Loyalty Program Liabilities and Point Values

39 Pages Posted: 28 Feb 2017 Last revised: 1 Aug 2018

See all articles by So Yeon Chun

So Yeon Chun

Georgetown University - Robert Emmett McDonough School of Business

Dan Iancu

Stanford Graduate School of Business

Nikolaos Trichakis

Massachusetts Institute of Technology (MIT)

Date Written: February 27, 2017

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

Suggested Citation

Chun, So Yeon and Iancu, Dan and Trichakis, Nikolaos, Loyalty Program Liabilities and Point Values (February 27, 2017). Stanford University Graduate School of Business Research Paper No. 17-20. Available at SSRN: https://ssrn.com/abstract=2924480 or http://dx.doi.org/10.2139/ssrn.2924480

So Yeon Chun (Contact Author)

Georgetown University - Robert Emmett McDonough School of Business ( email )

3700 O Street, NW
Washington, DC 20057
United States

Dan Iancu

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

Nikolaos Trichakis

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

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