Loyalty Programs and The Selection Effect

My first real specialty in marketing was customer lifecycle management (CLM). That’s a fancy term for caring about the total profit you generate from a specific customer. That can mean everything from channel management (figuring out which sources of customers are more valuable for you than others) to cross-selling and upselling; From customer acquisition to customer retention. It was a pretty broad way to look at marketing – and a very analytic way. It was a nice base for the rest of my career, and I highly recommend it to students looking for an initial foray into marketing.

One sub-specialty within CLM that I spent a lot of time with was Loyalty Programs. Loyalty Programs have become very popular over the years. A big reason is that they are so visible. When a company has an excellent CRM system or distribution system or save desk it is basically invisible to the public and their competitors. But a Loyalty Program is obvious to everyone. When a CEO sees a competitor (or even a company in a different industry) with a Loyalty Program they will often ask their CMO: “Why don’t we have a Loyalty Program? I’ve heard that Loyalty is more important than customer acquisition, so shouldn’t we have one of those?”

When a CEO asks for something that involves spending more money on marketing, most CMOs say yes.

The result is more companies with Loyalty Programs – which causes more CEOs to ask, “Why don’t we have one of those?” It’s a flywheel.

A trend like that can get something started, but most businesses are pretty good at shutting things down if they aren’t working. Somehow Loyalty Programs have stuck around, and if anything become more prevalent (especially in travel and retail). And yet I argue that most of the time they are a bad idea (in retail – travel Loyalty Programs are generally done right). The reason is Selection Effect.

 

First: What do I mean by a Loyalty Program?

“Programs” that drive loyalty could mean many many things. Amazon Prime drives loyalty, but in general it is not considered a Loyalty Program (but maybe it should be). In general people mean one of two things when they call something a Loyalty Program:

  1. A program that gives you points when you spend at a company. Those points sit in your account and, after they accumulate, you can redeem them for product or merchandise  (usually the same company’s products, but often other companies as well)
  2. A tier-based program. Tier programs give customers defined benefits after they have performed specific activities in a set time period (usually something like a specific number of stays, number of miles traveled or dollars spent)

I will use a separate post to talk about the second type of Loyalty Program. For now let’s stick with the classic “earn and burn” points-based program.

There are definitely different varieties of points-based Loyalty Programs, some of which at first glance don’t look like point programs at all. The most common of these is the “Frequent Visit” stamp card. You’ve definitely seen these: Buy ten coffees, and your next one is on us. Another example (if you are as old as I am) were those Subway stamp “passports”. These examples are very different from the more a standard Marriott Rewards Points, but the principle is the same: Spend now to earn points (Marriot Points/”Coffee Points”), then later spend those points for stuff (Hotel stays, free coffee). The only difference is how many points you earn when you spend and how much those points are worth when you spend them.

 

What’s the value of a Loyalty Program?

It’s definitely not to drive Loyalty. Point based Loyalty Programs are effectively complicated discount programs. In exchange for being tracked (sometimes companies don’t even ask for that), a customer gets points today, that can be used for discounts tomorrow. The difference between paying $0.90 for a coffee and paying $1 for a coffee, with a 10-stamp loyalty card is almost the same – or for that matter a $1 coffee that earns you 10 points, with each point being worth 1-cent on future coffee purchases. Here are the differences:

  1. Breakage: Some percentage of people will not use the points you give them. Those un-used points are called “Breakage”. Depending on the design of the program breakage rates can vary from 0% to 80%. In the above example, if your program has 33% breakage (pretty common), you could give you 30-points on that $1 coffee purchase and it would be the cost to you as offering the coffee for$0.90.
  2. Psychology: Generally people value things that aren’t cash at a lower rate than cash (Duh). People don’t buy gift cards for more than their face value – especially for their own use. But sometimes if a program is designed right and you pull the right strings you can get people to act on points when you would not be able to on dollar discounts. Usually this isn’t done with the base program, but rather with promotions. “2x points” sounds a lot better than “An extra 1% off”, and you would not be surprised to know it gives a much bigger sales lift.
  3. Selection Effect: Only some people will join your Loyalty Program. Most people will just not care enough. Who joins? You should not be surprised to know it is to some extent price sensitive people, but mostly it is people who are your highest use customers.

Apart from those subtle differences (that are all worth exploring as I wrote more about Loyalty Programs on this blog), basically Loyalty Programs are price discounts. And price discounts do not generally drive loyalty.

So if the value of the Loyalty Program isn’t loyalty, what is it? There are a number of uses, but the most common one is to collect data on your customers. Without something like a loyalty program, Marriott would only know people per visit. They wouldn’t know who their best customers were in order to treat them differently.

But that is NOT the reason most companies build Loyalty Programs. Most build them because they think they will drive Loyalty (and because everyone else is doing it).

 

Why do companies think Loyalty Programs are Driving Loyalty when they are not?

Most senior executives aren’t stupid. Why would they think that their Loyalty Program is driving Loyalty when it really isn’t? The answer is the Selection Effect.

If you take all your customers and break them into two groups: Those on your Loyalty Program and those not on your Loyalty Program, it will be very very clear that the customers on your Loyalty Program have (1) Longer Tenure with your company, (2) Spend more, (3) Churn at a lower rate.

Wow.

That sure sounds like the Loyalty Program drives Loyalty.

But it’s a classic case of correlation not being causation. In this case the impact is the reverse:

Customers who are planning to spend more with your company in the future (and usually have spent more in the past) are the most likely to join your program. Why? Because they have the most to gain.

There is a cost to joining a program. The cost usually isn’t very high, but it does usually mean signing-up with some forms and keeping a card in your wallet. But that small barrier to entry is enough that many customers will not join your program – specifically customers who aren’t planning on spending very much with you in the future. Meanwhile the heavy users would be crazy not to sign up and get 1% or more off all of their purchases.

So when you compare Loyalty members to non-members, the loyalty members always look more loyal. But the kicker is it’s not the program that is making them loyal, it’s their loyalty which is getting them in the program.

Most companies stop right here by the way. The head of the Loyalty Program shows the bar chart showing members spend more than non-members and the CEO is happy and they keep spending money on the program.

Some companies try to get more sophisticated. The first thing analysis will do is compare Loyalty Members before and after they join the program. They eliminate all the members that were not purchasing for at least 1 year prior to joining, and then look at their spend before and after joining. The really good analysts will try and create a control group of similar customers who did not join the program. It’s commendable to try, but this has a similar, if slightly more complicated problem.

Imagine two customers that are identical. They have both been shopping at your store regularly for a year. Then one day they both come into the store. Customer A is planning to move to Phoenix in the next few weeks. Customer B actually lives across town and was only visiting when he visited his mom who lives nearby. As luck would have it, Customer B just bought s new home near his mom, so he is planning to visit the store more often in the future.

Guess which customer signs-up for your Loyalty Program that day?

And guess how much impact the program itself has on his increased spending?

It’s another example of selection effect. You can’t get around it.

 

Getting Around Selection Effect

There actually is one way to get around selection effect. It’s called A/B testing. Take a group of customers and randomly assign them to two groups. Then do something to Group A but not to Group B. Watch and see what the long term impact is across the two groups.

Because they were randomly assigned there was no Selection Effect.

The problem is that this only works if you do things “Below the Line”. As soon as something is public and everyone can see it, you can’t keep Groups A and B separate anymore.

This makes A/B testing great for website landing pages or email campaigns or direct mail campaigns or even television campaigns (if done regionally). But if you want to create a company-wide Loyalty Program, it’s really hard to only offer it to 50% of your customers.

But it can be done.

The best time to do it is when you are first planning to launch the program. Instead of launching it fully-formed to the public, you can try launching it in ‘beta’ as a below-the-line test to a select group of your customers. And instead of offering it to your best customers, offer it randomly. Take your entire customer database and divide it in two. Email half of them with an offer to join the program and don’t send anything to the other half.

Then, instead of measuring the lift of people who joined the program vs those who did not, just measure the lift of the group that was OFFERED the program vs the group that wasn’t. If you did your job right in randomized group selection any difference you see will be driven by the existence of the program. You may even see a lift in the people who you offered the program to, but they didn’t join (this is the best case – increased sales without any increased cost).

 

Any time you create any program without doing a proper A/B test you are at risk of having your results invalidated by the Selection Effect. Loyalty Programs are the biggest example, but I’ve seen it with everything from add-on services (Customers who buy the security package have lower churn, so let’s give away the security package for free), to customer service (customers who visit the branch more often are less likely to churn, so let’s drive more customers into the branch).

Beware the Selection Effect.

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