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.