Loyalty programs are an expensive proposition.  In the supermarket industry various estimates place the cost of running a program at 1% to 1.5% of revenue.  In other industries, they could cost between 2% to 5%.  Some of the typical cost components of a loyalty program include technology (software and hardware), program overhead (staffing), program rewards and benefits (financial and privileges), and regular communications (mailers, text blasts, magazines). Furthermore exit barriers of a loyalty program are high.  The more successful a program, the more difficult it is to switch off.  It is very hard to take away what you have already given.
With such prohibitive costs, why then bother with a loyalty program?  Does a loyalty program really produce any economic benefits for a business?  Why not use the savings from investments in program start-up, maintenance, and marketing towards more competitive prices and value-added services?
In today's highly competitive and crowded marketplace, customers expect companies to reward loyalty.  Most major hotels, airlines, supermarket chains, banks, telecommunication companies and other types of businesses have some form of "preferred" customer program.  It is no longer a "nice" value-added but a minimum that customers have come to expect.  If all else is equal, customers will choose to patronize an establishment or service that gives her something back for her loyal patronage.
But there is a more important reason to invest in a loyalty program, and it is this:  loyalty pays.  Study upon study confirms the economic benefits of loyalty are well worth the price that companies invest in their programs.  Loyalty programs can yield financial benefits by enhancing customer value as follows:
Customer Retention
It can cost five times more to get a new customer as to keep an existing one.  The acquisition costs of a new customer can be quite high--advertising, loss leader pricing to encourage switching, promotions, discounts, and freebies.  Companies can lose as much as 40% of their customers every year.  A loyalty program can minimize customer churn.  Minimizing customer churn by even just 5% to 10% per year can have a significant impact on a company's bottom line.  According to Bain and Company Research, a 5% increase in customer retention can yield a 75% increase in enterprise profitability.  Without a program, a company is not even aware that it is losing customers.  Or worse, which customers it is losing.
A loyalty program can help companies keep customers longer through relevance in communications and offers, rewards for desired behavior, and recognition for loyal patronage.  Furthermore, a program will allow companies to know when a customer has defected, which can lead to win-back programs for defected customers.  This would simply not be possible without a loyalty program.
Identifying Most Profitable Customers
Not all customers are created equal.  Treating all customers equally undervalues your best customers and overvalues the rest.  It has come to be a widely accepted principle that 20% to 30% of a company's customers will account for 70% to 80% of its profits.  This is called Pareto's Principle.  This principle applies universally to all types of products, industries, and services.  A loyalty program allows companies to identify this critical 20% of customers.  Understanding the economic value of your customers can save you tremendous amounts of revenue and effort.  If all customers are not created equal, a company should be able to direct its resources to its best customers, leading to savings and enhanced retention of best customers.
Increased Sales and Revenues
One of the goals of a loyalty program is increased sales and revenues. A good program will keep customers coming back for more despite the presence of competition.  Loyal customers are often willing to pay a small price premium, and very loyal customers will actively promote your company to others.  All this leads to increased sales and revenues. 
However, you need to determine the hot buttons that most affect profitability within an organization.  You need to ask the question of what types of customer behavior will be accretive in terms of incremental profit--be it frequency of purchase, share of wallet, size of purchase, or repeat visits.  Once this is determined, a program can be designed to encourage and reward the customer behaviors that most affect profitability within an organization.
Capture Actionable Customer Data
Information is power and information about customers presents a great opportunity to use customer insight as a source of competitive advantage.  Loyalty programs can help "manipulate" customer behavior with the end view of increasing customer profitability.  For example, customers could be encouraged to buy more, to visit more, to shift spending into higher margin products.  This could be done through suggestive selling, by showing customers related products that they had purchased in the past, or products purchased by others like them.
Does Customer Loyalty Pay?
All this comes with a caveat.  Customer loyalty management, strategy and economics are inextricably entwined. Without a deep understanding of the customer profitability dynamics of your organization, the best intentions of a loyalty initiative will likely yield little long-term benefits.  Ask the hard questions up front.  Some examples of these questions would be the following.  What is the rational investment in order to achieve the desired customer behavior?  What is the statistical delta between the present customer behavior and enhanced behavior that will make a difference to the profitability of the entire organization?  What degree of change is required in customer behavior in order to earn a solid return on that investment?  What are the operating margins of the business?  What is the optimum level of reward that is attractive enough for the customer, but still affordable to the company?  Be very certain that there is a thorough understanding of the profit dynamics prior to designing a loyalty program. 
Does a loyalty program pay?  Can you afford to have one?  Done right and over time, it pays!  The question that you need to ask yourselves is this: can you afford NOT to have a loyalty program?

Frances Yu is Chief Retail Strategist of Mansmith and Fielders, Inc. For details, you can call 584-5858 orinfo@mansmith.net.