Calculating WOM in Customer Lifetime Value

Word-of-mouth delivers “free” new customers

As discussed in the article on word-of-mouth (WOM) benefits, leveraging customer referrals provides a good stream of new customers that come to the brand with a zero acquisition cost. This has three benefits for the firm:

• Its average new customer acquisition cost is reduced
• It may be able to reduce (or redirect) its  promotional budget as a result
• Overall profitability of each customer is enhanced (that is, a higher CLV)

As we know, primarily due to the potential of social media to engage consumers, word-of-mouth has become a important priority for most marketers and has long been considered a reason why customers become more profitable over time.

How to calculate word-of-mouth in the customer lifetime value formula

The reduction of the acquisition cost per customer is a cost saving – it is NOT an increase in customer revenues (on a per customer basis). This cost savings is passed onto the company by being able to redirect or reduce their promotional expenses targeted at non-customers of the brand.

Therefore, to ensure that the customer lifetime value calculation (CLV) aligns of financial situation of the firm, it is appropriate to account for the word of mouth benefit as a cost saving – in other words,  “negative” cost in the CLV formula, which how it is treated in the free Excel CLV template.

An example of incorporating WOM into CLV

To see how word-of-mouth (WOM) should be handled in the customer lifetime value calculation, let’s assume the following example for a brand:

• The average acquisition cost for a new customer has been calculated as $200
• The firm has been identified that 1,000 new customers were attracted during the year by referrals (word-of-mouth) from 500 existing customers. This means that each of these customers referred two new customers during the year.

The total acquisition cost saving for the brand is:

• 1,000 (new customers obtained through WOM) X
• $200 (average new customer acquisition cost) =
• $200,000 (total promotional “savings” – refer note below) /
• 500 (number of referring existing customers) =
• $400 (acquisition cost savings per referring customer)

This $400 cost saving would then be built into the appropriate year/s of the CLV calculation.

NOTE: The above promotional “savings” might not be in the form of a reduction in the marketing budget, but rather the ability to allocate the  budget across more areas of marketing activities, which should lead to a more effective use of marketing funds.

EXAMPLE OF WOM IN CLV IN GRAPH FORM

The following chart highlights the pattern of revenue/costs due to the inclusion of word-of-mouth acquisition cost savings in the customer lifetime value formula. As you can see, a major customer referral campaign was conducted by the firm in year 3. For that particular year, there is a reduction in customer costs – as the existing customers have “saved” money for the firm – which results in a jump in the per customer profit contribution for that year.

These customers are therefore more profitable because they have added to the firm by delivering new customers at a zero acquisition cost, allowing the firm to redirect its marketing budget into other areas of its growth programs.

Why use WOM in a CLV calculation?

Should word-of-mouth benefits be used to help calculate customer lifetime value?

In today’s media environment, with consumers having greater engagement with social media and their willingness to add comments and information on comparison and review websites, the potential benefit from word-of-mouth has grown significantly. Today most large companies have dedicated staff who are primarily engaged in leveraging word-of-mouth and customer referrals via online and social media methods.

Word-of-mouth via social and online media has the potential to generate many new customers through supporters of the brand. Consider, for a moment, successful social media campaigns that have been able to generate significant new business for a brand with a minimal budget.

Therefore word-of-mouth leverage is a marketing tactic that allows the marketer to maximize the profitability of a customer base (and CLV). As a result, it should be included in customer lifetime value calculation – particularly in a firm/product where customer endorsements and word-of-mouth referrals are common.

WOM and Customer Segmentation

The inclusion of WOM into a CLV calculation is generally more insightful when analyzing customer lifetime value on a per customer segment basis. This is because the addition of the word-of-mouth benefits will highlight the importance of key influencers and consumer advocates on per customer profitability.

It is true, that in most cases, strong supporters and advocates of the brand are more likely to be heavy users of the brand anyway, and would be quite profitable in their own right. However, it can be possible that some low value customers are also strong supporters of the brand.

As an example, consider a retired person with limited income and therefore low value to a bank. But this customer might be so impressed with the customer service that he receives that he often refers his extended family and friends to open an account at the bank. Each year he might be responsible for introducing five new customers!

Obviously this customer is quite valuable to the bank and should be retained. But if the bank was to look at this customer on a pure accounting basis of funds in his account, then he would be classified as a low or negative profit customer.

Therefore, the role of WOM (and acquisition cost savings) in the customer lifetime value calculation is to ensure a more accurate view of the customer lifetime value based upon the customer’s full contribution.

Word-of-mouth Benefits for CLV

Word-of-mouth benefits when calculating customer lifetime value

Customers may also become more profitable over time as they become advocates the firm or brand. This means that they are willing to recommend and promote the brand to other consumers. This may happen on a face-to-face basis, or through social media, or through comments on comparison websites.

Essentially, the customers that engage in positive word-of-mouth and attract new customers to a brand are actually reducing the average acquisition cost of new customers. Let’s quickly look at an example to demonstrate this effect.

Example of word-of-mouth benefit in CLV

Assume a company normally spends $1 million per year to attract 10,000 new customers. In this case, the average customer acquisition cost is $100 ($1 million divided by 10,000 new customers).

However, assume the company also has a loyal customer base that collectively – through word-of-mouth – generates a further 2,500 new customers. In this case, the average customer acquisition cost becomes $1 million divided by 12,500 new customers, which now equals $80 per customer.

If the company wanted to attract the 12,500 new customers and had to rely upon its own promotional methods – without the support of word-of-mouth – would actually cost the company $1.25m. Therefore, as you can see, the word of mouth benefit in this example is around $250,000. Costs to the company have been reduced by this amount, while still generating the benefits of increased customer base. This obviously has the effect of increasing customer profitability.

Therefore, one of the considerations when calculating customer lifetime value – particularly on a customer segment basis – is to consider the impact of word-of-mouth benefits and the reduction in corresponding customer acquisition costs.

While this may require some analysis to identify, there is a significant risk if the word-of-mouth benefit is excluded from the customer lifetime value calculation. This is because you could have a customer segment (or individual customers) that provide a low profit contribution in terms of direct revenue, but are supporters of the brand and are strong contributors in terms of word-of-mouth behavior.