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 type 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 first based 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 is likely to 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 mediocre quality). Likewise, 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.

This model then looks at the strength of the business relationship; it proposes that this strength 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 committed to the relationship, and if there are bonds keeping them in the relationship. The existence of these bonds acts as an exit barrier. There are several types of bonds, 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.

This 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: 1) the customer moves away from the company's service area, 2) the customer no longer has a need for the company's products or services, 3) more suitable alternative providers become available, 4) the relationship strength has weakened, or 5) 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 between 25% and 85% (in terms of net present value) depending upon the industry. However, Carrol and Reichheld (1992) dispute these calculations, claiming that 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 occurs only at the beginning of a relationship: 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 supplemental products.
• Long term customers tend to be satisfied with their relationship with the company 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 processes involved, 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 feed back into higher 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 marketers 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 for this is the patronage concentration ratio. This calculation is hindered by the difficulty in allocating costs to individual relationships and the ambiguity regarding relationship cost drivers.

Expanded models