Editor's note: for additional chart click the PDF below:
Some loyalty programs are designed and launched with only a passing relationship with profit. The end result is nearly always failure. How can you avoid this unfortunate result? By developing a financial model before launch, you can build an attrition benefit into your financial model.
When you're building a house, you can proceed one of two ways. You can carefully lay out your home's design on blueprint, consulting along the way with the architect, the carpenter, the electrician and the plumber to ensure that your finished home will be rock solid and built within your budget. Or, you can simply pour a foundation, start nailing boards together and hope for the best.
Loyalty programs are no different. The best way to build a successful program is to build a solid financial model to measure your projected return on investment before launch.
When projecting the ROI of a prospective program, your first step is to define and identify the program's financial benefits and costs. The difference between measuring the ROI of an existing loyalty program, versus that of a prospective one, is that you can readily identify the benefits of the former by comparing member behavior to that of a control group. To identify the financial benefits of the latter, you have to make assumptions.
Do these necessary assumptions make measuring the ROI of an existing program an exercise in futility? Absolutely not. In fact, if your company ever hopes to fully understand the financial impact of a loyalty program on your bottom line, then modeling the ROI before launch is essential. So where do you start?
All loyalty programs should provide a few direct, tangible benefits. Which of these benefits becomes reality will depend on the program's structure, the nature of your industry and even the state of your brand. In general, a loyalty program provides three core benefits: an increase in customer retention or an attrition benefit; an increase in the amount your customers spend or the lift benefit; and an increase in the rate at which your company attracts new customers or the acquisition benefit.
If you hear a lot of companies talking about the importance of customer retention, it's because they have good reason. Competition in most industries is brutal. Customers are promiscuous. Couple these trends with the old but true saw that it costs more to acquire a customer than it does to retain one, and focusing your marketing efforts on existing customers makes sound business sense. Customer loyalty programs have a proven track record of stemming attrition through the targeted application of tangible rewards, coupons, rebates or special treatment and recognition. The more attractive and relevant your value proposition appears to your customers, the less likely they are to defect to the competition.
In order to incorporate an attrition benefit into an ROI study, you'll need to make a few key assumptions. As you build the study, ask yourself these questions?
How likely are my customers to attrite? A loyalty program will affect each of your customer segments differently. Some customers are more likely to defect than others. The attrition benefit of your program will be greater for a customer at high risk of defection and correspondingly smaller for one at lower risk. In other words, you can realize an attrition benefit from keeping a customer only if that customer would indeed have left you without the loyalty program. Understanding a customer's likelihood of attrition will help you predict the attrition benefit of your program with greater accuracy.
How does my value proposition affect attrition? Once you've estimated the likelihood of attrition for a given customer segment, then you can apply different attrition benefit estimates based on the attrition risk of that segment. For example, you might estimate a 15 percent decrease in attrition for customers in a low-risk segment compared to a 10 percent improvement in customers at high risk.
Here, you can apply a simple rule: the richer your value proposition, the greater your ability to reduce attrition. As an example, consider a simple cash-back program: you can safely assume that you'll see more improvement in attrition with a 2 percent cash back program than for 1 percent back. That doesn't, however, mean that to succeed a loyalty program has to wreck your profit margin. It's the program's perceived value that counts- airline miles, for example, have more perceived value than a simple discount. The more perceived value you can build into your program, the greater the attrition benefit you can achieve.
How can I translate reduced attrition into a financial benefit? As you're building your financial model, you'll need to make many educated guesses. One of the most important assumptions you'll make is to determine how many customers you'd have with the program in place, and how many you'd have without it. The difference between those two numbers tells you how many customers your program helps you retain. You can then estimate how much these customers spend with you over their lifetime and arrive at the estimated financial benefit of the reduced attrition. It's a simple concept, but you'd be surprised at how many programs are launched without making even these basic assumptions.
Once you've estimated the attrition benefit of your program, you may decide that your financial model is in pretty good shape. But there's a subtler aspect to attrition that many program managers overlook. To accurately reflect the attrition benefit, your model needs to account not only for the benefit derived from retaining your existing customers, but must also account for retaining new customers as well. After all, these customers, newly acquired over the life of your program, exhibit attrition behavior that presumably will also be deterred by your attractive value proposition.
In addition, unless there are mitigating factors in play, the attrition benefit typically should have a compounding effect. A customer retained thanks to your brilliant loyalty play will accrue financial benefit to you not only at the point of time where the attrition event would have occurred, but also into the future. If your company retains a customer today, the true benefit is the sum of what they spend today as well as what they spend in the days to come.
Table 1 demonstrates the compounding nature associated with the attrition benefit. Note that, without the loyalty program, the net customer growth rate is flat; in this example, the rate at which the company acquires new customers each year equals the rate at which customers are lost because of defection. A loyalty program allows the company to retain customers that they would otherwise have lost. This retention effect results in a positive net growth of customers over time. Furthermore, the number of customers retained increases year over year due to the compounding effect: customers retained in year 1 also may be retained in year 2, customers retained in year 2 may also be retained in year 3, and so on.
Of course, once you actually launch your program, you can soon measure the actual attrition benefit against your projections. By asking the same questions of your existing program that you asked of your model, you'll have the essential information necessary to conduct a worthwhile ROI study. In fact, you'll periodically evaluate your program's ROI to determine if it's meeting the financial returns that you forecasted before its launch.
It's the only way to determine if the program is achieving the impact you intended. If your original financial model was solid, then you'll be in business. Nothing is more satisfying, after all, than relaxing in a house you built yourself.
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