The not so broken telephone game
How valuable is word of mouth?
The value of any one customer does not reside only in what that person buys.
How valuable is word of mouth?
The technology for managing customer relationships has gotten fairly sophisticated. Companies can draw on databases that tell them how much each customer has purchased and how often, which they may supplement with detailed demographic profiles.
However, as Bain consultant Fred Reichheld says, “The One Number You Need to Grow,” the value of any one customer does not reside only in what that person buys. In these interconnected days, how your customers feel about you and what they are prepared to tell others about you can influence your revenues and profits just as much.
Clearly, a corporation that accurately targets those of its customers who are likely to make profitable referrals will earn a better return on its marketing investment than its competitors that do not.
Measuring a Customer’s Value
We analyzed each customer’s transactions on a monthly basis and projected forward for a year the discounted average monthly contribution less marketing costs to obtain our CLV estimates. Calculating the referral value (CRV) is more complicated than calculating lifetime value. We must first estimate the average number of successful referrals after offering an incentive through a marketing campaign.
In our experience, referrals made by customers after a referral-incentive marketing campaign can be attributed to that campaign for about a year. So, we count only those referrals made within a year, erring in our prediction of referral behaviour, as we did with our CLV calculation, on the side of caution.
Next, we must estimate how many of those referrals would have become customers anyway, even if someone had not recommended the company. The distinction is important. If a new customer, let’s call him John, would not have joined without a referral (what we call a “type-one” referral), then the referral value should incorporate the value of John’s business. But if John would have become a customer without a referral (a “type-two” referral), then the CRV should incorporate only the savings in acquisition costs for John, since no direct marketing effort was needed to get him.
The value of type-two customers, as we’ve noted, is simply the present value of the savings in acquisition costs. Note that if the cost involved in acquiring type-two referrals exceeds the cost of alternative acquisition methods, type-two customers can be a liability.
What the Calculation Reveals
To see how much the CRV calculation can affect total customer values, we will apply our valuation formulas to a customer from each sample. While significant, these numbers are far lower than these customers’ referral values. Analysis of prior referral behaviour suggests that after the launch of a referral program, these customers will typically refer four customers in each observation period, of which half are type-one referrals and half are type-two.
If customer lifetime value and customer referral value were simply and positively correlated, the difference between them would not be particularly interesting from a managerial perspective. But when we looked into the specific referral behaviour of customers with different CLV levels, we found that a high CLV is not a good predictor of CRV and so is a very questionable proxy for a customer’s total value.
It’s clear that in many situations, companies need to rethink their CRM strategies and tactics, ensuring that they not only focus their efforts on increasing purchases but also make it easier for their customers to communicate positive information about their firm’s products and services to others.
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