COLLOQUY Corner: The joys of a well-constructed financial model

Loyalty marketing economics are relatively simple. You derive two main financial benefits from a well-designed, well-executed loyalty program:

You can retain more customers. Given the natural growth of new customers from acquisition efforts and the reduction in lost customers from the loyalty initiative, your total number of customers increases over time. Customer value compounds over time and affords you a longer period to recover acquisition costs. You can model the financial benefit of retention by multiplying customer value times the number of retained customers. This financial benefit increases over time.

You can increase the yield from existing customers. Increased yield results from greater frequency, more spending per visit and higher price points per transaction. You derive this yield largely through gaining share of customer at the expense of your competition. You can model the value of the increased yield by multiplying the incremental gain times the number of members who change their behavior.

The incremental revenue from these two sources generates incremental margin for you. This margin will be higher than your current percentage because you accommodate the incremental growth without incurring additional fixed expenses. You must, however, subtract the variable costs of your program from the gains. Account for all program costs, including rewards, and attribute the resulting benefit to your loyalty program.

Since this benefit accrues over time, marketers typically use a net present value analysis to determine the success of their loyalty program investment. Most well executed programs reach break-even in 18 months or less; some do so within 12 months. At that point, the return on investment accelerates as the retention and yield benefits deliver far more than they did originally. Expect difficulty in making money your first year because of the investment required to set up your database, systems and enrollment materials.

The key to operating a financially sound loyalty program, of course, is to model the financial results before launch. While your analysis must contain basic assumptions about enrollment, funding, program operating costs, retention benefits and increased yield potential, you’ll still find it extremely useful. The model helps you determine program feasibility, and it helps you establish the performance metrics you’ll need to monitor to determine financial success or failure. Throw all the numbers in the hopper, press the “print” button on your PC, and if the numbers come out in the black within that 12-18 month period, then you’re in business.

If they come out bleeding red, however, then it’s time to recalibrate your program. Keep trying until the numbers add up— or you realize that the numbers won’t ever add up, and a loyalty play may not be for you.

The linchpin of your financial model is your program’s funding rate. Your funding rate corresponds to the percentage of member spending that you set aside for rewards. Breakage will offset this cost and deliver a net funding rate lower than the gross. You fund the incremental program cost out of your marketing budget.

Your funding rate should maximize customer retention and yield at the lowest net cost. Always be aware of your net funding rate, the percentage profit increase you derive from it and what impact, if any, you see when the rate goes up or down. These measures help you determine the true profitability of your program and the optimal funding rate required to change customer behavior.

There are, of course, other measures of program success, such as reward redemption and participation metrics. The percentage of your members who earn and redeem for rewards is a measure of program success. The percentage of your members who respond to your e-mails, or who participate in an auction or a survey, is indicative of member involvement, which usually corresponds to program success. Finally, if you’re running a tiered membership program, the percentage of members in each tier who move up to a higher tier over time is a strong indicator that your program is achieving desired results – both for you and your customers.

But the bottom line is always the final arbiter of success and failure. I’ve said it before, and I’ll say it again: loyalty marketing is measurable marketing. You can track, report, analyze and take corrective action on everything you do. You know what’s working and know the exact return on investment associated with your program costs. Over time, you’ll realize that the most important difference between loyalty marketing and your other marketing initiatives is the precise understanding of what you get for what you spend.

Measurement, however, requires discipline. You need tools for reporting and analysis, and a dedicated person within your organization responsible for periodic financial assessment of the program. Only through rigorous analysis can you truly achieve loyalty nirvana.

Rick Ferguson is the Editorial Director for the COLLOQUY Group of Milford, OH.