Stanford: Customer loyalty programs are a waste of money

PALO ALTO
October 23, 2006 12:01am

With every tenth car wash, you get one free. Or fly so many miles and get a free ticket.

These are forms of loyalty programs businesses small and large use in an effort to keep customers coming back.

Forget about it, they don’t really work like you think, say researchers at Stanford University’s Graduate School of Business.

In fact, such programs have limited effectiveness -- and sometime end up just costing organizations money, the researchers say.

“The question is, do reward programs get customers to buy more often after they have accumulated a lot of credits toward the reward?” asks Brian Viard, assistant professor of strategic management.

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.

Messrs 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,” Mr. Viard says.

Adds Mr. 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 Mr. 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 Messrs 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,” Mr. Viard says.

Extrapolating from their research, the two 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 Mr. 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 Mr. 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 Stanford work 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 Mr. Viard.

If their results indeed prove to be broadly applicable to a wide variety of settings besides golf courses, as the Stanford professors 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.