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ANALYSIS: Lock 'em Up!

ANALYSIS: Lock 'em Up!

Reprinted by permission of Harvard Business School Press. Excerpt of Information Rules: A Strategic Guide to the Network Economy. By Carl Shapiro and Hal R. Varian. Copyright 1998. All rights reserved (US$29.95; contact HBSP at 888 500-1016).

Capturing and keeping customers, known as lock-in, is increasingly becoming the competitive advantage weapon of choice for "smart" (that is, information savvy) companies. The customer loyalty program is gaining ground on product and price in its importance to success, and in the next millennium companies will escalate the battle to lure away and lock in each other's best customers. CIOs in every industry and every size company need to understand the concepts of customer lock-in and the loyalty program because information is the key that unlocks the power of both. In the excerpt below, from the new book Information Rules: A Strategic Guide to the Network Economy, authors Carl Shapiro and Hal Varian demystify lock-in and discuss loyalty programs and their variations.

Lock-in is inherently a dynamic concept, growing out of investments made and needs realized, at different points in time. We have developed a diagram to help you think dynamically about lock-in. We call this the lock-in cycle. The easiest place to hop onto the lock-in cycle is at the brand selection point-that is, when the customer chooses a new brand. Brand choice could mean purchasing a new multimillion-dollar switch, buying a video disk player, purchasing a new software program or signing up for a new frequent-flier program. The first time a specific customer picks a brand, that customer will have no preference for any one brand based on lock-in.

You are not born "locked in"; you get locked in only by virtue of choices you make. The next time around the cycle, the playing field will not be so level, however. Brand selection is followed by the sampling phase, during which the customer actively uses the new brand and takes advantage of whatever inducements were made to give it a try. One of the dangers of offering powerful sweeteners to attract new customers is that they will take the free sample but never turn into revenue-paying customers. Some book clubs take this risk by offering eight books for a dollar; others require new members to buy a minimum number of books at regular prices. Extending introductory offers to new customers is especially tempting for information providers because of the low marginal cost of information. This is all the more so with a CD that costs less than a dollar to produce, in comparison with printed material that could cost US$5 or more to produce.

Customers who do more than sample move into the entrenchment phase. This is when the consumer really gets used to the new brand, develops a preference for that brand over others and perhaps becomes locked in to that brand by making complementary investments. Usually, the supplier tries to drag out this phase and delay active consideration of other brands, hoping that the customers' switching costs will go up. The entrenchment phase culminates in lock-in when the switching costs become prohibitively expensive.

We return to the brand selection point when the customer either switches brands or actively considers alternative brands without selecting them. Of course, circumstances will have changed in comparison with his last time around the cycle. Certainly, the customer's switching costs are higher than they were the first time around. For specialized products, some alternative suppliers may have dropped out in the interim or lost capabilities. On the other hand, new technologies can emerge.

The most basic principle in understanding and dealing with lock-in is to anticipate the entire cycle from the beginning. In fact, you need to go beyond any one trip around the circle and anticipate multiple cycles into the future in forming your strategy from the outset. Valuing your installed base is part of looking ahead: By figuring out how much customers will be worth to you in the future (next time around the cycle), you can decide how much to invest in them now (by inducing them to take the next step and enter the sample phase, for example). This is especially true if switching costs are rising over time (as with information storage and brand-specific training) rather than falling over time (as with durable equipment that depreciates and will be replaced by new and superior models).

You can influence the magnitude of your customers' switching costs in a number of ways. One of the most information-intensive methods is to offer customers more value-added informational services. The pharmaceutical drug wholesaling business illustrates this point nicely. Traditionally, this business has entailed ordering pharmaceutical drugs from manufacturers, warehousing them and delivering them to customers such as drugstores and hospitals. The role of information systems and services in this industry has grown markedly in the last decade. The industry leaders, McKesson Corp., Cardinal Health, Bergen Brunswig Corp. and AmeriSource Corp., now distinguish themselves by offering sophisticated reporting services to large, national customers. To further entrench these customers, the large wholesalers have developed their own proprietary automated dispensing and reporting systems along with consulting services to deepen their relationships with clients. Value-added information services such as these are excellent lock-in methods, but the most common entrenchment tool is the customer loyalty program. The most popular and well known of these are the airlines' frequent-flier offerings.

Recently, hotels have followed suit with frequent-guest programs. Even local retailers use this tactic, giving one unit for free after 10 purchases. For example, our local film store will develop one roll of film for free after you have paid for 10 rolls. The nearby Mexican restaurant does the same with burritos, if you remember to bring along your card and have it punched. Loyalty programs create switching costs in two ways. First, you may forfeit certain credits if you stop buying from your regular supplier. If you have 15,000 miles in your airline account, and it takes 25,000 miles to get a free ticket, the 15,000 miles will be lost if you fail to fly another 10,000 miles before they expire. Second, and more important, are benefits based on cumulative usage, such as double miles or preferential service for members who fly more than 50,000 miles a year. These benefits become part of the total switching costs: Either the customer loses them (a customer switching cost) or the new carrier matches them (a supplier switching cost). As online commerce explodes, more companies will adopt loyalty programs, giving preferential treatment to customers based on their historical purchases precisely to create such switching costs.

The variations on these discount programs are virtually endless. You can offer your customers a discount for buying exclusively from you or for committing to a certain minimum order size. You can offer discounts for customers who buy more than they did last year. You can utilize volume discounts to encourage customers to keep buying from you rather than sampling other suppliers. Or, to attract new customers, you can offer introductory discounts as a way of helping defray their costs of switching to you from a rival. Perhaps the ultimate weapon here is to base the offer you make to a prospective new customer on information about that customer's status in your rival's loyalty program. For example, an airline will often offer "gold status" to someone who holds gold status on a competing airline in hopes of inducing them to switch carriers.

Loyalty programs will become far easier to administer as companies keep more information about their customers' historical purchasing patterns. Already, many retailers collect detailed information on individual customers' buying patterns. These methods require tracking individual customer purchases over time, establishing accounts for each customer that record purchases and maintaining a balance of some credits associated with frequent buying. As information technology continues to advance, this information processing will become less expensive, and more and more companies, including smaller retailers, will find customer tracking to be cost-effective.

Preferential Treatment

The key to loyalty programs is that the reward for past loyalty must be available only to customers who remain loyal. Usually, this is done in two ways, each of which involves ongoing special treatment of customers who have accumulated substantial usage in the past. First, those customers may be given preferential treatment; this is the essence of United Airlines' Mileage Plus Premier program, whereby very frequent fliers are given preferential seating, chances to upgrade to first or business class, a special telephone number for service and so on. Second, historically heavy users are given bonus credits when they buy more goods or services; with United Airlines, this takes the form of double or triple miles for those who travel heavily on United. In the end, all these methods are forms of volume discounts: favorable terms for incremental purchases to customers who are heavy users on a cumulative basis.

In an earlier era numerous retailers banded together to offer cumulative discounts: That was the essence of the Green Stamps system, whereby customers would accumulate stamps issued by many vendors and then trade in books of stamps to earn prizes. In today's economy, smaller vendors will again find it attractive to link arms with companies selling noncompeting products to offer cumulative discounts. We doubt your customers will be using stamps. They will likely do more clicking than licking, accessing online reports of their cumulative purchases from you and other companies with which you are affiliated.

Smaller and smaller businesses will find it worthwhile to set up their own loyalty programs as the information necessary to operate these programs becomes more accurate and more easily available.

These artificial loyalty programs have the prospect of converting more and more conventional markets into lock-in markets, as consumers find themselves bearing significant switching costs in the form of foregone frequent-purchaser benefits when they change brands. For the same reasons, consumer "loyalty," as measured by the tendency of consumers to frequent one or a few suppliers rather than many, is likely to grow. Whether the industry is clothing retailing (traditional catalog or online), hotels or long-distance telephone service, the companies that can structure their charges to attract and retain the lucrative heavy users will edge out their rivals, in much the same way that American Airlines Inc. gained an edge by introducing the first frequent-flier program back in 1981.

Competition is likely to take the form of sophisticated information systems and targeted promotional activities as much as traditional product design and pricing.

(Carl Shapiro is professor of business strategy at the University of California at Berkeley's Haas School of Business and holds a joint appointment at the university's department of economics. Hal R. Varian is dean of the School of Information Management and Systems at the University of California at Berkeley, with joint appointments at the university's Haas School of Business and department of economics. They can be reached at www.inforules.com.)

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