the 1940s. But ignoring loyalty to focus on these "more pressing" problems may be exactly the wrong fix. A few large companies have managed to buck the depressing trends of the past couple of decades and have increased their revenues, profits, and productivity at rates as robust as those we're used to seeing only in startups--and almost all these large but swiftly growing organizations place a heavy emphasis on customer and employee loyalty.
In short, loyalty is not dead, nor is it irrelevant or unrewarding. It is, however, a different kind of loyalty than that of our parents and grandparents, and understanding this difference is critical to understanding how modern loyalty-based business systems work. Fifty years ago, loyalty was a much larger part of everyday life than it is today. People were deeply loyal to their families, of course, but they also displayed unquestioning loyalty to a long list of civic, religious, and professional authorities as well as to the companies they bought from and worked for. Many people made a profound commitment to an employer, for example, and in return, some employers repaid them with a promise of job security--normally unspoken, but nevertheless kept.
Nearly all these unconditional loyalties have followed the whooping crane to virtual extinction. It's probably safe to say that none of us feels an absolute obligation to anything anymore except ourselves and our children. We're still fairly loyal to kin and country (though not as loyal as we used to be), and some of us are still somewhat loyal to a community or to a school, but very few of us feel unconditionally loyal to anyone or anything. The very idea of blind, unquestioning loyalty to a company--whether as its employees, customers, or owners, for that matter--seems alien.
Old-fashioned "Yes, sir" loyalty is hard to find, especially in business. Some people claim to mourn its loss, but that oversimplifies the reality. Loyalty itself is not gone--only the unqualified, hierarchical loyalty that looked so much like obedience. Free markets have replaced it with something far superior: mutual, earned loyalty, that is, loyalty that works in two directions. Now we say to the corporations we buy from or work for, "I will invest my loyalty in businesses that can deliver superior value. When value is insufficient or a reasonable effort to fix the problem fails to produce results, I will defect to a business in which my loyalty can create better value."
Few people would make so conditional a commitment to their families, but in the business marketplace this kind of loyalty is not only appropriate but constructive. Loyalty is as basic a virtue as it ever was. But today, in business, there is a critical difference between blind trust and eyes-wide-open loyalty. The former is out-of-date and unproductive. The latter, properly understood and managed, can mean great value for customers and employees and a long life of sustained growth and profit for the corporation.
At the turn of this century, a Harvard philosopher named Josiah Royce outlined a hierarchy of loyalties. At the lowest level was loyalty to individuals; next was loyalty to groups. At the highest level of loyalty was practical devotion to a set of values and principles. Because time and information have stripped away most of our old, blind loyalties, we are left with loyalty to principles, and we give our loyalty to people and organizations only when they live up to the principles we prize. In the case of a business, that practical principle is the creation of value in some form (e.g., quality, money, security, speed). All who participate in the business system--customers, employees, and investors--seek and reward value. Business leaders, then, must realize that value creation will keep businesses healthy, growing, and profitable by inspiring loyalty in all these participants.
On the basis of what we learned, my consulting colleagues and I developed a new business model based on two principles: value creation, which generates the forces that hold these businesses together, and loyalty, which is inextricably linked to value creation as both a cause and an effect. As an effect, loyalty reliably measures whether or not the company has created and delivered superior value. Customers either come back for more or they go elsewhere. As a cause, loyalty initiates a series of economic effects that cascade through the business system as follows.
Profits are not at the heart of this new model. They are critically important, of course, as an end in themselves and because they are the source of the incentives that keep employees, investors, and customers loyal. But the source of all cash flow--including the cash flow that eventually becomes profit--is the rising spiral of value that results from creating superior value for customers that soon involves employees, investors, managers, suppliers, communities, and all the other constituencies that the business touches.
Surprisingly, even though a few companies--the ones we call loyalty leaders--have pursued loyalty-based strategies for decades (with remarkable but largely unpublicized results) and the principal ramifications of customer and employee retention have been identified and analyzed, loyalty-based business systems are still relatively unfamiliar. My recent book on loyalty, The Loyalty Effect: The Hidden Force Behind Growth, Profits and Lasting Value, examines loyalty-based management in depth and presents its economic benefits in hard numbers (3). But we really must research loyalty's third- and fourth-order effects, especially regarding the question of investor loyalty, because we know less than we'd like to in that area.
Loyalty is not simply an isolated quality. It is an integrated system that affects customers, employees, and investors (4). All companies prefer to have loyal customers, and all companies make some effort to find them and win their hearts. But how many companies have understood that employee loyalty is a vital component of customer loyalty or that investor loyalty is critical to both customer and employee loyalty? What works is the system--not isolated bits and pieces of best practice.
According to Hamel and Prahalad, companies that compete successfully in coming decades will be those that think clearly and carefully about the future (5). For example, return on investment has two components: a numerator made up of net income and a denominator composed of assets, costs, and head count. The companies that succeed into the future will focus on increasing the numerator, not spending their energies on downsizing and divestitures in efforts to decrease the denominator. In other words, the winners will be the companies that grow their revenues by delivering outstanding value to their customers and earning their loyalty.
People often suppose that loyalty as a management approach gives little thought to the future, concentrating all its attention on the past ("How loyal has this customer or segment been?"). In fact, although loyalty-based management measures past behavior, it looks relentlessly forward. Its goal is to build Hamel and Prahalad's numerator into the future by targeting the right customers and mapping out strategies for future value creation. (Of course, it also lowers the denominator by targeting the right employees and earning their loyalty in order to increase productivity.) One result is that a loyalty-based business system can predict future cash flow and profitability with an accuracy that an accounting system--which does focus on the past--can hardly match.
Integration of principles, people, systems, and technology has probably never reached greater heights than at insurance giant United Services Automobile Association (USAA). Thomas Teal's 1991 interview with then-CEO Robert McDermott, entitled "Service Comes First," is a study in how to build customer loyalty by focusing on employee loyalty (7). When McDermott took over in 1968, employee turnover was prodigious; productivity was abysmal; technology was nearly nonexistent. The chances of finding any particular customer's service file on any given day were about 50/50. McDermott decided to enrich the jobs with training, mobility, compensation, cutting-edge technology (which was never used to create or justify a layoff), better working conditions (including a company-wide four-day work week), better promotion prospects, country club benefits, and the satisfaction of providing the best customer service and value creation the company could invent. The program probably worked better than McDermott himself imagined. Today the company invests 7% of its revenues in technology, and job satisfaction and productivity have made phenomenal gains. The 1960 employee turnover rate of 43% is down to 6%, and while the company's financial assets have grown 100-fold over 30 years, employment has grown by a factor of only 5. To top it all off, customer churn is under 2%, about as close to perfect as possible.
No one can guarantee a company's future, but people need a fairly high level of predictability if they're to concentrate not on protecting their own skins but on the only question that really matters: What can I do to create value? So, managers need to give people a predictable relationship with the company, a predictable agenda, predictable ways to succeed, and predictable rewards if they do succeed (8). Mutual, earned loyalty is, by definition, a two-way street. The company gives employees a sense of order, mission, and credibility; the employees give back commitment to the vital task of building customer loyalty and the cash flow, growth, and profit that go with it.
In practice, of course, few investors do any of these things, because they are not committed to the long-term welfare of the companies they own. In other words, they are not loyal to their own investments, which seems illogical. The fact remains that, whereas loyal, involved investors like Warren Buffet make far more money than opportunistic investors (e.g., most pension and mutual funds managers), stock market churn is rising steeply. As Michael Porter pointed out, we are moving in the wrong direction and crippling our nation's economic capacity as we do so (9). Peter Drucker, however, observed that at least the larger institutional investors will soon have no choice but to become more involved in corporate governance (10). The funds they administer are becoming so large and unwieldy that they can no longer churn their holdings. You can buy 1000 or even 10,000 shares of any company as a speculative investment, because you can sell whenever the price reaches your target. But a 5% ownership interest in a large corporation is not a thing you can sell without disastrous effects on the price you wanted to get. The only realistic alternative these investors have is to abandon the idea that they are speculators and turn their attention instead to what Drucker calls maximizing the wealth-producing capacity of the enterprise--a fair definition of what investor loyalty means.
Whereas Porter and Drucker deal with the broad social and policy implications of investor shortsightedness, investor disloyalty also impairs a company's ability to retain its human assets and therefore has a negative effect on growth and profits. As I pointed out (3), the root of the problem is corporate leaders' failure to think of investor loyalty the same way they're beginning to think of customer and employee loyalty, that is, as a two-way street. Company executives are experts at measuring and managing the value that they deliver to stockholders; now they must begin to measure and manage the benefits, less the costs incurred, that they receive from investors. They will discover that some investors absorb more value than they help to create. Such investors often urge expedient action to boost short-term reported earnings or pressure managers to embrace management fads and fashions instead of focusing on superior long-term return on investment. If a set of loyal owners would increase the company's long-term earnings trajectory by, say, 5% per year, then that opportunity cost should be loaded back onto the shoulders of the high-churn investors to find the real cost of their capital. This analysis sheds startling light on the actual price of short-term capital, confirms the arguments made by Porter and Drucker, and will give anyone who implements it a new appreciation of the value of low-cost, loyal capital.
Customer defections, with a goal of zero, can be used as a litmus test of whether the value you're offering your customers is adequate (11). The concept of zero defects revolutionized manufacturing. Zero defections, then, is a way of thinking about and managing value creation that can eradicate the root causes of customer dissatisfaction. It is not simply theory; it's already in practice. The great companies--the loyalty leaders--really think this way and come as close to zero defections as anyone can get. USAA, remember, retains more than 98% of its customers.
Satisfaction surveys can be useful tools in this effort, but they are riddled with shallow and misleading indicators (12). Companies that take satisfaction surveys at face value are certain to stumble into one or more of the common pitfalls. One of these traps is mistakenly labeling the customer who does not have the option to defect--for reasons ranging from lack of competition to, say, a rewards program that holds the customer captive--as a loyal customer. Another trap is the failure to distinguish between the right customers and the wrong ones. Not all customers are created equal, but many companies give equal weight to first-class and third-rate customers in allocating resources to counteract defections, and some overzealous customer-recovery units spend money to save unprofitable customers or customers that actually cost the company money. Companies with high fixed costs such as automobile manufacturers and telephone companies easily fall into this trap. Every customer brings in revenue that helps offset fixed costs, so every customer looks like a good customer.
Airlines are a good example. Every time an airplane leaves a gate, its precious empty seats are rendered instantaneously worthless, so all customers, including last-minute bargain hunters, seem attractive. British Airways' Sir Colin Marshall shows how important it can be to target customers even in an industry with high fixed costs and a commodity-like product (see sidebar) (13). The goal need not be the 100% of target segment that some insurance companies shoot for. If an airline can enrich its mix from 20% target customers to 40%, it's off to the races. Marshall's views should be required reading for managers in all the industries that have failed to focus on target customers and to grasp the concept of loyalty-based management in general.
When CEOs see falling short-term profits as the only critical problem worth struggling to repair, they concentrate on a symptom and miss the underlying breakdown in the value creation system. When CEOs see customer issues as secondary to profits and delegate them to the marketing department, they are misreading their own responsibility.
Questions about customer value are questions about basic company strategy. Consequently, decisions about value creation and customer loyalty must be cross-functional, far sighted, and fundamental. They are the province of CEOs and other senior executives. In fact, unless senior executives are involved, customer defection analysis is likely to be as ineffective as satisfaction surveys are. The moment defection analysis is dished off to the lower levels of the organization, it becomes routine and trivial and ceases to be the exercise that can move a company toward robust growth, vigorous cash flow, and sturdy profits.
For all the companies we call loyalty leaders, the road to zero defections began at the top, with leaders such as Robert McDermott, Sir Colin Marshall, and Scott Cook (Intuit). These CEOs never assigned a loyalty project to marketing or anyone else. They never thought of loyalty as a project, much less as a project they could delegate. They committed themselves and their organizations to a mission higher than profits: the creation of so much value for customers that there would be plenty left over for employees and investors. They recognized that loyalty was not only an important means of accomplishing this mission but also the best measure of their progress. They understood that losing one-half of their customers every five years--the dismal average at most American companies--would be very bad business, indeed; as a test of value creation, it would be a failing grade. They also realized that long-term superior performance without loyal customers, employees, and investors was almost impossible.
Adapted by permission of Harvard Business School Press. Excerpted from The Quest for Loyalty: Creating Value Through Partnership, Frederick F. Reichheld, Ed. Copyright 1996 by The President and Fellows of Harvard College; all rights reserved.
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