PM Tips & Experiences: A model for pricing loyalty programs

Today I write about pricing upfront payment-based loyalty programs for E-commerce. I do not have a lot of direct experience in this area. So, what you read is based on product sense and discussions with people working in this area. It is a remarkably simple model that can be used as a template and expanded.

The premise of a loyalty program for commerce is simple. Buyers show loyalty towards a service. The service pays the buyer back in benefits. You can find 3 typical models in the industry for this:

1. More transactions = more benefits. For example, Hotels.com runs a loyalty program in the travel industry. If you book 10 nights with them your 11th night is free. That is a 9.1% discount. (source)
2. Get points to convert for rewards. For example, You collect points every time you fly with American Airlines. Once you habe 12,500 points you can exchange them for a ticket from mainland US (United States) to Mexico. (source)
3. Pay for better services. For example, you pay £20 for a delivery pass from Sainsbury’s online grocery. With that you get free delivery for your orders, else you end up paying £1- £4.50 per delivery. (source)

I want to focus on pricing for the 3rd model which is quite common today. There are 3 questions you need to consider.

What is the value your buyer sees in the program?

What is the value you get from a loyal buyer?

How is the competition doing this?

Let’s start with my hypothetical business. Showy Socks is my most amazing new socks company. We sell socks. You can pay to be a member of the “Socky” Club. Club members get free 1 day shipping for any sock they buy.

My business

So how much should Socky Club membership cost if pricing rationally? Here is some data we will need to come up with the price.

• Average order value: $30
• Average shipping cost per order buyer needs to pay. $3
• Average number of times a person orders per year: 4
• Benefits you get in Socky Club.

1. Free shipping
2. Free video call with an expert to pick a sock.
3. 60-day return window instead of 30 days

Value to the buyer

Treat this like a value exchange. Buyer is looking for value from being in the program. The cost for them is the money you charge per year. Hence for the program to make sense for them. Hence the key equation is:

Value from the program > Cost of the program

Value from the program = Value of free shipping for their order + Value of expert help + Value of longer return window

If you have done your homework, you can quantify the value of expert help and longer return window to buyers. I have cheated on it. I will assume the value of expert help + longer return window to be $3.

Value from the program = Money saved from the shipping costs for 3 orders + $3 = $3 x 4 + $ 3 = $15

So, the maximum your buyer is willing to pay is $15. It will be more for frequent buyers (they save more on shipping costs) and less for others. But should you really charge them $15?

The Socky sock benefit program

Value to your business

What are the benefits you get from the Club program?

1. The fee paid your buyers.
2. Buyers who are more likely to buy more often from you. Thus, you end up with more sales.
3. Savings on marketing costs. You spend money on Google & Facebook to get new customers for your business. With club members you need to spend less money.

We need some more data now to decide pricing.

• Average order value $30
• Average margin you make per order. (Shipping & marketing costs are not included) $6 (20%)
• Average shipping cost per order buyer needs to pay. You do not make any money from this. All of this goes to FedEx. $3
• Average number of times a person orders per year : 4
• Average number of times a club member orders per year: 6
• Your average marketing cost per order ordinarily: $1
• Your costs of managing the Club program annually. $3 per member

The key equation here is:

Your value from the loyalty program > Cost of your loyalty program

Or in other words.

Fees from the club program + Incremental more money you make from club order + Savings in marketing costs > The shipping fee you are now paying out of your own pocket + Costs of managing the club.

Let us assume the fee for the program is $C per year.

C + (6–4) more orders per year X $6 margin + 6 order X $1 saving per order > 6 orders shipped x $3 each + $3 per member.

C + $12 + $6 > $18 + $3

C > $3

Based on these assumptions you can price your Club membership at $3 a year for break even. Anything more is profitable for you. Let us say you decide to price the membership at $5. On average you will make ($6 margin X 6 orders + $5membership fee + $1 marketing cost saved x 6 orders — 6 orders x $3 shipping paid by you — $ 3 cost per member) = $26 per Club member. Contrast this to ($6 margin x 4 orders) = $24 you make from a non-member.

There is a network effect of having a larger number of transactions. Your fixed costs per order like technology goes down on a per order basis. You may be able to get volume discounts from suppliers. More revenue gives you more cash for brand building. We have not incorporated this in our calculations.

Business value of the program

Competition

This one is not scientific. Just look around and see how competition is pricing. DON’T COPY THEM. Use your own models but keep them as a reference point.

Summing up

I presented a model for pricing a loyalty program based on advance payment to get better services. This is a basic model you can adapt to your situation. A. Use the concept of value exchange to figure out the maximum a buyer is willing to pay. B. Understand the value of loyalty to your business to find the break-even point. C. Look at competition to see how they are doing this. Then pick a starting value and start testing. Getting your buyers feedback is better than any model.