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It seems like every time I go into a shop or open my mail I get asked to join a loyalty program of some sort or other. This post looks at why they are so popular (both with retailers and consumers) and also looks at how they are implemented.

Organisations generally have 2 motiviations for creating loyalty programs. They either want to understand what their customers are doing, or they want to change what their customers are doing (i.e. by encouraging people to buy more goods & services), or both.

The organisations that are most prominent in running loyalty programs are retailers, credit card providers and airlines (i.e. 'frequent flyer' programs). The blend of motivations, and the implementations, differ between these groups, so in this post we'll just be looking at retailers who sell things like clothes and groceries to individual consumers. In a later post I'll look at how and why credit card and airline loyalty programs differ.

For most retailers, loyalty programs are all about being able to track what customers are doing. Any modern POS system will be able to report on how much of each product has been sold, but retailers also want to know who has been buying each different product, so they can tailor their marketing appropriately. The problem is, in an ordinary retailer payment transaction, there is no way for the POS to capture anything about the identity of the purchaser.

By giving customers a plastic card with a unique ID encoded on it, and encouraging the customer to produce that card every time they make a purchase, retailers get to associate purchases made at different times and at different stores with the one customer. They also will have made the customer provide their name, address and other demographic data at time of signup. This means the retailer can work out e.g. what models of leaf blowers are most popular with married male self-funded retirees (and therefore should be advertised in Holding Hands in an Autumn Breeze - The Magazine For Married Male Self-funded Retirees Looking for a Leaf Blower).

The incentive for consumers to first, tell retailers who they are, where they live, and how much money they have, and second, hand over that bit of plastic with their unique ID on it everytime they front up at a POS, is that the retailer offers rewards to people willing to participate in this data-collection exercise.

For some retailers, the reward takes the form of a discount made at the time of the initial purchase. These rewards are certainly easy to implement. But other retailers have decided that the cost of administering a more complex reward and redemption system is worth the benefit of making the customer come back later to use their reward. The ideal result here is if the retailer can motivate you to take your reward in the form of a discount towards something that you wouldn't have otherwise bought.

Putting it all together, a typical retailer loyalty program looks like this:

• A customer signs up to a retailer's loyalty program, and in the process provides demographic data. The retailer stores this data in a database, associates the customer record with a unique ID, encodes that unique ID on a plastic card, and mails the card to the customer.
• Whenever the customer buys goods from that retailer, they present their card, which is swiped through the POS. The POS captures their unique ID, and forwards that ID along details of individual items purchased on to a central tracking database.
• Data from the tracking database goes in to a data warehouse, that is used by marketing analysts to see who they typical customers are for different products. This information is used to tailer marketing and advertising programs.
• At regular periods (most frequently this is quarterly), a process will be run to work out how many rewards each customer has earnt. Usually the rewards earned are directly proportionate to the total value of goods purchased with that retailer.
• Once the reward values have been calculated, a letter will be sent out to the customer telling them what their reward is. Often this letter will also include marketing material tailored to this specific customer. Remember the whole point of the program is to let the retailer know exactly what each person buys.
• As well as telling customers the value of rewards earnt, the mailout will also include information about how the rewards can be redeemed. In a few cases (e.g. FlyBuys) the rewards are redeemed by selecting goods or services from a catalogue, and either dialing a call centre or using a web application to redeem rewards for the selected goods. This style of redemption is generally only used for programs (like FlyBuys) that are not specific to a single retailer. It is far more common for the rewards to be presented in the form of a voucher or gift card that must be presented in store, that way the retailer has the opportunity to sell you more stuff while you are there.

If we look at the economics of a single retailer program, we'll see that costs fall into these areas:

• System Development & Maintenance - The original loyalty programs where all in-house custom development jobs run by major retailers who are able to amortise the development costs over hundreds of stores. Nowadays the tracking and analysis components of loyalty programs are becoming available as off the shelf products
• Marketing Data Analysis Loyalty Programs generate a heap of data, and it takes a lot of MBA graduates with wizard-level Excel skills to turn that data into useful knowledge about customers. But any retailer thinking about a loyalty program will probably already be spending a lot on market analysis anyway.
• Funding The Rewards - In the best case, customers will spend their rewards on things they wouldn't otherwise buy, and thus running a loyalty program can fund itself by leading to increased sales. Alternatively, with the right market analysis (to identify what products each customer is most interested), and a good relationship with the suppliers, it may be possible for retailers to reward customers entirely with discounts funded by suppliers (e.g. find people who buy a lot of Schick razors, then tap Gillette for some marketing funds to send those people coupons worth 50% off Gillette razors. ) In the worst case however, retailers will end up giving a discount to customers on items that the customer was going to buy anyway. In other words, like any discount program, there is always the risk that loyalty programs can lead to an erosion of margins without any corresponding uplift in volumes.

So there's lots of room for risks of cost blowout and margin erosion, and potentially a lot of reward in the form of improved market intelligence. As loyalty programs evolve in to an off-the-shelf product, a lot of the risks are being diminished, although the potential for a loyalty program to offer any competitive advantage is also diminished at the same rate.

In fact as loyalty programs become more and more ubiquitous they also become less and less useful, to the point where they can become an essential cost that all market participants have to wear, but non derive any benefit from. In my next post on this topic, I'll look at how this has happened to airline and credit card loyalty programs.