Leveraging the Loyalty Margin: Rewards Programs That Work

Leveraging the Loyalty Margin: Rewards Programs That Work

          
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Leveraging the Loyalty Margin: Rewards Programs That Work

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    The Economics of Loyalty

    The value of a loyalty program can be determined using a formula developed by BCG that is based on the loyalty margin. Any program’s value is a function of the loyalty margin—the benefits that the program offers to customers relative to the cost of those benefits to the company—as well as the incremental share the program generates and the size of the program. (See Exhibit 1.) In our experience, the design of a program, including even minute details, can have a substantial impact on the size of each of the three factors: loyalty margin, incremental share, and program size.

    exhibit

    Loyalty Margin. The loyalty margin is a function of how much of a particular kind of product or service a company gives away and how fast it does so. This calculation is the foundation of every loyalty program: it determines the program’s attractiveness, its underlying economics, and its degree of flexibility—the ability to tailor the program to various user groups. Loyalty programs originated in the travel industry because airlines and hotels have high-value, perishable assets—airline seats and hotel rooms—that they can give away at little or no incremental cost. (A “free” hotel room costs the hotel only the expense of cleaning the room—in a hotel that is not sold out. But to the customer it can be worth several hundred dollars.) Travel companies have high loyalty margins. However, if a retailer gives a price discount, the loyalty margin is narrow to nonexistent. The company invests 5 percent of revenues, for example, in a 5 percent price cut, and the customer values that reward at—you guessed it—5 percent. In this instance, the fact that the loyalty proposition and the reward are totally transparent actually undermines the company’s ability to expand its margin and leverage its loyalty economics. In fact, by giving what is in effect a discount, the company has set a new price for the product or service—a move that competitors can easily copy.

    For this reason, many programs use points and recognition systems that set varying speeds at which customers can earn and redeem rewards. Points provide several attractive benefits for companies, including the ability to pace how quickly customers reach reward levels, the luxury of a floating currency that the company controls, and a simple means for expanding the number of reward mechanisms. Points are particularly helpful in sectors in which the loyalty returns are low, the result of companies giving away tangible goods with real costs. Companies can use a variety of components—points, reward tiers, and non-dollar-based rewards, for example, some of which have bigger costs than others—to manipulate the loyalty margin. Loyalty programs also provide mechanisms for low- or no-cost gestures of recognition, such as tiers and in-store benefits, which customers appreciate and respond to positively. A coffee shop can, for example, greet its best customers by name and give them access to new products that add little to the shop’s costs.

    Incremental Share. Incremental share also determines a program’s economics. If a program gives away rewards but fails to cause customers to spend more, it becomes no more than a recurring marketing cost—and not a very effective one at that. For a loyalty program to be profitable, customers must contribute more in incremental-margin dollars than the company invests in funding the program.

    The most profitable programs invest more in their customers who spend more. This is the basis for tiered rewards programs, which seek to increase spending and incremental share by laying out what the company will do for those who meet climbing expenditure thresholds. The targets and qualifying time (usually a quarter or a year) are defined in advance, and customers are given progressively more valuable rewards as they reach each spending target. If a tiered program is designed correctly, it drives significant incremental share with a company’s most loyal customers. In many cases, the added benefits—for example, seat upgrades on a plane or the ability to choose one’s own hotel room—have a high loyalty margin because they are inexpensive to provide. Getting the balance right is critical for success—and profitability. If a company gives away too little, customers won’t spend more. If it gives away too much, costs will exceed the value of incremental share.

    Program Size. That program size determines how much profit the program contributes is a straightforward but critical point. When a company is establishing a new program, it cannot yet know what the optimal loyalty margin will be or what incremental share it can achieve. The company should start small enough to limit the downside and minimize the impact of early design mistakes, including a trial period during which it can iron out the economics before scaling up. The program must have enough critical mass, however, particularly on the reward side, to attract members. Additionally, the company will need to grow the program sufficiently to get a good handle on the fixed costs. Once a program proves its profitability, generating a sustainable loyalty margin and a healthy incremental share, the goal should be to increase its size and attract a larger portion of the company’s customer base to contribute greater profitability and tie customers more closely to the company. Growing too slowly can undermine a program’s impact, but if a company is going to make a mistake on speed, it’s better to go too slow than too fast: once a program is established, pulling back can be painful.

    The loyalty margin equation plays out differently in different categories. Margin is driven by the costs of a company’s underlying products, while incremental share and program size are functions of consumers’ interest in and engagement with the category. It is easier to make programs economically viable in big-ticket, relatively high-frequency categories, but all kinds of companies are becoming more sophisticated in program design, including those that are demonstrating that carefully constructed loyalty programs can work in small-ticket categories as well.