Customer Referral Management: Optimal Reward Programs

Sellers who plan to capitalize on the lifetime value of customers need to manage the sales potential from customer referrals proactively. To encourage existing customers to generate referrals, a seller can offer exceptional value to current customers through either excellent quality or a very attractive price. Rewards to customers for referring other customers can also encourage referrals. We investigate when referral rewards should be offered to motivate referrals, and derive the optimal combination of reward and price that will lead to the most profitable referrals. We define a delighted customer as one who obtains a positive level of surplus above a threshold level, and consequently recommends the product to another customer. We show that the use of referral rewards depends on how demanding consumers are before they are willing to recommend (i.e., on the delight threshold level). The optimal mix of price and referral reward falls into three regions: 1. When customers are easy to delight, the optimal strategy is to lower the price below that of a seller who ignores the referral effect, but not to offer rewards. 2. In an intermediate level of customer delight threshold, a seller should use a reward to complement a low-price strategy. As the delight threshold gets higher in this region, price should be higher and the rewards should be raised. 3. When the delight threshold is even higher, the seller should forsake the referral strategy all together. No rewards should be given, and price reverts back to that