CHAPTER 6: MANAGING RELATIONSHIPS AND

BUILDING CUSTOMER LOYALTY

Learning Outcomes of the Chapter:
Upon completing this chapter, students will be able to:
LO 1: Recognize the critical role of customer loyalty in driving the profitability of a service
company.
LO 2: Understand why customers remain loyal to a service company.
LO 3: Know how to develop a loyal customer base through an understanding of the core
strategies of the Loyalty Wheel.
LO 4: Appreciate the importance of service companies targeting the right customers.
LO 5: Use the service tiering approach to manage the customer base and build loyalty.
LO 6: Know how to strengthen customer relationships through cross-selling and bundling.
LO 7: Understand the relationship between financial and non-financial rewards in reinforcing
customer loyalty.
LO 8: Appreciate the power of social bonds, customization bonds, and structural bonds in
enhancing loyalty.
LO 9: Understand the factors that lead customers to switch to competitors and how to minimize
such defections.
LO 10: Identify the actions that customers may take in response to service failures.
LO 11: Understand why customers complain.
LO 12: Explain the service recovery paradox.
LO 13: Know the principles of an effective service recovery system.
6.1. The Importance of Customer Loyalty
➢ LO1: Recognize the critical role of customer loyalty in driving the profitability of a
service company.
Customer loyalty in a business context refers to the willingness of customers to continue
patronizing a company over an extended period of time—more precisely, to rely on the company
as a primary provider—and to recommend the company’s products or services to friends and
organizations. Loyalty extends beyond mere behavior; it also includes emotional attachment and
future purchase intentions. It is clear that loyal customers are associated with a company’s growth
and profitability. The “Leaky Bucket Theory” suggests that businesses are constantly losing
customers; therefore, for a company to grow, the number of new customers must exceed the
number of customers lost, and the loyalty of existing customers must be strengthened (i.e.,
reducing customer attrition). This can significantly impact a company’s growth. Figure 6.1 below
illustrates this theory: Company B has a lower customer attrition rate than Company A, while both
companies acquire the same number of new customers each year. As a result, after 14 years,
Company B will have doubled in size compared to Company A.

According to Frederick Reichheld, there are four factors through which customer loyalty generates
profits for service providers:
Increased profits from increased purchases: Over time, a typical business customer tends to grow
and therefore requires larger purchase volumes. Individual customers may also buy more as their
families grow or as they become more affluent. Both types of customers may be willing to
consolidate their purchases with a single high-quality service provider.
Increased profits from cost savings: As customers become more experienced, they require less
information and support, and they tend to prefer self-service options from the provider. They are
also less likely to make mistakes when engaging in service processes, thus contributing to higher
operational efficiency. Increased profits from word-of-mouth referrals: Positive word-of-mouth
functions like free sales and advertising, reducing the company’s need to spend heavily on these
areas. Increased profits from price premiums that loyal customers are willing to pay: New
customers often require promotional discounts during the early stages of their relationship,
whereas long-term customers are more likely to accept regular pricing. When customers are highly
satisfied, they tend to be less price-sensitive. Additionally, customers who trust their provider may
be willing to pay more for critical services—for example, during peak periods or when the service
is essential to their work.
6.2. Why Customers Stay Loyal to a Service Company
➢ LO2: Understand why customers remain loyal to a service company
Customers do not automatically become loyal to any company. Instead, we must give them a
reason to reinforce their purchase decisions and encourage repeat purchases over time. It is
essential to create value for customers when they choose to become and remain loyal.
So, what kinds of value do customers perceive from a long-term relationship with a service
company? The following are key factors that can generate value for loyal customers:

• Confidence benefits: When a relationship with a business is established, customers believe

that they face fewer risks when consuming services from a familiar provider. They feel less
anxiety during purchases because they know what to expect and are often entitled to the
best treatment or offers from the service provider.
• Social benefits: These include mutual recognition between customers and employees,
being greeted by name, forming friendships with service providers, and enjoying the social
aspects of the relationship. For example, you may become a regular at a hair salon where
the cheerful owner frequently tells humorous stories to loyal customers. This familiarity
and interaction make regular customers feel relaxed and at home.
• Special treatment benefits: These may include better prices, discounts on special deals not
available to most customers, additional services, priority when waiting, and faster service
compared to other customers.
6.3. The “Wheel of Loyalty” and Building a Foundation for Customer Loyalty
➢ LO3: Know how to develop a loyal customer base through an understanding of the core
strategies of the Wheel of Loyalty.
We use the “Wheel of Loyalty” as a model to discuss how to build a strong foundation for customer
loyalty.
It consists of three sequential strategies:

❖ First, the company needs a solid foundation to build customer loyalty. This involves
developing an accurate segmentation of the customer base, attracting the right customers,
implementing a tiered service structure, and delivering consistently high levels of customer
satisfaction.
❖ Second, the company should develop close relationships with its customers. This can be
achieved by deepening the relationship through cross-selling and bundling products, or by
adding value through loyalty rewards and higher-level bonds such as contractual
agreements.
❖ Third, the company must identify and eliminate factors that cause disruption or “churn” —
elements that lead to the loss of existing customers and the resulting need to replace them
with new ones.
6.3.1. Focusing on the Right Customers
➢ LO4: Appreciate the importance of service companies targeting the right customers.
The process begins with identifying and targeting the right customer segments. Customers differ
in their needs and the value they contribute to the business. Not all customers are suitable for a
company’s capabilities, delivery technologies, or strategic direction.
Companies need to carefully select the market segments they aim to serve if they want to build
successful long-term relationships. This section emphasizes the importance of serving a carefully
chosen portfolio of market segments and striving to build and maintain customer relationships.
Managers also need to think carefully about how customer needs align with operational factors
such as speed and quality, service availability, the organization’s capacity to serve many customers
simultaneously, and the physical attributes of service facilities. They must also consider how well
service employees can meet the expectations of specific customer types. Finally, managers should
ask themselves whether the company can match or exceed the services offered by competitors
targeting the same customer group. The outcome of carefully targeting customers—by aligning the
firm’s capabilities and strengths with customer needs—is that the company delivers services in
ways that customers perceive as valuable. As Frederick Reichheld stated:
“The result should be a win-win situation, where profits are achieved through the success and
satisfaction of customers, not through their spending alone.”
Valuing Customer Worth over Quantity
Too many service firms still focus on the number of customers they serve rather than on the value
each customer brings. For example, a global hotel chain found that just 2% of its top customers
generated an astounding 30% of its profits. In general, customers who purchase frequently and in
large volumes are more beneficial to a business than occasional buyers. However, some market
segments deliver immediate profitability, while others offer potential long-term profits. There are
also segments with stable consumption patterns and others with cyclical behavior—spending
heavily at one time and cutting back at another. A wise marketer is one who combines various
market segments to minimize this volatility.
6.3.2. Managing the Customer Base through Effective Service Tiering
➢ LO5: Use service tiering to manage the customer base and build loyalty
Marketers should adopt strategic approaches to retaining, upgrading, and even ending relationships
with certain customers. Customer retention involves developing cost-effective, long-term
connections with customers that benefit both parties. However, such efforts do not need to be
applied uniformly to all customers. Recent research shows that most companies have customer
segments with varying levels of profitability, expectations, and needs.
Similarly, service products can be tiered to reflect different levels of value. For instance:

• Hotels: ranging from 1-star to 5-star ratings

• Airlines: first class, business class, premium economy, and economy class
• Car rentals: categorized by vehicle class
In later examples, customer tiers may be structured around varying levels of profit contribution,
customer needs (including sensitivity to factors such as price, comfort, and speed), and identifiable
profiles such as demographic characteristics. Zeithaml, Rust, and Lemon illustrated this principle
using a four-tier customer pyramid:
 • Platinum: These customers represent a small proportion of the customer base but have high
purchasing power. They are less price-sensitive, expect high quality, and are willing to
invest in trying new services. →→ They should be offered exclusive benefits not available
to other tiers, and firms should adopt strong retention strategies for them. Example:
postpaid mobile plans.
• Gold: This tier includes a larger number of customers than platinum, but each individual
contributes less profit. They are somewhat price-sensitive and typically show less
enthusiasm or emotional attachment to the company.
• Iron: These customers form the mass market. Their sheer numbers generate economies of
scale for the business. As such, they play a crucial role in helping the company maintain a
certain level of capacity and infrastructure, which in turn supports the service offered to
gold and platinum customers. However, iron customers only generate modest profit
margins.
• Lead: Customers in this tier tend to produce low revenue yet often demand the same level
of service as iron-tier customers. →→ Companies may consider merging them with the
iron tier or ending the relationship altogether. Consolidation can be achieved through
strategies such as introducing base fees or increasing prices. Imposing a minimum fee that
is waived when a certain spending threshold is met may also encourage these customers to
consolidate their spending with a single provider.
→→ Marketing efforts may be used to encourage greater purchase volume, service upgrades, or
cross-selling of additional services for customers in any tier. However, these efforts should be
tailored in strength and design according to each tier, as their needs, purchasing behaviors, and
spending patterns differ.
6.3.3. Creating Bonds to Foster Loyalty
[Link]. Deepening Relationships through Cross-Selling and Bundling Services
➢ LO6: Know how to strengthen customer relationships through cross-selling and bundling.
Through bundled services and cross-selling, companies can tighten and deepen their relationships
with customers. For example, banks often aim to sell as many financial products as possible to a
single account holder or household. When a household simultaneously holds a checking account,
credit card, savings account, safety deposit box, and an auto loan with the same bank, the
relationship becomes stronger and switching to another bank becomes less likely—unless they are
extremely dissatisfied with the service. Customers can benefit from purchasing multiple services
from a single provider due to the convenience of one-stop shopping, as well as the increased
service integration that often accompanies a higher transaction volume with that provider.
[Link]. Reward-Based Bonds
➢ LO7: Understand the relationship between financial and non-financial rewards in
reinforcing customer loyalty.
At a basic level, reward-based bonds are incentives tied to the frequency of purchases, the value
of purchases, or a combination of both.
By nature, reward-based bonds can be either financial or non-financial.
❖ Financial rewards are created when loyal customers receive benefits that have monetary
value, such as purchase discounts, frequent flyer miles from airline loyalty programs, or
cashback from credit card companies.
❖ Non-financial rewards are benefits that cannot be directly translated into monetary terms.
Examples include priority placement on waiting lists when calling customer service, or
access to exclusive services. Some airlines, for instance, offer perks such as higher baggage
allowances, priority upgrades, or access to airport lounges for frequent flyer program
members—even when they are traveling on economy tickets.
Intangible rewards also include being recognized and thanked in a personalized manner. Customers
tend to appreciate thoughtful attention to their needs or efforts made to accommodate their special
requests.
[Link]. Social, Customization, and Structural Bonds
➢ LO8: Appreciate the power of social bonds, customization bonds, and structural bonds in
strengthening loyalty.
Reward-based programs, as discussed earlier, are relatively easy to imitate and rarely provide
sustainable competitive advantages. The following types of bonds offer more enduring benefits for
businesses in building customer loyalty:
a) Social Bonds
Social bonds are built on personal relationships between the service provider and the customer.
For example, a hair salon owner who always greets you by name and asks why she hasn’t seen
you lately is engaging in a form of social bonding. Although social bonds are more difficult and
time-consuming to develop than financial incentives, they are also harder for competitors to
replicate. A business that successfully establishes social bonds with its customers is more likely to
retain them in the long term. When these social connections expand into customer communities
and shared experiences among customers, they can become a major driver of loyalty to the
organization—for instance, the Mercedes business-class customer clubs.
b) Customization Bonds
Customization bonds are formed when service providers successfully personalize services for loyal
customers. For example, Starbucks encourages its staff to remember regular customers’
preferences and tailor their service accordingly. One-to-one marketing represents a more advanced
form of personalization, where each individual is treated as a unique market segment. Many major
hotel chains leverage data from loyalty programs to learn about customer preferences. This enables
staff to anticipate guests' needs—from their favorite drink or snack in the minibar to their preferred
pillow type or choice of morning newspaper. Once customers become accustomed to this
personalized service, they are less inclined to switch to a provider that doesn’t understand them as
well.
c) Structural Bonds
Structural bonds are commonly found in B2B (business-to-business) contexts, aiming to foster
loyalty through embedded relationships between supplier and client. Examples include joint
investments in projects, shared information, systems, and equipment. Structural bonds can also be
created in B2C (business-to-consumer) environments. For instance, some airlines offer SMS
notifications about flight departures and arrivals, helping passengers avoid long waits at the airport
in the case of delays. Certain car rental companies allow travelers to create personal profiles on
their websites, storing details of past trips such as vehicle types and insurance preferences. This
simplifies and speeds up future bookings. When customers integrate their routines or processes
with those of the provider, structural bonds form strong links that are difficult for competitors to
disrupt.
6.4. Minimizing Factors That Lead to Customer Defection
➢ LO9: Understand the factors that cause customers to leave a business for competitors and
how to minimize switching behavior.
6.4.1. Factors That Cause Customers to Leave
Susan Keaveney conducted a large-scale study across a range of service industries and identified
several key reasons why customers defect from service providers. The most common reasons
include:

• Core service failure – 44%

• Service encounter failures (disappointing interactions) – 34%
• High prices, perceived dishonesty, or unfair pricing – 30%
• Inconvenience (related to time, location, or delays) – 21%
• Poor response to service failure – 17%
Many respondents indicated that their decision to leave was not due to a single incident but rather
the result of interconnected events—for example, a service failure followed by an unsatisfactory
recovery effort.
6.4.2. How to Eliminate Factors That Cause Customer Defection
a) Monitor and Analyze Customer Defection
In the telecommunications industry, companies often perform what is known as a churn
diagnostic—a process used to identify and understand customer behavior changes that may signal
impending defection. This involves analyzing data from customers whose usage is declining,
conducting brief exit interviews with those who decide to leave (e.g., call center agents asking
short questions when customers request to cancel an account), and in-depth interviews with former
customers conducted by third-party research firms to uncover churn-related factors. Many service
providers use Churn Alert Systems to monitor individual customer accounts and predict the
likelihood of switching providers. High-risk accounts are flagged and trigger proactive retention
efforts—such as sending discount vouchers or having customer service staff call to assess the
relationship status and take appropriate recovery actions.
b) Focus on Root Causes
Susan Keaveney’s research highlights the importance of addressing common churn factors by
delivering high-quality service, minimizing inconvenience and non-monetary costs, and ensuring
transparent and fair pricing. In addition to general drivers of churn, industry-specific factors also
play a role. For example, Apple frequently releases new iPhone models—just like Samsung—so
to reduce the risk of customers switching to Samsung, Apple collaborates with telecom providers
in certain developed countries like Japan and Singapore. In Japan, for instance, carriers like
SoftBank offer promotions such as free upgrades from older to newer iPhones for long-term
residents or Japanese citizens, provided they commit to a 2-year contract. This reduces customer
churn by tying benefits to long-term loyalty.
c) Implement Effective Complaint Handling and Service Recovery Processes
Handling complaints effectively and delivering outstanding service recovery are essential in
preventing dissatisfied customers from switching providers. This includes offering customers easy
ways to voice their concerns and responding with strong, appropriate recovery efforts. (See Section
III for more on this topic.)
d) Increase Switching Costs
Another strategy to reduce customer defection is to raise switching barriers. Some services
naturally have high switching costs—for instance, when a customer has multiple debit and credit
accounts, loans, and other services tied to one bank account, they may hesitate to switch banks due
to the effort required to relearn product features and procedures. Switching costs can also be
created through contractual penalties—such as early loan repayment fees, or equipment return fees
(e.g., the modem return charge a customer must pay to FPT if they want to switch to VNPT).
6.5. Implementing Service Recovery Strategies
6.5.1. Customer Complaint Behavior
a) Types of Customer Responses to Service Failures
➢ LO10: Identify the actions customers may take in response to service failures.
When a service failure or breakdown occurs, customers may take one or more of the following
three actions:

• Engage in public action – such as lodging a complaint with the company, contacting a third
party like a consumer protection agency or a regulatory body, or even bringing the issue to
civil or criminal court.
• Engage in private action – such as switching to another provider.
• Take no action.
It is important for companies to recognize that customers can choose to take any one of these
actions, or a combination of them. Managers must understand that the consequences of customer
defection go beyond the loss of future revenue from that individual. Angry customers often spread
negative word-of-mouth, and the internet gives them access to thousands of people through posts
on their social media walls, blogs, or public forums, where they can share their bad experiences
and name the business involved.
b) Understanding Customer Behavior in Response to Service Failures
➢ LO11: Understand why customers complain
To handle complaints effectively and resolve dissatisfaction, managers must understand key
aspects of complaint behavior, starting with these questions:
Why do customers complain?
➢ To receive compensation
➢ To vent frustration or restore self-esteem
➢ To help improve the service (e.g., in sectors like education or banking)
➢ Out of altruism – they may want to forgive repeated or common mistakes, and offer
feedback so that other customers do not suffer the same problems
How many dissatisfied customers actually complain?
➢ Research shows that only about 5–10% of dissatisfied customers file complaints—a
surprisingly low percentage.
➢ Why do dissatisfied customers remain silent?
➢ They don't want to waste time writing letters, sending emails, filling out forms, or making
calls—especially if the service is not important enough to justify the effort
➢ They believe that complaining will not lead to meaningful action, and that nobody cares or
is willing to resolve the issue
➢ They don’t know whom to complain to, where, or how
➢ They feel uncomfortable complaining, or fear confrontation—especially when it involves
someone they are familiar with
Complaint behavior is also influenced by perceived roles and social norms. Customers are less
likely to voice complaints in situations where they feel they have little power. This is particularly
true when the problem involves professional service providers such as doctors, lawyers, or
architects. Social norms often discourage criticism of professionals due to their perceived
expertise.
Who is most likely to complain?
Studies show that individuals with higher socioeconomic status are more likely to complain.
Education, income, and higher social involvement give them the confidence, knowledge, and
motivation to speak up when they encounter service failures.
Where do customers usually complain?
Research indicates that most complaints are made at the point of service. Customers also tend to
use non-interactive channels such as email or direct mail. In reality, without a well-structured
customer feedback system, only a small fraction of customer complaints ever reach the company’s
headquarters.
What do customers want when they complain?
Whenever a failure occurs, people expect to be compensated in a fair and appropriate manner.
However, many studies show that complaining customers often feel they have not been treated
fairly or adequately compensated. When this happens, their reactions tend to be immediate,
emotional, and long-lasting. Stephen Tax and Stephen Brown identified three dimensions of
fairness that determine 85% of satisfaction with service recovery outcomes:

• Procedural fairness: This relates to the policies and procedures customers must follow to
obtain redress. Customers expect the firm to acknowledge responsibility and provide an
easy, accessible process for recovery. This includes flexibility in the system and
consideration of the customer's concerns as input in the recovery process.
• Interactional fairness: This refers to the attitude and behavior of staff during the recovery
process. Providing an explanation for the failure and making a sincere effort to solve the
problem is critical. However, these efforts must be perceived as genuine, honest, and
respectful.
• Outcome fairness: This involves the actual compensation the customer receives to make
up for the inconvenience or loss caused by the service failure. This includes not only redress
for the failure itself but also for the time, effort, and energy the customer spent throughout
the recovery process.
6.5.2. The Service Recovery Paradox
➢ LO12: Explain the service recovery paradox
The service recovery paradox refers to a situation in which:
Customers who experience a service failure that is resolved satisfactorily are more likely to make
repeat purchases in the future than customers who encountered no problems during their initial
purchase. However, this paradox does not apply if a service failure occurs a second time—in such
cases, the trust may be irreparably damaged. After receiving excellent recovery once, customer
expectations increase, meaning that such exceptional service recovery becomes the new standard
by which future service failures will be judged.
6.5.3. Principles of Effective Service Recovery
➢ LO13: Know the principles of an effective service recovery system
To build an effective service recovery system, companies must:
❖ Make it easy for customers to provide feedback on service performance.
❖ Enable a recovery system that works efficiently. An effective recovery system should
include the following elements:
• Proactive recovery: Ideally, companies should resolve the issue before the customer
has a chance to complain.
• A clearly planned recovery process: Recovery procedures should be systematically
designed in advance.
• Training recovery skills for staff: Employees should receive training on how to handle
service recovery professionally.
Empowering frontline employees: Staff should be given authority to make decisions in the
recovery process.
The generosity of the recovery should depend on:
❖ The company's positioning strategy
❖ The severity of the service failure
❖ Who was affected by the failure
Guidelines for frontline staff when handling customer complaints:
❖ Act quickly
❖ Acknowledge the customer’s emotions
❖ Don’t argue with the customer
❖ Show that you understand the issue from the customer’s perspective
❖ Clarify the facts and explain the root cause
❖ Investigate whether similar complaints have occurred in the past
❖ Suggest necessary steps to resolve the issue
❖ Keep the customer informed of the complaint-handling progress
❖ Consider an appropriate form of compensation
❖ Be persistent in regaining the customer’s goodwill
❖ After the customer has left, conduct a self-assessment to determine the cause of the failure
and continuously improve the service to restore and strengthen the company’s reputation.