Loyalty Programs Can Be a Waste of Money
STANFORD GRADUATE SCHOOL OF BUSINESS—Loyalty or reward programs like frequent flyer plans or buy-ten-get-one-free cards have been touted as powerful tools for increasing company profits. But recent research at Stanford Graduate School of Business suggests that in fact such programs have limited effectiveness—and sometimes end up just costing organizations money.
"The question is, do reward programs get customers to buy more often after they have accumulated a lot of credits toward the reward," says Brian Viard of Cheung Kong Graduate School of Business. Analyzing data from a reward program offered by a southern California golf course, he and Wesley Hartmann, assistant professor of marketing, found that the lure of getting one round of golf free for every ten played only motivated a small fraction of customers to play more frequently when they were about to earn a reward—and these were infrequent players. The heaviest golf users—those responsible for the majority of the course's sales—did not change their playing frequency as they approached a reward.
Hartmann and Viard analyzed purchasing behavior over a year, noting how players timed their games when they were farther away and closer to obtaining the free 11th game. They also studied how often heavy users played who cycled through numerous rounds of 10, contrasting their behavior with that of others who rarely or never earned the reward.
"When the most frequent players got close to the reward, they didn't show any signs of hurrying up their last few games to get the free round, but rather just steadily plowed through the program," Viard said. Added Hartmann: "These people valued the reward. They played more. But no more, and no less, than if the course had just lowered the price by 10 percent." In other words, the reward program did not hook heavy players into using the course more often when they were about to earn a reward.
For infrequent players, however, the situation was a bit different. When such users eventually got close to earning the free round—in the seventh-, eighth-, and ninth-game range—they did indeed accelerate their playing to capture the prize more quickly. "By the time they were 80 percent of the way there, everything had changed for them," says Hartmann. "At that point they viewed the program as offering a substantial discount. They suddenly became more loyal to the firm to get the reward."
Triggering such changes in incentives and spending behavior is indeed what motivates many companies to implement reward programs. The work of Hartmann and Viard suggests, however, that reward programs only function in this way for infrequent buyers. For the golf program, the least frequent users accounted for less than 20 percent of the company's revenue. "The money you make from any incentive program from the low-user group will hardly offset the cost of providing free goods and services to the large user group," Viard says.
Extrapolating from their research, Hartmann and Viard posit that reward programs work as intended only if a firm's heavy buyers are also the most price-sensitive customers. "In the case of the golfers, the heavy users care the least about the discount, but get it anyway," says Hartmann. "A discount can be an attractive lure to the light users, but a frequent buyer program excludes many of them from it." A more successful reward program might be one that could segment out the penny pinchers. "A campus coffee shop might make more money with a program that offers one free coffee for every ten to students with an ID only, but not to faculty or staff," suggests Viard. "Students, who are more price conscious, might make the effort to stick with that coffee shop instead of going to another."
Are frequent flyer programs, then, a waste of airlines' time—and money? Not necessarily, say the researchers. Although the greatest beneficiaries, again, are the haves—those either with enough income to fly a good deal to begin with, or whose companies pay for their tickets—other factors operate to make such programs worthwhile for their sponsors. Business travelers whose companies pay for their airfare may tend to stick with one airline rather than shop around for cheaper tickets because of the frequent flyer miles that kick back to them.
The work of Hartmann and Viard contradicts the perspectives of many economists and psychologists who have studied the reward program phenomenon. They argue that most researchers have failed to realize how the frequent customers, who often represent up to 80 percent of sales, respond to reward programs. "Up to this point, economists have not measured the effects of these programs on actual customers' decisions, and psychology studies have focused mainly on simulated experiments that cannot reflect how heavy buyers behave when experiencing their second, third, and fourth spells in a reward program," says Viard.
If their results indeed prove to be broadly applicable to a wide variety of settings besides golf courses, as Hartmann and Viard believe they will, firms may want to consider putting the money they're setting aside to print buy-ten get-one-free cards to better use.
"Do Frequency Reward Programs Create Switching Costs?" Wesley R. Hartmann and V. Brian Viard, Stanford Working Paper #1941
Information Rules: A Strategic Guide to the Network Economy, Carl Shapiro and Hal R. Varian, Chapters 5 and, Harvard Business School Press, 1998.
"Repeat-Buyer Programs in Network Industries," Severin Borenstein, inNetworks, Infrastructure, and the New Task for Regulation, The University of Michigan Press, 1998.
"Moral Hazard and Customer Loyalty Programs," Matthew T. Clements, Thomas W. Ross and Leonardo J. Basso, 2006 PDF