Optimizing Incentive Structures for Referral Programs

An Ambassador eBookOptimizing Incentive Structures for Referral Programs

eBook Title Table of Contents ContentsIntroduction........................................................................... 3Chapter 1: Determining the Optimal Incentive Cost... 5Chapter 2: Choosing Your Incentive Structure...........14Incentive Structure Decision Tree.................................22Conclusion..........................................................................23 Page 2

Optimizing Incentive Structures Introductionfor Referral ProgramsIntroductionRunning an incentive program to reward yourambassadors for referrals is a time-tested method ofdramatically increasing WOM success. The refer/rewardstructure taps into an innate desire to help others.People already like to give referrals, but they absolutelylove being rewarded for it. Such programs present a lot ofroom for creativity in the structure, cost and developmentof the referral incentives. Page 3

Optimizing Incentive Structures Introductionfor Referral ProgramsIncentives can run across a broad spectrum incorporatingboth monetary and non-monetary offers. With so manyoptions, though, finding the right incentive can be difficult.Businesses must assess a number of financial anddemographic components to ensure they are getting themost from their program.In this eBook, you’ll learn how to optimize your incentivestructure to improve your business’ WOM marketingexponentially. Page 4

Optimizing Incentive Structures Chapter 1: Determining thefor Referral Programs Optimal Incentive CostChapter 1: Determining theOptimal Incentive CostThe first step in setting up your incentive structure isdetermining how much it will cost you. In order to properlyset the cost of your incentive you should consider:The incentive should be enough to interest yourcustomers to participate.The incentive should not erase the profit of the newrevenue generated. Page 5

Optimizing Incentive Structures Chapter 1: Determining thefor Referral Programs Optimal Incentive CostA good first step is to investigate the Customer LifetimeValue (CLV) and compare that with you CustomerAcquisition Cost (CAC). Warning: It’s going to get a littlemathematical. But we’ll put everything into easy tounderstand terms and language.Calculating the true CLV and CAC can becomeabsurdly complex and relies on a number of academicstudies (I tried to read them, I don’t recommend it).And while aggregating statistical data on each componentof CLV is scientifically sound, don’t worry if you have toapply experience or broad estimates. You’ll still get a solidunderstanding of your customers and won’t have to earn aMasters in Economic Theory.Analyzing your CLV before starting your program is quick,relatively simple and extremely important for thesustainability of your referral marketing program.A few definitions to get us started:Customer Lifetime Value (CLV): The amount of economicvalue a customer brings over their “lifetime” of sales with Page 6

Optimizing Incentive Structures Chapter 1: Determining thefor Referral Programs Optimal Incentive Costyour business.Customer Acquisition Cost (CAC): The monetary cost ofacquiring said customer.These two concepts are extremely important forbusinesses who are looking to get a good ROI on theirmarketing investment (read: every business). Say your CACis $30, but your CLV is only $20. Your losing $10 for everynew customer, not a sustainable situation in the least bit.That’s just common sense.Now let’s dive into it.First, you’re going to want to calculate the marginalprofit on the average sale your business makes. This ispretty simple for most businesses so let’s use a typicalbusiness, say a coffee shop, to illustrate (Note: Thesenumbers are all hypothetical).Say your average coffee shop customer spends about$4.35 on a latte. But like in any business there are hiddencosts associated with that latte (milk, cups, coffee, etc). Page 7

Optimizing Incentive Structures Chapter 1: Determining thefor Referral Programs Optimal Incentive CostIf those costs are $1.00, then the coffee shop is onlymaking $3.35 on the sale. That’s their marginal profit.Obviously every business has different cost structuresassociated with it, but this should prove a good example inillustrating the concept.Moving on. The next step to understand CLV is tocalculate the actual lifetime of your customer (CL). Thisnumber is important for understanding the amount oftotal profits brought in by one customer (hopefully they’llbe making multiple purchases).Your first step is calculating Customer Retention Rate (CR).This one’s easy, just take the total number of customersyou had last month/year/whatever who are still customerstoday and divide. Equation: Marginal Profit = Revenue - CostsThe attrition rate is the percentage of customers that leavein a give time period (month, year, etc).So if you have 100 customers last year and 80 are stillengaged with your brand, CR = (1 – 0.2) = 80%. It gets a Page 8

Optimizing Incentive Structures Chapter 1: Determining thefor Referral Programs Optimal Incentive Costlittle more complicated in the upper echelons of academia,but in an effort to cause as few headaches as possible we’lljust say that’s an adequate assessment.Once you have your CR it’s easy to calculate CL:CL = 1/(1-CR)In our example, CL = 1/(1-.80) = 5 years.That’s a great CL so don’t worry if your number comes outa little lower. Also take into account that this number mayfluctuate based on whether or not your business offers asubscription service.Next we need to tackle the Cost Per Acquisition (CPA) orthe cost of acquiring one new customer. Luckily running anincentive driven WOM program makes this really simple. It’sjust the amount your are willing to pay for your referralincentives. So your customer receives $5 from eachreferral that successfully converts to a sale. Your CPA is $5.That’s pretty much it.If you’re currently running a traditional marketing program, Page 9

Optimizing Incentive Structures Chapter 1: Determining thefor Referral Programs Optimal Incentive Costyou can aggregate the total amount spent and see whereyou’re marketing budget is at. This will be important whendetermining how large of an incentive you are in a positionto offer.In summary:CLV = (Marginal Profit * CL) * CRPlugging in our earlier numbers...CLV = (3.35 * 5) * 0.8 = $13.40 Equation: CR = (1 - Attrition Rate) Page 10

Optimizing Incentive Structures Chapter 1: Determining thefor Referral Programs Optimal Incentive CostThis means that your average customer spends $13.40over their lifetime with your business. To set an profitablemonetary incentive, you need to ensure that it does notcost more than $13.40 per new customer. Or, CLV > CPA,preferably by a large margin.Now, there are a lot of other metrics to take into accountwith referral marketing specifically. Mainly the Value of aReferral (VR).This metric takes into account the subsequent salesgenerated by the referral, or the compounding effect thatone brand ambassador can have on sales. This is a helpfulmetric for analyzing the success of your program as moredata comes in.To determine your Value of Referral, you’re going to usethe following equation:(% of new customers coming via referral * # of newcustomers * CVL)# of referrals made Page 11

Optimizing Incentive Structures Chapter 1: Determining thefor Referral Programs Optimal Incentive CostMost businesses estimate the “percentage of newreferral customers” and “number of referrals made” usingsurveys of new customer acquisitions. But again, thisequation won’t really be valuable until your program is upand running.Once you are up and running however, you canincorporate VR into your equation for CVL. This will giveyou an accurate assessment of the total value of one brandambassador.On the next page you’ll find a helpful worksheet to helpyou keep track of all of the numerical data while planningfor your program. Page 12

Optimizing Incentive Structures Chapter 1: Determining thefor Referral Programs Optimal Incentive CostDetermining the Cost of Incentive WorksheetValues:Marginal Profit = _________Attrition Rate = _________Cost per Acquisition (total) = _________Cost per Acquisition (incentive) = _________Equations:Marginal Profit = ______ (revenue) - ______ (cost)Customer Retention = 1 - ____ (attrition rate)Customer Lifetime = 1 / (1 - _______ (CR))Customer Lifetime Value = _______ (marginal profit) * ____ (CL) * ____ (CR)Is CLV > CPA (incentive)? __________One final note. It’s always helpful to assess what yourcompetitors are doing to develop an effective, competitiveprogram. If you find that your competitors are runningoffers that do not meet the restrictions imposed on yourbusiness, look into a non-monetary incentive explained inthe next section. Page 13

Optimizing Incentive Structures Chapter 2: Choosing Yourfor Referral Programs Incentive StructureChapter 2: Choosing YourIncentive StructureNow that we’ve determined the financial equationssurrounding incentives, the next question to ask is whatincentive structure will effectively generate the mostreferrals?There are a number of considerations to take into accountbefore determining which structure and reward will workbest for your business. Taking the time to fully analyzeyour customer base will help immensely with the successof your program. What does it take to What does it take to What does it take to convince your incentivize the get a customer to customer that potential customer promote your they’re giving a to act on their product? good exclusive deal friend’s to their network? recommendation? Determining primary Determining secondary incentive incentive Page 14

Optimizing Incentive Structures Chapter 2: Choosing Yourfor Referral Programs Incentive StructureTo start off, here’s a good guide to keep in mind as wecontinue through the chapter:Evaluating the StructureFirst, you must take into account the structure of thereferral program that you will run as there are manydifferent options out there. Bear with me, because its goingto be a little academic for a bit.A study conducted in 2011 by the University of Pittsburghand Korea University identified two types of structures,each with their own benefits and costs based on thelikelihood to refer.Single Incentive: A single incentive structure only rewardsthe original referrer for the new sale generated as a resultof their activity.Dual Incentive: A dual incentive structure rewards both thereferrer and the new customer.The study analyzed two levels of brands. Strong brandswere defined as brands that were well-established and had Page 15

Optimizing Incentive Structures Chapter 2: Choosing Yourfor Referral Programs Incentive Structurea high level of brand awareness. Weak brands weredefined as less-established brands with low-brandawareness.Taking a look at the condensed chart provided by theresearchers gives us a lot of good insight on how to besttarget customers based on business models:Notice that for weak brands, referral likelihood increasedby a large margin when rewards were introduced in bothsingle and dual incentive structures, although the singleincentive preformed marginally better.As explained in the study, costumers care more about the A Penny for Your Thoughts: Referral Reward Programs and Referral Likelihood, Journal of Marke.ng, 2007 Page 16

Optimizing Incentive Structures Chapter 2: Choosing Yourfor Referral Programs Incentive Structurevalue of the reward when they are more sensitive to price.In situations where price is an important factor or whencustomers are not familiar with your brand, that will beattracted more towards high-value rewards programs.Generally, running a high-value rewards program can becostly in a dual-incentive structure so for weak brands asingle-incentive structure makes more sense.For strong brands, the dual incentive structure workedsignificantly better. The researchers attributed this to aprevious likelihood to refer based on an already existingrelationship and trust with the brand.Customers who are familiar with the brand and productsare less attentive to price (they had already determined thecost was worth it) so a larger reward had less of an impactthan the opportunity to share with friends.But how does this relate to your business’ rewardstructure? For a smaller brand, a single incentive structurewith higher value proves more effective than a dualincentive structure in with both participants receive less ofa reward. Based on these results, it is more effective forrewards to be skewed in favor of the original referrer forsmaller brands. Page 17

Optimizing Incentive Structures Chapter 2: Choosing Yourfor Referral Programs Incentive StructureFor a strong, established brand a dual incentive structureworks better as a result of existing customers having anestablished relationship with the brand that deters pricesensitivity; meaning that new customers should be targetedand rewarded more than existing customers.This data actually proves beneficial for less-establishedbrands as a single incentive structure is inherentlycheaper than dual incentive (you are only rewarding oneperson, not two), allowing the business to give biggerrewards to increase referral likelihood.Both types of brands should take into account the benefitsof an escalating reward structure, where-in referrers arerewarded more for each subsequent referral they loop in.This is based on the assumption that recommendations toclose friends and family would have occurred anyway soit’s important to keep ambassadors engaged. In this case,the structure should be geared towards rewarding referrals Page 18

Optimizing Incentive Structures Chapter 2: Choosing Yourfor Referral Programs Incentive Structureto casual acquaintances.Type of RewardAfter you determine your reward structure, it’s time toconsider what type of reward you’ll be offering your brandambassadors. These rewards generally fall into twocategories:Monetary incentives: Essentially a finders fee, monetaryrewards tend to be successful at generating referrals andare easily quantifiable. These incentives can include cash,rebates/discounts, gift cards, commissions or other morecreative offers.Benefits: Monetary incentives are beneficial in a number ofways. It’s extremely easy to calculate your CustomerAcquisition Cost (CAC), or the total cost of acquiring onenew customer (more on that later). If you already have ahigh CAC, a monetary incentive may not be the way to go.It can also simplify things when analyzing the effectivenessof your program as you’ll have a baseline numerical valueto use.Costs: By offering commissions or cash you run the risk of Page 19

Optimizing Incentive Structures Chapter 2: Choosing Yourfor Referral Programs Incentive Structurethe customer taking their rewards to another business. Likeall social systems, there’s an implicit moral hazardassociated with referral campaigns that may detractbusinesses from simply offering cash. A gift-card, rebate orstore credit will ensure more sales down the road and arerelatively easy to track. You do run the risk of losingexcitement with your ambassadors though as they acquiremore and more credit whereas cash never goes out ofstyle.Non-monetary: These are less transparent rewards that canstill be used to excite new brand ambassadors. They mayinclude access to products before non-ambassadors,public recognition (in an email shout-out, tweet, etc) orinformation before new product releases.Benefits: Non-monetary rewards allow you to “shield yourhand,” so to speak. Because there is not tangible valueattached to the incentive you can theoretically offersomething at next to nothing and still reap the benefits ofreferrals.Costs: It takes a very strong level of brand engagement ora novel, exciting product to make these types of incentiveseffective. After all, if no one is familiar with your business Page 20

Optimizing Incentive Structures Chapter 2: Choosing Yourfor Referral Programs Incentive Structureit’s difficult to convince customers about the true value ofyour offer.If your find that your LTV < CAC in the case of a monetaryincentive, a non-monetary incentive can help alleviate thecosts of payouts.As a general rule of thumb:Your incentives should be always be tailored to your targetadvocates (your customers), should be profitable for yourbusiness, and encourage engagement with your brand. Page 21

Optimizing Incentive Structures Chapter 2: Choosing Yourfor Referral Programs Incentive StructureIncentive Structure Decision TreeWhen going ahead and planning your campaign, use thistree to determine what type of program would be mosteffective for your business. Note: This is only meant to bea guide and should in no way limit your decision. In theend, your program will only be as effective as the effortand drive you put into it. Level of brand awareness Strong Weak High CAC Low CAC High CAC Low CAC CLV < CAC CLV > CAC CLV < CAC CLV > CAC Dual Incentive, Dual Incentive, Single Incentive, Single Incentive, Non-Monetary Monetary Non-Monetary Monetary Page 22

Optimizing Incentive Structures Conclusionfor Referral ProgramsConclusionRunning an effective incentiveprogram can be one of the mosteffective strategies towards building acoalition of passionate supporters andbrand ambassadors. But without theright incentive structure in place, youmay be losing out on an fullyoptimized ambassador programThis is only meant to be a guide andshould in no way limit your decision.In the end, your program will only beas effective as the amount of care andattention you give your customers.Take into account survey data,competitor’s behavior and your owninstincts and experience whendeveloping your program. With theright attitude and commitment you,and your customers, will start seeingreal and lasting rewards. Page 23

Optimizing Incentive Structures Conclusionfor Referral ProgramsAmbassador enables any company to easily track,manage & reward their advocates for referring customersand driving conversions. Receive actionablechannel-specific metrics; including shares, clicks,conversions, revenue and clicks per share. Ambassadorcan be fully integrated into your website, maintaining yourlook & feel while providing a frictionless experience foryour advocates. Page 24

Optimizing Incentive Structures for Referral Programs

by Ambassador on Aug 29, 2012

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