Explore Rice

7/15/2005 12:08:00 AM

Does it pay to reward customer loyalty? Only if you have rewards to spare

Half of the ten largest U.S. retailers -- including drug and grocery stores, mass merchandisers, hotels and airline companies -- offer "frequent customer" loyalty programs. A new university study provides the most realistic assessment yet of such programs and warns that they may be profitable only if companies use excess capacity to provide the rewards.

---------------------

Customer loyalty programs such as airlines' frequent flyer incentives are very popular among both consumers and retailers. Because of the common belief that loyal customers purchase more and pay premium prices, and the cost of selling to them is less than to the occasional buyer, companies believe loyalty programs are worth the investment. A new study by university researchers shows that  firms with excess production or service capacity are most likely to profit from customer loyalty programs.

"An example of excess capacity is an airline taking off with empty first-class seats," explains Siddharth Singh, an assistant professor of management at Rice's Jesse H. Jones Graduate School of Management and co-author of a study that explores the profitability and financing of customer loyalty programs in a competitive market.

"The airline could potentially use those seats as rewards for loyal economy class passengers, thus using existing resources to buy customer loyalty."

On the other hand, without the availability of spare capacity to absorb the cost of such rewards, Singh says, a company's customer loyalty program might not be profitable.

Using a game theoretic framework, Singh and his colleagues Dipak C. Jain at Northwestern University and Trichy V. Krishnan with the National University of Singapore analyze certain factors that prior studies have not considered when analyzing the profitability of these types of programs. The result is a more realistic picture of when and how companies can expect to profit from a customer loyalty reward program.

According to the researchers, the most important factor is a company's excess or spare capacity. In addition, they consider the expenses required to launch loyalty programs, such as IT and human resource personnel and one-time promotional expenses, and the ongoing costs of funding the loyalty rewards.

"Our analysis shows that a company's spare capacity is a major source for funding the loyalty reward cost, which is good for the firm," Singh explains, "because excess capacity is mostly a wasted resource, especially in a service firm."

The researchers also found that when a company has a higher space capacity to absorb loyalty rewards costs – costs which primarily pertain to the additional benefits given to loyal customers – its operating profits become larger and the company is able to charge a lower price.

"The ‘lowered' price enables the firm to still be attractive to customers who are not interested in the loyalty program, thus resulting in a profitable situation," Singh says.

A member of the Jones School since July 2003, Singh has also conducted empirical analyses of customer lifetime purchase behavior and profitability and product returns and has collaborated on studies involving the impact of survey participation on short- and long-term customer behavior.

Singh received his Ph.D. degree from Northwestern University, his master's in business administration from the University of Illinois and an undergraduate degree in technology from Banaras Hindu University.

For more information on this research, contact Singh at sssingh@rice.edu or Debra Thomas in the Jones School at dthomas@rice.edu.