Loyalty Program Liabilities and Point Values

Abstract

Problem definition. Loyalty programs (LP) introduce a new currency---the points---through which customers transact with firms. Such points represent a promise for future service, and their monetary value thus counts as a liability on the issuing firms' balance sheets. Consequently, adjusting the value of points has a first order effect on profitability and performance, and emerges as a core operating decision. We study the problem of optimally setting the points' value in view of their associated liabilities.

Academic / Practical Relevance: Firms across numerous industries increasingly utilize LPs. The sheer magnitude of LPs coupled with recent changes in accounting rules have turned the associated liabilities into significant balance sheet items, amounting to billions of dollars. Managers (from CFOs to CMOs) struggle with the problem of adjusting the points' value in view of these liabilities. Academic work is primarily aimed at understanding LPs as marketing tools, without studying the liability angle.

Methodology. We develop a multi-period model and use dynamic programming techniques and comparative statics analysis.

Results: We show that the optimal policies depend on a new financial metric, given by the sum of the firm's realized cash flows and outstanding deferred revenue, which we refer to as the {\it profit potential}. The total value of loyalty points is set to hit a particular target, which increases with the profit potential. We find that loyalty programs can act as buffers against uncertainty, with the value of points increasing (decreasing) under strong (weak) operating performance, and increasing with uncertainty.

Managerial Implications: Setting the point values and adjusting operating decisions in view of LP liabilities should be done by tracking the firm's profit potential. Loyalty programs can act as hedging tools against uncertainty in future operating performance, which provides a new rationale for their existence, even in the absence of competition.

Keywords: Dynamic programming, Operations-Accounting-finance Interface, Loyalty (reward) program, Profit, Liability