Here’s Why Reward ProgramsWork for Retailers

Rewards programs are popular among retailers for a reason: They work.

While detractors once labeled them cheap promotional devices and a marketing fad, rewards programs – which have roots going back at least as far as 1896 with the S&H Green Stamps program – have a proven track record for building customer loyalty. And since it costs more to win new customers than retain existing ones (5% to 25% more, depending on the industry), repeat customers are inherently valuable. One study by Frederick Reichheld of Bain & Company found that increasing customer retention by 5% resulted in profit growth of 25% to 95%.

The popularity of rewards programs took off in the 1980s following the deregulation of the airline industry, and they now are also common across many other sectors – restaurants, hotels, rental car companies, and most major retailers. They come at a cost to the businesses that offer them, so it begs a question: How do such programs translate into profits?

In a recent article for Decision Sciences, researchers Monire Jalili and Michael S. Pangburn found some distinct benefits of retail rewards programs over alternatives that offer immediate discounts. Most notable is that the rewards programs with delayed discounts affect shopper behavior in ways that can yield greater-than-expected profits for the business.

Retail rewards programs – or loyalty programs, as they are often called – operate on a common structure that offers customers a future benefit based on their current spending. For instance, a customer who makes a $50 purchase might earn a 10% reward – or $5 – toward a future purchase. In some cases, the rewards come as points that are translated to dollars in batches (e.g., $10 in credit for every 1,000 points earned).

A salient characteristic of rewards programs is that they typically apply across time and products. A traditional sale discount, by contrast, applies to a specific product in a particular week. So, while some rewards programs have usage restrictions, others allow customers to use their rewards whenever they want. This means the programs need to be robust enough to perform well across distinct products, periods, and customers.

Some retailers offer reward discounts that customers can apply immediately, such as Target’s REDcard program, which provides an immediate 5% discount off any purchase; and Bed Bath & Beyond’s recent Beyond+ program, which provides a 20% instant discount. Still, the delayed-discount promotion structure is quite common. A 2019 review of the best customer rewards programs by DealNews.com found that 15 of the 53 featured programs used a future credit-based rewards approach.

The advantage of a delayed discount over an immediate price reduction might at first seem nonexistent, since a 10% discount saves the shopper 10% whether it’s used immediately or three months later. The only difference for the customer (or the retailer) is the timing of the purchase. But if the delayed discount of a rewards program impacts customers’ decisions to buy more products, more expensive products, or to shop more often than they would with immediate discounts, then the retailer stands to increase its profits.

In other words, to properly assess the effect of earned credit, you must consider its potential impact on consumers’ purchasing behavior. If consumer behavior changes based on the availability of an earned reward, then that impact goes beyond the simple matter of translating discounts in time.

To better understand the true benefits of delayed discounts over immediate discounts, the researchers established a variety of parameters and analyzed an example retailer selling two distinct and differently priced products to diverse customers. They assumed that customers could seamlessly (costlessly) apply rewards at checkout, and would view those rewards rationally – neither under- or over-assessing the value of credit, nor forgetting to use it. And, they explored the segmentation power of delayed discounts by doing a computational study using a set of 1,000 randomly generated problems.

Without delayed discounts, the researchers found that consumers’ resulting behaviors yielded two distinct segments: “heavy shoppers” who would purchase regularly from the firm (consumers of both lower and higher priced products), and “light shoppers” who would shop only sporadically for lower-priced products. In contrast, with delayed discounts, the researchers found that a third consumer segment emerges: “rewards shoppers.” These are customers who, when holding credit from a past purchase, are incentivized to buy a product they would not otherwise purchase.

The researchers found that multiple forms of rewards-shopping behaviors can emerge for consumers with delayed discounts. Customers who place a moderate value on the product they are considering for purchase, for instance, will spend more after earning credit from a prior purchase.

The researchers also found that the seller achieves profits from delayed rewards by stimulating additional shopping behaviors that result in more varied customer segmentation.

An interesting aspect of delaying rewards is that consumers then experience a variety of net prices.  Consider distinct products a customer buys for $20 and $40, respectively, and a seller with a rewards program offering 10% delay credit.  Assuming a customer’s consecutive purchases were for a $20 product, a $20 product, a $40 product, a $40 product, and then a $20 product, the net prices they would face at checkout would be $20, $18, $38, $36, and $16.

This expansion in the number of net-price states results in an increase in the number of rational consumer shopping behaviors. But the potential profit benefit from such a delay vanishes if consumers demand the same product over time or if cash-flow time discounting is inconsequential.

Ultimately, the profits gained from delayed rewards (relative to immediate discounts) are quite robust, and this held true in a variety of settings tested by the researchers. They found that the profit-increasing potential of delayed discounts stems from their ability to stimulate a larger number of coexisting shopping behaviors, thus yielding a more stratified segmentation of consumers and that sellers should increase the discount levels when adopting delayed rewards rather than instantaneous ones.

Citation:  Jalili, M. and Pangburn, M.S. (2021). Understanding the value of delayed discounts in retail rewards programs. Decision Sciences 52(4), 952-985. https://doi.org/10.1111/deci.12474