To evaluate the success of a loyalty program, many marketers look at its impact on revenue and profit growth. But a huge factor in loyalty program ROI is the cost, the bulk of which is determined by investment in rewards costs. At most companies, marketing and finance departments use budget limitations to set an “acceptable” level of rewards, but like any investment, the right way is to look at the return. Do higher — or lower — rewards levels make more sense? To simplify the answer this question, we’ll use a loyalty metric know as Reward Cost Efficiency, or RCE.
RCE tracks incremental dollars generated for each dollar spent on rewards. To see it in action, let’s consider a simple example. Say I run a loyalty program for 7-H Stores, a fictional specialty retailer, and I’m evaluating whether to increase my rewards level. Currently my program has a 4% funding rate, but I’m considering upping that to a more generous 7% funding rate. I judge the profitability impact of the 7% funding rate over the 4% rate to be promising. What should I do?
Here’s the formula for calculating RCE:
Simply put, RCE takes revenue lift from the program and divides that by how much you’re paying out in rewards. To measure incremental revenue for existing programs, you can do a pre/post comparison of member spend. For a new scenario, you could run an experiment with test and control groups. Generally speaking, the total costs of rewards should exclude fixed costs (administrator costs, SaaS loyalty platform subscriptions, set-up fees, etc.).
Now, let’s calculate RCE for 7-H Stores. With the current 4% funding rate, let’s say I drove $30M in incremental revenue over 1 year at a total rewards cost of $5M. However, let’s say that an experiment shows the 7% funding rate would generate $36M lift in revenue for $9M in rewards over the same period. Calculating the RCE for each, I get an RCE for the 4% funding rate of 6, and an RCE for the 7% funding rate of 4. The 7% funding rate generated higher sales, but at a lower return on rewards.
The breakeven point for RCE is determined by a business’s gross margin. Specifically,
Let’s say the gross margin at 7-H Stores is 50%. Then my breakeven RCE is 2. This means that, in order to break even on my reward costs, I need to generate at least $2 of revenue for each dollar spent on rewards. Looking back at RCEs for the 7% and 4% funding rates of 6 and 4 respectively, we see that the 7% funding rate getting closer to not breaking even. We can do more to understand the risk of not breaking even through sensitivity analysis for different increases in member frequency, as well as a year-by-year breakdown of the RCE.
Of course, to choose between the 4% and 7% scenarios, you would ideally consider other factors. For example, is the RCE higher than return you’re seeing on dollars spent for other forms of marketing? If so, there’s a strong case for investing those dollars in rewards costs. And we’re only scratching the surface here on how RCE can be used. For example, you could calculate RCE to evaluate changes in rewards structure, the addition of premium status tiers, and so on.
If there’s a simple takeaway, it is that rewards costs are investments, and should be treated as such. RCE can help ensure that your funding rate and program structure yield maximum return on your marketing dollars.
Arif Damji is Director of Strategy & Development at 500friends, which helps retail brands maximize the profitability of their customer relationships. Email him at email@example.com.