Making Your Customers Marketing Partners-The Value of Referrals

Obviously one of the most important elements of the “value” of a particular customer is the projected volume of business from that customer during a specified future planning period. Using sophisticated customer relationship management (“CRM”) technology companies can now harvest information about historical purchasing habits and use statistic models to determine when customers will make future purchases, the volume of each projected order and the method (i.e., “channel”) that customers will use to fulfill their requirements.  This analysis allows the company to provide directions to its sales force as to when and how to contact customers so as to ensure that the company is positioned to sell when the customer is ready to purchase.  In addition, if this process is done well, the company will be able to use its database of customer information to determine which customers are most likely to be interested in new products or services that the company may decide to offer in the future.

 

It should not be forgotten, however, that customer relationships can also be significantly valuable to a company as a source of referrals for new business.  If customers have a good feeling about a company and its products and services they may be willing to provide support in the form of referrals to potential new customers.  Companies should consider strategies for turning customers into marketing affiliates and providing them with incentives to spread the word about the company and its products and services to third parties who might be influence by a favorable opinion from the referring customer.  In many cases, a customer that might not purchase a high volume of products and services for its own account may nonetheless be much more valuable to the company than another customer who buys a significant amount because the first partner is willing and able to introduce the company to a steady stream of strong leads of which a high percentage are turned into profitable new customer relationships.

 

In order to measure the true “value” of a customer it is necessary to identify, understand and calculate both the customer’s lifetime value (“CLV”) and the customer’s referral value (“CRV”).  Both values are discounted cash flow calculations that take into account profits and costs over a specified planning or forecast period.  The CLV at any point in time is the net present value of projected purchases by the customer over a specified period minus the sum of the marketing costs associated with acquiring the customer in the first place (“acquisition costs”) and the marketing costs associated with retaining the customer long enough for the customer to make all of the projected purchases (“retention costs”).  A CLV is, of course, a projection and its utility is tied to the sophistication and accuracy of various predictions regarding future customer demand, product pricing and margins, retention costs, competition and general economic and market conditions. 

Calculating the CRV is much more complicated and requires estimating the value of successful referrals that can be related to a particular referral incentive as well as the CLV of the new customers landed through the referral program.  While the CRV can be crudely defined as the net present value of expected future business from referred customers less the costs of providing the incentive to refer, several difficult issues need to be considered when determining the CRV.  Obviously, in order for a referral to be “successful” it must result in a profitable new customer relationship.  A customer that recommends the company’s products and services to others that never buy is not creating new value for the company.  It is also essential to determine how many of the successful referrals are tied to the company’s referral incentives.  In many cases companies use a simple rule of thumb and assume that referrals made within a specific period after the incentive is offered, such as six months or a year, should be included when analyzing the efficacy of a referral campaign.  A related issue is coming up with an accurate prediction of how many referrals an existing customer will actually made after being provided with a referral incentive.  Once the referral program has been in place for awhile reference can be made to historical data (which should also identify the “best marketers” among the existing customers); however, at the very beginning it is difficult to determine which existing customers will, in fact, proactively seek out potential new customers for the company. Each new customer should also be evaluated to determine if it would have purchased the company’s products or services even without the referral and if so the value of its purchases should not be included in the referring customer’s CRV although some credit should be given to the referring customer for allowing the company to avoid the acquisition costs for the new customer. 

 

After taking these issues into account, a customer’s CRV is the net present value of the profits and costs over the measurement period associated with new customer relationships formed solely because of the referral plus the net present value of acquisition costs that the company saved with respect to new customer relationships that would have been formed whether or not the referral was made.  In determining the value of new customer relationships formed solely because of a referral one must compute the profit generated from the customer’s purchases over the measurement period, add the savings in acquisition costs for the customer, and then subtract both the cost of the referral incentive and the retention costs for the customer.  Since a major element of the CRV is the projected CLV for the new customer referrals it is subject to the same caveats described above including the predictability of the new customer’s demand—something that is particularly problematic since there is no prior purchase history with the company to rely on when making predictions.

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