How Incorrect Breakage Assumptions Can Negatively Impact Your Bottom Line

Company loyalty programs attract the attention of customers with incentives that make them feel valued.

One of the primary reasons companies use loyalty programs is because they encourage clients to return to the business, while providing opportunities for the business to get insight into new products and promotional opportunities. In short, they keep the pulse of customer engagement going, and, if calibrated correctly, can drive up sales.

However, loyalty programs do come at a cost, and require that a company has a robust understanding of its breakage rates in order for them to know how much revenue to defer in order to offset costs incurred by the loyalty program. These costs, known as loyalty program liability, can be relatively benign if correctly anticipated, but can deal a devastating blow if not taken seriously.

The role of breakage and user redemption rates

In order to know how much revenue to allocate towards loyalty program liability, a company must know both the cost per point, and the percentage of points that get redeemed. The latter is also known as the ultimate redemption rate (URR), and it reflects a phenomenon known as breakage, or the percentage of rewards points that go unredeemed.

If a company over-estimates breakage, it will result in the creation of underfunded cash reserves to address the liability. This, of course, can put the company in a compromising financial situation, and should be avoided at all costs.

Moreover, a breakage-heavy strategy for minimizing loyalty program liability carries the undesirable effect of reducing customer engagement, as high breakage rates simply reflect that your company has been forgotten in the minds of its customers.

Still, if overestimating breakage is harmful, underestimating it is not much better.  

While at first glance it may seem that underestimations of breakage might simply result in the company discovering “spare change,” the reality is that, from an accounting perspective, underestimating breakage can lead to more revenue than necessary being channeled towards paying down the loyalty program liability. This causes companies to stagnate without need, and creates what is known as “stuck revenue” for companies.

Stuck revenue is revenue that has been deferred to create a cushion against loyalty program liability, whose scope is much smaller than that of the precautionary fund. Unnecessarily deferring this revenue prevents it from being applied in more generative ways, and lessens the investment capacities of a company.

The bottom line

Both underestimating and overestimating breakage result in negative outcomes for companies. Overestimations signify that not enough money will be set aside to address loyalty program liability, and underestimations create the conditions necessary for stuck revenue to flourish.

As a consequence, it’s incumbent upon companies to accurately model and predict their breakage rates. Thankfully, the rise of emerging technologies, including predictive analytics and intelligent software solutions, are making it faster and easier for companies to correctly gauge breakage amongst loyalty program members, and optimize their loyalty programs.

July 2020
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