Companies have several ways of acquiring new customers. One approach is to open a shop or place a sales executive where they know that customers are likely to be. Another approach is to invest in advertising, telling customers about the product and where they may find it. Yet another approach is to incentivise existing customers to recruit new ones, through a referral programme. For instance, some Universities give a cash prize to MBA alumni that recommend new students for their MBA programmes; or health clubs may offer personal training sessions to current members who recruit new ones.
Referral programmes tend to deliver very good results. First, they can be relatively inexpensive and, as the cost is incurred only if / when the new customer converts, they can be very cost-effective, too. Second, these programmes can help understand current levels and pockets of (dis)satisfaction among existing customers. After all, customers who are unhappy with the service provided are unlikely to recommend it to their friends. Third, referral programmes tend to attract customers that spend more, are cheaper to serve and stay longer than non-referred customers. In a study of German bank customers, researchers found that customers acquired via referral programmes represented a lifetime value for the firm 16% to 25% higher than the average.
But why is it that referral programmes tend to attract customers with better contribution margins (i.e., spend more and cost less to serve) and lower churn (i.e., stay longer) than non-referred customers?
Researchers Christopher Van Den Bulte, Emmanuel Bayer, Bernd Skiera and Philipp Schmitt investigated this question, by analysing the profiles of the customers of a German bank. They studied 1,800 customers who had been acquired via referral programmes, the customers that had referred them, and 3,663 customers who had been acquired during the same period by other means. The results from that investigation were reported in the paper entitled “How customer referral programs turn social capital into economic capital” which was published in the Journal of Marketing Research.
According to the authors, there are two main reasons or mechanisms that explain the high contribution and low churn of referred customers: matching and social enrichment.
Matching refers to the fit between the customer’s needs and the firm’s offerings. According to Van Den Bulte, Bayer, Skiera and Schmitt, existing customers tend to refer others who they think would be well served by the company’s offer. They know both the firm’s offering and their friends’ needs and preferences (e.g., risk aversion, preference for 24 hours’ service…), so they filter out those acquaintances who are not a good fit, and recommend only those that are likely to appreciate the firm’s offerings.
Because of these, the referred customers are likely to buy more, be less price sensitive and require fewer servicing costs (e.g., fewer instructions, fewer product adaptations, etc…) than new customers acquired via other means. They are also more likely to be satisfied with the firm’s offer, and, therefore, are likely to continue transacting with the firm for longer.
Social enrichment refers to the value added to the relationship between the new customer and the firm, by the fact that the referrer is also a customer of the firm. New customers gain emotional benefits (e.g., higher trust in the brand) when others in their social network are also customers of the brand. New customers can also gain functional benefits (e.g., information about pros and cons, or how to get the most from the product) through their social networks.
As with matching, the social enrichment arising from referral programmes leads to customers who are willing to spend more, need less support, and are likely to stay longer, than others.
Whilst referral programmes can lead to very significant benefits for the firm, through the matching and social enrichment mechanisms, they can also have downsides.
Specifically, Van Den Bulte and his colleagues found that when the referring customer stopped buying (i.e., churned), the referred one was likely to follow suit, and leave the company, too. This observation led the authors to caution that customer retention initiatives are doubly important for firms that rely on referral programmes: retention is important directly, in terms of that specific customer’s contribution to the firm; and retention is important indirectly, in terms of that specific customer’s impact on the others that s/he had previously introduced to the company.
To this note of caution, I would add that firms want to make sure that the referring incentive is big enough to motivate existing customers to acquire new ones, but not so big that they become a goal in itself. After all, we want our customers to be mostly motivated by helping their friends (vs gaining some large prize), so that they focus on the strong ties in their networks – i.e., those contacts in their network that are mostly like them (to maximise the matching effect), and who feel connected to them (to maximise the social enrichment effect).
Did you follow a friend’s recommendation that backfired?