Rafi Mohammed

Loyalty Programs Can be Bad for Business

Posted on June 12th, 2012 (0 Comments)

Reprinted from the Harvard Business Review website.

My mother, a careful shopper, rarely misses a chance to use loyalty cards at her favorite establishments. Several years ago, as a checkout clerk was stamping her Subway Sub Card club (buy 8 six-inch subs, get the ninth one free), I asked her: "Does this loyalty club make you patronize Subway more often?" After a moment of reflection, my mother responded with a knowing smile: "No, but it is nice of them to offer it."

In my work with companies on pricing strategies, it's common for executives to feel compelled to offer loyal customers something for free. My immediate question is: "Why?" Giving something away for free as a gesture of thanks has become almost reflexive in business. But when you examine the strategic value and underlying costs of these programs, I've found that loyalty discounts are rarely necessary to close a deal, nor are they always highly valued by customers.

Of course, you should always say "thank you" to customers. But "free" can be more expensive than most think. Small discounts may seem innocuous, but they come straight off the bottom line. Consider a company with a 10% operating margin: A typical $100 sale transaction breaks down to $90 in costs and $10 in profit. A 5% loyalty discount — $5 off a $100 sale — results in a 50% decrease in profits. The costs remain the same, but instead of earning $10 from the sale, profit is reduced to $5. What appears to be a small discount — in this case, 5%, — can significantly impact profits. It's important to share with your front-line workers how costly these discounts can be to the company's bottom line.

While I'm generally not a fan of loyalty discounts, there are select instances when they make sense:

1. Everyone else is offering them. Can you imagine an airline abandoning its frequent flyer program? It would lead to a real competitive disadvantage. If your competition has loyalty programs, you probably have to also.

2. The free benefit is an "extra," not a substitution. If Subway customers would have paid for their "free" sub, this is lost revenue. One way to avoid this "substitution effect" is to set time limits in a manner that incents more purchases. For instance, suppose customers typically patronize Subway six times over 2 months. If imposing a two month time limit to collect the requisite eight stamps motivates more visits, the promotion will likely be profitable. Similarly, instead of offering an entree to a regular "on the house," grateful restaurateurs can provide something that the diner would otherwise not order (drink, dessert, sample of a new entrée, etc.). Comping an "extra" avoids the revenue loss from the substitution effect.

3. Products or services with little differentiation. A loyalty program can be an important deciding factor if rivals sell similar products or services.

The next time you are about to give something away for free, stop and ask yourself, "Do I really need to?" Loyalty discounts, in many cases, are akin to throwing away money. There are many cheaper ways - which customers may appreciate more than discounts - to show gratitude. Following the fundamental adage of "under-promise and over-deliver" can inspire more loyalty than a small discount, for instance.

So what do you think? Am I being too scrooge-like in advocating restraint with loyalty discounts? What other ways can you show gratitude to customers aside from discounts? I'd love to hear your thoughts.

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