Valuing Your "Free" Customers

Businesspeople understand that not all customers are created equal—the 80-20 rule suggests that over time a small percentage of a company's customer base can generate a high percentage of its sales and profit. Models for calculating customer lifetime value (CLV) are built on just such a premise.

However, new research is starting to look at customers whose value is not as readily apparent and where CLV calculations break down. In a recent working paper, Harvard Business School professor Sunil Gupta calls them "free" customers—think of buyers at an auction. Traditionally, auction houses make most of their profit from fees paid by sellers; buyers don't pay fees. So although buyers are a necessary ingredient to the deal—no buyers, no sellers—their value is more difficult to quantify. To the auction house, is one buyer worth four sellers? Is one buyer worth one seller? That answer is critical for the auction house, which must determine how to allocate marketing and other expenditures between buyers and sellers to attract new business.

Now consider a firm such as eBay that has two sets of customers—buyers and sellers. EBay generates almost all its profits from sellers through commissions and listing fees. Buyers do not provide any direct profit to the firm. However, without buyers, the firm would have no sellers and vice versa. This kind of situation, which is called a two-sided market, is common in many industries such as real estate and employment services. A traditional model of CLV will not be able to estimate the worth of a buyer. And, how about "indirect network effects" where more buyers potentially attract more sellers and vice versa?

Customer value changes over time. As a business owner you have to know that, in general, each individual customer value initially increases as the company grows and then later declines when the firm reaches a critical mass or maturity. And, you have to know that it is quite possible that some customers have low tangible value (i.e. they don't buy anything), but high intangible value (i.e. they promote your company/ talk about your products to others in a positive way/ use their influence to encourage others to buy). Traditional models would label such customers as low value and would miss a huge opportunity for a firm.