Rewards-Supply Aggregate Planning in the Management of Loyalty Reward Programs - A Stochastic Linear Programming Approach

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1 Rewards-Supply Aggregate Planning in te Management of Loyalty Reward Programs - A Stocastic Linear Programming Approac YUHENG CAO, B.I.B., M.Sc. A tesis submitted to te Faculty of Graduate and Postdoctoral Affairs in partial fulfillment of te requirements for te degree of Doctor of Pilosopy in Management Sprott Scool of Business Carleton University Ottawa, Ontario, Canada September YuengCao All Rigts Reserved

2 1*1 Library and Arcives Canada Publised Heritage Branc 395 Wellington Street OttawaONK1A0N4 Canada Biblioteque et Arcives Canada Direction du Patrimoine de I'edition 395, rue Wellington Ottawa ON K1A 0N4 Canada Your Tile Votre reference ISBN: Our file Notre reference ISBN: NOTICE: Te autor as granted a nonexclusive license allowing Library and Arcives Canada to reproduce, publis, arcive, preserve, conserve, communicate to te public by telecommunication or on te Internet, loan, distribute and sell teses worldwide, for commercial or noncommercial purposes, in microform, paper, electronic and/or any oter formats. Te autor retains copyrigt ownersip and moral rigts in tis tesis. Neiter te tesis nor substantial extracts from it may be printed or oterwise reproduced witout te autor's permission. AVIS: L'auteur a accorde une licence non exclusive permettant a la Biblioteque et Arcives Canada de reproduire, publier, arciver, sauvegarder, conserver, transmettre au public par telecommunication ou par I'lnternet, preter, distribuer et vendre des teses partout dans le monde, a des fins commerciales ou autres, sur support microforme, papier, electronique et/ou autres formats. L'auteur conserve la propriete du droit d'auteur et des droits moraux qui protege cette tese. Ni la tese ni des extraits substantiels de celle-ci ne doivent etre imprimes ou autrement reproduits sans son autorisation. In compliance wit te Canadian Privacy Act some supporting forms may ave been removed from tis tesis. Wile tese forms may be included in te document page count, teir removal does not represent any loss of content from te tesis. Conformement a la loi canadienne sur la protection de la vie privee, quelques formulaires secondaires ont ete enleves de cette tese. Bien que ces formulaires aient inclus dans la pagination, il n'y aura aucun contenu manquant. 1*1 Canada

3 Acknowledgements First of all, I would like to tank my supervisor Dr. Aaron L. Nsakanda for is patient guidance, valuable suggestions and enligtening comments during te period of my study in Carleton University. Tis dissertation owes a lot to is gentle, yet effective guidance. Witout is elp, tis dissertation could not ave been finised. His profound knowledge in management science definitely benefited me a lot. Working wit im as always been an enjoyable and rewarding experience. I would like to tank all te members of my tesis committee: Dr. Vinod Kumar, Dr. Micael Armstrong, Dr. Akif A. Bulgak, and Dr. Yiqing Zao wit individually and collectively contributed to te tesis. Secondly, I would like to tank te Sprott Scool of Business, Carleton University, for providing financial support and necessary researc facilities for tis tesis. It would ave been impossible for me to concentrate on my researc witout suc financial support. Many tanks go to members and staff of te Scool of Business, wo elped me during my studies at Carleton, in particular Melissa Doric, Greg Scmidt, and Jason Holtz. I would like to tank all of te great teacers and researcers I ave encountered ere at Carleton University, in particular Dr. Saobo Ji, Dr. Roland Tomas, and Dr. Uma Kumar. Finally, I would like to tank my parents, wose love, support, and sacrifice made me wat I am today. No words can properly express te love, gratitude, and admiration I ave for tem. 1

4 Abstract Loyalty reward programs (LRPs), initially developed as marketing programs to enance customer retention, ave now become an important part of customer-focused business strategies. One of te operational callenges faced by LRP managers is tat of planning for te supply of rewards in a given period of time. We ave developed tree matematical models for solving tis problem under various settings. In eac setting, te problem as been formulated as a two-stage stocastic linear programming model wit recourse. A euristic optimization procedure based on sample average approximation (SAA) is proposed for solving eac of tese models. We carried out extensive computational experiments to demonstrate te viability of te modeling and solution approaces for solving realistically sized (large-scale) problems as well as to evaluate te impacts of canges tat internal dynamics and external uncertainties ave on te performance of a loyalty reward program operating as a profit center. Findings from tese computational studies ave led to a number of managerial insigts. Our results sow tat demand variability as negative impacts on LRP performance. As suc, adopting an option contract provides good means for mitigation, especially wen demand uncertainty is ig. Our results ave also sown tat offering cooperative advertisement troug bonus points is a double-edged sword. It may bring in iger LRP profitability, but it also results in iger liability. Wen demand variability is ig, offering bonus points is not preferred in rewards-supply planning. Finally, our results indicate tat budget tigtness and liability control tigtness ave an impact on LRP performance to an extent tat varies across different system settings. Tis researc contributes to te literature in several ways: it syntesizes and extends te concept of supply cain management in te context of LRPs and it enances te understanding of LRPs and rewards-supply planning problems troug quantitative modeling and stocastic programming. Our findings will elp LRP managers to understand te roles of cooperative advertising troug bonus points and option contract in planning for te supply of rewards as well as to evaluate te impact of canges in te internal dynamics and external uncertainties on te performance of loyalty reward program operations. n

5 Table of Contents Acknowledgements Abstract List of Tables List of Figures List of Appendices i ii vi viii ix Capter 1 Introduction Background and Researc Motivation Researc Objectives Outline of te Tesis 8 Capter 2 Literature Review Loyalty Reward Programs (LRPs) Overview Typology Framework for LRPs Literature Review of LRPs Summary Supply Cain Contracts Overview Option Contracts Summary Cooperative Advertising Overview Cooperative Advertising and Budget Allocation Cooperative Advertising in LRP Operations Summary 51 Capter 3 Researc Framework and Matematical Models Loyalty Reward Programs - "Rewards-Points" Supply Cains LRP Rewards - Supply Aggregate Planning Models 57 in

6 3.2.1 LRP Rewards - Supply Planning Problem witout Bonus Points Modeling Assumptions Problem Description and Model Formulation LRP Rewards - Supply Planning Problem wit Bonus Points Modeling Assumptions Problem Description and Model Formulation LRP Rewards - Supply Planning Problem wit Option Contracts Modeling Assumptions Problem Description and Model Formulation Summary 78 Capter 4 Solution Metodology Stocastic Programming and Its Implementation Model Reformulation for Problem BP Model Reformulation for Problem EP Model Reformulation for Problem EP Solution Procedure Sample Average Approximation (SAA) Reformulation SAA Model for Problem BP-2SLPR SAA Model for Problem EP1-2SLPR SAA Model for Problem EP2-2SLPR SAA-based Heuristic Solution Procedure Implementation Issues in te Solution Procedure Summary 100 Capter 5 Design of Numerical Studies Procedure for Generating Testing Problems Testing te Effectiveness of te Solution Metodology Model Solvability Quality of Stocastic Solutions Testing te Impacts of Demand Variability Testing te Impacts of Budget Tigtness Testing te Impacts of Liability Control Tigtness 116 IV

7 Capter 6 Results and Analysis Testing te Effectiveness of te Solution Metodology Model Solvability Quality of Stocastic Solutions Testing te Impacts of Demand Variability Under BP Setting Under EP1 Setting Under EP2 Setting Comparison across BP, EP1, and EP2 Model Settings Summary Testing te Impacts of Budget Tigtness Under BP Setting Under EP1 Setting Under EP2 Setting Comparison across BP, EP1, and EP2 Model Settings Summary Testing te Impacts of Liability Control Under BP Setting Under EP1 Setting Under EP2 Setting Comparison across BP, EP1, and EP2 Model Settings More on Management Insigts from Liability Control Analysis Summary 200 Capter 7 Conclusions and Future Researc Directions Findings and Implications Limitations and Contributions Future Researc Directions 209 References 213 Appendices 222 v

8 List of Tables Table 2.1 Summary of te main streams of LRP literature 27 Table 2.2 Traditional supply cain versus "rewards-points" supply cain 34 Table 2.3 Summary of te main contributions of option contracts in OM/SC literature 42 Table 4.1 Summary of te models 101 Table 5.1 Problem generation parameters 103 Table 5.2 Problem generation parameters per partner type 104 Table 5.3 Summary caracteristics of te set of random generated problems 109 Table 5.4 Demand variability parameter and its values used for normal distributions Ill Table 5.5 Demand variability parameter and its values used for uniform distributions 112 Table 5.6 Values of LUB used for BP setting 118 Table 5.7 Values of L UB used for EP1 setting 119 Table 5.8 Values of LUB used for EP2 setting 119 Table 6.1 Quality of stocastic solutions of BP model 127 Table 6.2 Quality of stocastic solutions of EP1 model 129 Table 6.3 Quality of stocastic solutions of EP2 model 131 Table 6.4 Summary table of computational results wit different levels of demand variability under BP setting 134 Table 6.5 Summary table of computational results wit different levels of demand variability under EP1 setting 138 Table 6.6 Summary table of computational results wit different levels of demand variability under EP2 setting 142 Table 6.7 Impacts of budget tigtness under BP setting 151 Table 6.8 Impacts of budget tigtness under EP1 setting 156 Table 6.9 Impacts of budget tigtness under EP2 setting 160 Table 6.10 Computational results under BP setting 178 Table 6.11 Comparison of te budget usages under BP setting 180 Table 6.12 Computational results under EP1 setting 182 Table 6.13 Comparison of te budget usages under EP1 setting 184 Table 6.14 Computational results under EP2 setting 186 vi

9 List of Tables (Cont.) Table 6.15 Comparison of te budget usages under EP2 setting 190 Table 6.16 Comparison of te impacts of liability control on LRP profitability across different model settings 193 Table 6.17 Comparison of te impacts of liability control on cost of rewards across different model settings 194 Table 6.18 Comparison of te impacts of liability control on ordering quantity of rewards across different model settings 195 vn

10 List of Figures Figure 2.1 General LRP system 13 Figure 2.2 Organizational structure models: Type A (I, II, III) 14 Figure 2.3 Organizational structure models: Types B (I, II, III, IV) and Type C 15 Figure 2.4 Typology framework for LRPs 21 Figure 3.1 Conceptual model of a rewards-points supply cain 53 Figure 3.2 Illustration example of value creation 56 Figure 3.3 Effect of bonus points on accumulation demands 70 Figure 6.1 Estimated mean gaps wit different sample sizes and sample replications 122 Figure 6.2 Confidence interval upper bounds of te estimated mean gaps wit different sample sizes and sample replications 123 Figure 6.3 CPU times wit different sample sizes and sample replications 124 Figure 6.4 LRP profitability under BP, EP1, and EP2 settings 163 Figure 6.5 Liability ratios under BP, EP1, and EP2 settings 167 Figure 6.6 Ordering quantity of rewards under BP, EP1, and EP2 settings 171 Figure 6.7 Comparison of budget usage ratios across different model settings 195 vin

11 List of Appendices Appendix A.l Sample of LRPs in today's marketplace in Canada 223 Appendix B. 1 Computational outputs for examining BP model solvability and determining sample size and sample replications 228 Appendix B.2 Computational outputs for examining EP1 model solvability and determining sample size and sample replications 229 Appendix B.3 Computational outputs for examining EP2 model solvability and determining sample size and sample replications 231 Appendix C. 1 Summary table of bonus points to offer wit different levels of demand variability under EP1 Setting 234 Appendix C.2 Summary table of options to purcase and to exercise wit different demand variability under EP2 Setting 237 Appendix C.3 LRP profitability comparisons across BP, EP1, and EP2 239 Appendix C.4 Liability ratio comparisons across BP, EP1, and EP2 242 Appendix C.5 Budget usage comparisons across BP, EP1, and EP2 245 Appendix D. 1 Comparison of te impacts of budget tigtness wit a given level of demand variability under BP setting 249 Appendix D.2 Comparison of te impacts of demand variability wit a given level of budget tigtness under BP setting 252 Appendix D.3 Comparison of te impacts of budget tigtness wit a given level of demand variability under EP1 setting 256 Appendix D.4 Comparison of te impacts of demand variability wit a given level of budget tigtness under EP1 setting 259 Appendix D.5 Comparison of te impacts of budget tigtness wit a given level of demand variability under EP2 setting 263 Appendix D.6 Comparison of te impacts of demand variability wit a given level of budget tigtness under EP2 setting 266 Appendix D.7 Comparison of te impacts of te model settings wit a given level of budget tigtness and a given level of demand variability 270 ix

12 List of Appendices (Cont.) Appendix E. 1 Extended matematical model for Problem BP wit revenue-saring type of contracts 283 Appendix E.2 Extended matematical model for Problem EP2 wit multi-layer of contracts 286 x

13 Capter 1 Introduction Tis capter provides an introduction to te study. It starts by examining te status quo of loyalty reward programs (LRPs) wile introducing te concept and management of LRPs. After tat, te motivation of te study and te researc objectives are discussed. Finally, te organization of te tesis is presented. 1.1 Background and Researc Motivation Since te debut of te American Airlines' AAadvantage program in 1981 (Duffy, 1998), LRPs ave been employed by a wide range of companies in te consumer goods and service industries. LRPs are today being offered in a number of industries suc as airline, retail, otels, financial services, telecommunications, and gaming and entertainment. In te airline industry alone, more tan 130 companies ave an LRP, and 163 million people trougout te world collect loyaltybased air miles 1. LRPs ave been quite popular in te United States, United Kingdom, Canada, and a ost of oter countries. Recent studies (e.g., Berman, 2006) sow tat no less tan 90 percent of te consumers in tose countries ave at least one loyalty card. Many of tem are enrolled in multiple loyalty reward programs. Altoug various LRPs exist in today's business world, te fundamental business logic beind tese programs is te same: to offer consumers incentives or rewards for repeat business. Tese incentives or rewards, in turn, serve as motivation for consumers to continue buying products from te same product provider. Terefore, LRPs ave been widely adopted as an important component of customer relationsip 1 "Funny Money," Economist, December 24, 2005,

14 management strategy tat targets long-term customer profitability (e.g., Jain and Sing, 2002; Liu, 2007; Meyer-Waarden, 2008). Generally speaking, in a typical LRP system, tere are four key players: LRP members, an LRP ost, LRP partner(s), and LRP service provider(s). LRP members refer to te end consumers wo own a member account and/or a membersip card. LRP ost is te firm tat owns or manages te program. LRP partners refer to te business entities oter tan te ost firm, wo join te program to offer accumulation and/or redemption options to LRP members. LRP service providers refer to firms wic provide tecnical support (e.g., maintaining a customer database tat stores all LRP members' purcase istory) for te LRP business. In suc a system, LRP members, based on some specified accumulation sceme, earn loyalty units (e.g., points or miles) along wit teir purcases of products trougout te network of LRP commercial partners. Tese units can later be redeemed based on a "reward cart" pre-establised by te LRP ost. Loyalty units tat are not redeemed by LRP members are saved in a "reserve" account and constitute te LRP outstanding balance (referred to as "liability" 1 ). Loyalty units (e.g., points) earned by LRP members during a given period (e.g., a year) constitute te LRP accumulated points (referred to as "accumulation"), wereas loyalty units redeemed by LRP members for rewards during a given period constitute te LRP redeemed points (referred to as "redemption"). In recent years, tere as been a general recognition in te industry of a need for more sopisticated loyalty-based systems capable of responding to long-term competitive treats suc 1 Liability refers to te value of future redemption obligation of loyalty units (e.g., points or miles) earned by LRP members in an LRP. 2

15 as retail overcapacity, spending on mass advertising, and consumer attrition issues. Two new trends of LRP development ave been noticed. One trend is tat some of te LRP service providers ave replaced te traditional LRP ost firms (e.g., airline companies or retail firms) to become LRP osts temselves and treat LRP as teir core business. For tese loyalty-based service companies, te primary source of teir revenue comes from te sale of loyalty units to commercial partners' (referred to as "accumulation partners"). Tese LRP osts incur teir main costs at te time an LRP member redeems points for rewards, as te LRP ost as to purcase te rewards from its commercial partners (referred to as "redemption partners"). Anoter trend is tat in order to compete effectively and to continue contributing to value growt, many existing LRPs ave been restructured or expanded in scope to partner wit oter non-lrp firms to offer new products and/or services. As suc, te competition between tese LRPs is no longer among individual business entities, but among te networks of business entities involved in tese LRPs. Te growt of LRPs in recent years as led to a considerable increase in teir management and control complexities. For example, Aeroplan, Canada's premier loyalty program, was founded in 1984 by an airline company (Air Canada) as an internal marketing program. Since ten, Aeroplan as experienced organizational restructure and expansion several times. Now te program is owned and operated by Group Aeroplan Inc., a loyalty-service-oriented company. At present time, Aeroplan as an accumulation and redemption network of over 75 commercial partners representing more tan 150 brands. In 2010, more tan two million rewards were issued to members. Te revenue from te sale of Aeroplan 2 Miles was $1,033 million, and te total cost of rewards was $665 million in te year Air 1 ttp:// Reports/ MDA.pdf (page 7, accessed in July, 2011) 2 ttp:// Reports/ MDA.pdf (page 15, accessed in July, 2011) 3

16 Miles, a primary competitor of Aeroplan founded in 1992, as more tan 9.5 million active mile collector accounts, representing approximately two-tirds of all Canadian ouseolds. Te program is owned and operated by anoter loyalty-service-oriented company named LoyaltyOne, Inc. Air Miles offers its members more tan 1,200 different leisure, entertainment, mercandise, travel, and oter lifestyle rewards wen members sop at one of more tan one undred brand-name sponsors of te program 1. Despite te wide adoption of LRPs in te business world, te increasing economic impacts of tese programs, and te increase of te complexities in managing tem, tere are few academic models tat specifically deal wit LRPs to support planning and operational decision making. Te majority of te existing papers are limited in teir coverage of marketing-oriented LRP management problems. Many LRP operational issues ave not yet been fully explored. Tese issues relate to, for instance, prediction and control of liability; sort-, medium-, or long-term planning for rewards and points supply; accumulation and redemption demand forecasting; contract design for coordination between LRP ost and partners; and revenue assessment. Tis motivated us to devote our researc efforts to addressing operational issues in LRP management. 1.2 Researc Objectives A crucial operational issue faced by LRPs is tat of planning and managing te supply of rewards (and points) efficiently and effectively in order to acieve management goals - suc as meeting customer demand, improving customer satisfaction, lowering operational costs, or generating iger profits - wile taking into account bot internal (e.g., resource limitations, 1 ttp://lovalty.com/busmcss/air-rniles-rcward-program (accessed in July, 2011) 4

17 management requirements or targets) and external dynamics (e.g., demand uncertainties or competition treats). In fact, LRP managers rely on good planning for rewards-supply to maintain a balance between te customer service levels and te overall costs of rewarding customers, and to assess te growt of te program and te risk level associated wit tis growt. Te lack of availability of rewards at te time of redemption results in a poor service level and/or an increase of te reward supply costs to meet customer demands, since te LRP ost will ave to acquire te additional rewards at a iger cost. On te oter and, too muc availability will result in a iger cost as well (altoug te level of customer service would be ig in tat case). Te unused rewards availability will result in a penalty wenever te LRP ost decides to reduce or cancel teir reservation of rewards or return unused rewards to reward suppliers (i.e., LRP partners). In effect, in setting up long-term contracts wit partners, te LRP ost must decide te volume of rewards to purcase in advance. Moreover, good planning for rewards-supply provides LRP managers wit te ability to develop promotion plans tat seek for better management of redemption demand among multiple partners, or for better management policies to mitigate te risks associated wit te increases of liability. It is for tese reasons tat we explore te planning of te supply of rewards in tis study. More specifically, we focus on examining aggregate rewards-supply decisions and te associated LRP performance for a single-period planning orizon. We study te planning issue from only te LRP ost point of view. Our researc objectives are defined as follows: 5

18 (1) Develop an analytical model to cope wit rewards-supply planning decisions in te presence of (a) multiple commercial partners wo are involved in te redemption and accumulation business to offer various points collection and redeeming options to LRP members; (b) multiple resource constraints suc as budget and capacity constraints; (c) multiple management concerns including LRP profitability, liability control, and demand uncertainties. (2) Examine te impacts of internal dynamics and external uncertainties on LRP profitability and an LRP ost's rewards-supply planning decisions. Te internal dynamics tat we focus on in tis study are te canges in rewards budget and te canges in target liability. Te external uncertainties tat we focus on are LRP members' accumulation and redemption demand uncertainties. (3) Investigate te role of cooperative advertising in dealing wit internal dynamics and external uncertainties in LRP rewards-supply planning. It is a common practice in LRPs tat LRP members can receive "bonus points" wen tey purcase specified products or services from some LRP partners during a certain time period. Tis kind of advertising/promotion activities is offered by an LRP ost as a type of cooperative advertising between te LRP ost and its partners. As pointed out by practitioners 1 : "te timing and amount of bonus points increase (point) liability, and sould be used strategically to drive beaviors tat continuously increase spending or create a deeper sense of loyalty"), bonus points not only ave an impact on LRP members' accumulation demand but also on liability. 1 Sneed, G.L "Points Liability - Enoug, or Too Muc?" ttp://newsoct05.maritzloyalty.us/..index.ptml (accessed in July, 2011) 6

19 (4) Investigate te role of option contracts in dealing wit te internal dynamics and external uncertainties in rewards-supply planning. In te supply cain and operations management (SC/OM) literature, option contracts are widely regarded as a type of SC coordination mecanism between commercial suppliers (e.g., manufacturers) and buyers (e.g., retailers). Researcers ave pointed out tat option contracts can provide more flexibility in coping wit demand uncertainties. In an LRP, redemption partners can be viewed as te suppliers of rewards and te LRP ost can be viewed as a buyer of rewards. Terefore, instead of resorting to a traditional supply contract, suc as wolesale-priceonly, we assess weter option contracts can provide more flexibility to cope wit internal dynamics and external uncertainties in rewards-supply planning problem. Tis study contributes to LRP literature and practices by addressing te following researc questions: 1) How can te rewards-supply planning problem (RSPP) be formulated matematically and solved effectively so as to ensure tat good quality solutions can be obtained for largescale problems in a reasonable computational time? 2) How does demand variability affect LRP performance in terms of LRP profitability, liability, and cost of rewards? Do te impacts of demand variability vary among different model settings? 3) How does budget tigtness affect LRP ost decisions as well as LRP profitability and liability? Do te impacts of budget tigtness vary among different model settings and under different levels of demand variability? 7

20 4) How does te liability control tigtness affect LRP ost decisions as well as LRP profitability and reward costs? Do te impacts of liability control tigtness vary among different model settings and under different levels of demand variability? 1.3 Outline of te Tesis Te tesis is divided into seven capters. Te next capter reviews te literature tat is most relevant to tis study. Te literature review is based on tree areas: loyally reward programs, option contracts, and cooperative advertising. In addition, a typology framework is presented to provide a guideline for understanding te features of LRPs. Capter 3 first describes te teoretical background used to develop our analytical models, and ten provides a detailed explanation of te matematical models, including model assumptions, problem description, and model formulation. Capter 4 reports on te solution metodology. It starts wit a brief introduction to stocastic linear programming and ten presents a euristic-based solution procedure for solving our models. Te callenges involved in te implementation of te solution procedure are also discussed. Capter 5 describes te design of our numerical studies carried out troug computer simulation. Te computational results under eac model setting, as well as across te model settings, are presented and analyzed in Capter 6. Finally, Capter 7 igligts te main findings and managerial implications, summarizes te contributions and limitations of tis study, and discusses future researc directions. 8

21 Capter 2 Literature Review Tis capter provides an overview of previous studies on tree subjects: LRPs, option contracts, and cooperative advertising. It begins by reviewing literature on LRPs and examining te status quo of LRPs in today's marketplace. Tis leads to proposing a typology framework to capture te variety of LRPs. Te type of LRPs tat tis researc focuses on is ten presented in detail. Next, te literature on supply cain contracts is discussed, especially option contracts and teir modeling in te literature. After tat, te concept of cooperative advertising is introduced and a brief review of te literature on advertising budget allocation and advertising-sales response function follows. Eac section contains a summary of te relevance of previous studies and of tis researc work. Because LRPs, cooperative advertising, and option contracts are tree broad researc areas, we limit our literature review to te concepts and models tat are relevant to our study. 2.1 Loyalty Reward Programs In tis section, we first introduce te concept of LRP and provide a typology framework of LRPs. Ten a survey of tirty-nine well-known LRPs in today's marketplace is provided. After tat, we review and discuss te main researc streams in te LRP literature. Our view of LRPs in tis study is also presented Overview LRPs are also known as loyalty programs, rewards programs, "frequent-sopper" programs, "frequent-guest" programs, and "frequent-flier" programs. "Loyalty" and "reward" are te core 9

22 concepts in tese programs. More specifically, loyalty is te primary purpose of LRPs and reward is te key instrument for attaining it. According to Oliver (1999), customer loyally is a deeply eld commitment to buy or patronize a preferred product or service consistently in te future. Altoug academia still debates te meaning of customer loyalty (e.g., Dick and Basu, 1994; Palmer, 1996; O'Malley, 1998), tere is no doubt tat customer loyalty as become an important asset to a firm (Liu, 2007; O'Brien and Jones, 1995). It as long been proven in psycology studies (e.g., Ebert, 2003) tat reward as a strong impact on a person's decision making as well as on beavior modification. In LRPs, rewards refer to all kinds of incentives suc as discounts, rebates, free goods, or special services. Tese rewards are designed to encourage customers to keep doing business wit one firm or a group of firms sponsoring te same LRP rater tan wit competitor firms. In te literature, tere is no universal definition of LRPs because researcers view tem in different ways. Some of te researcers (e.g., Taylor and Neslin, 2005; Berman, 2006; Nunes and Dreze, 2006) take a broad view and consider any business/marketing program tat uses certain formats of rewards to enance repeated purcases by customers as LRPs. Using tis definition, irrespective of weter a program uses a simple format like "buy a cup of coffee ten times and get one free at te elevent time" or applies a complex structure as in te case of Aeroplan, it will be designated as LRP. However, oter researcers old te view tat some of te simple format programs suc as "20% off towards your next purcase" are not true LRP programs because tese programs do not reward loyal beavior on te basis of a customer's purcase istory of products/services. In oter words, tese programs focus on sort-term profits 10

23 rater tan long-term customer assets (Sugan, 2005). Terefore, we propose a different definition of LPRs, wic is based on literature and our studies. A business/marketing program may be considered as a loyalty reward program (LRP) wen it displays all of te following features: Te program targets customers' long-term profitability or customers' life-time value. Te program requires customer enrollment. Te program collects customer information and records customers' purcase istory of products/services troug membersip cards, co-branded credit cards, or identification numbers (e.g., login ID) tat customers use. Te program rewards repeated customer purcase beavior on te basis of customer's purcasing istory. Te program as clear reward scemes explicitly stating ow customers will be rewarded and te benefits tat customers can obtain after tey join te program. Despite te increasing use of LRPs worldwide, and proliferation of a large variety of LRPs in recent years, few studies ave addressed classification of LRPs, except Kadar and Kotanko (2001), Bagdoniene and Jakstaite (2006), and Berman (2006). Kadar and Kotanko (2001) studied LRPs in terms of organizational structure and classified LRPs into tree categories: exclusive one-company programs, inclusive company-specific programs, and cross-company programs. Exclusive one-company programs refer to programs operated and controlled solely by one firm; inclusive company-specific programs refer to programs wic ave been extended to include a 11

24 number of partners; and cross-company programs refer to te programs created by a group of companies togeter. Focusing on te customer perspective, Bagdoniene and Jakstaite (2006) classified LRPs into open or closed programs, programs for end customers or for intermediate customers, and direct or indirect programs. In an open program all customers are eligible to join te program, as long as tey purcase goods or services from te LRP firm. In a closed LRP program only desired or invited customers can join. Programs for end customers are te business to consumers (B2C) LRPs, wereas tose for intermediate customers are business to business (B2B) LRPs. Direct LRPs provide customers some financial benefits as rewards, suc as permanent discounts, gift cards, or free products. In contrast, indirect LRPs provide customer rewards tat are non-financial privileges (e.g., pre-board services or free access to te business lounge at airports) (Bagdoniene and Jakstaite, 2006). Berman (2006) in is study discussed four types of LRPs in terms of reward sceme: members receive additional discount at register, members receive one unit free wen tey purcase n units, members receive rebates or points based on cumulative purcases, and members receive targeted offers and mailings. We found tat altoug tese classifications touced different aspects of LRPs, none of tem capture te full expanse of te variety of LRPs in today's marketplace. Terefore, we address tis issue and propose a compreensive framework for LRP classification in te next section. Our typology framework was developed based on business to customers (B2C) LRPs only Typology Framework for LRPs Te typology tat we propose ere is based on te relationsip view of an LRP system. In general, tere are five fundamental entities involved in an LRP system (see Figure 2.1). Te ost 12

25 is te business entity tat launces or owns te program. LRP is te program itself Partners (also known as sponsors) refer to te business entities tat join te program to provide redemption and/or accumulation options. Members are te consumers wo participate in te program to redeem rewards troug purcasing products or services from osts or partners/sponsors. Service providers are te business entities tat provide service or tecnical support for te program but do not communicate wit te members directly (Nsakanda et a, 2006). v4=l Dimensions: \ Redemption ; (and accumulation) Sceme Dimensioni: Organizational Structure Figure 2.1: General LRP system (source: Nsakanda et a, 2006) Te variety of LRPs can be viewed as arising from te different relationsips among tese entities. As bot organizational structure and redemption (and accumulation) sceme are te key determinants of te relationsips among tese entities, we treat tem as two dimensions of te framework. Organizational structure defines te relationsips among entities in te lower triangle; wile te redemption (and accumulation) sceme defines te relationsips among te entities in te upper triangle, especially among members and te oter tree entities (i.e., ost, LRP, and partners). 13

26 Typology Dimension One Organizational Structure Organizational structure defines te relationsips among LRP ost, LRP service providers, and LRP partners. Along tis dimension, LRPs are grouped into tree categories: Type A, single sponsor programs; Type B, multi-sponsor programs; and Type C, joint programs. Under types A and B, tere is a subdivision, wic we ave adopted from Gudmundsson et al. (2002) (see Figure 2.2). Gudmudsson et al. (2002) identified tree internal structure models of airline frequent flier programs (FFPs). We find tat tese structure models are also common in LRPs oter tan FFPs. Te graps in Figure 2.2 sow te differences among tese structure models. Type A Single-sponsor LRPs Host Host Host Type A-I Type A-II Type A-III Figure 2.2: Organizational structure models: Type A (I, II, III) (source: Gudmundsson et al., 2002) Types A-I, A-II, and A-III illustrate structures were an LRP is fully and solely owned by an LRP ost. In Type A-I, te LRP is an internal unit of te LRP ost and fully managed by te ost. Type A-II represents te structure were an LRP is partially managed by an LRP ost and some of te management functions are outsourced to oter firms or a tird party; wereas in te Type A-III model, all of te management functions of te LRP are outsourced. Te "exclusive one-company programs" mentioned in Kadar and Kotanko (2001) are quite similar to te Type A-I LRPs tat we define ere. 14

27 In te above models, te LRP ost is te sole sponsor offering accumulation and redemption to LRP members. In general, suc LRPs are limited in flexibility and are narrow in scope. We noticed tat in recent years many existing LRPs ave been restructured to contribute to value growt. Some of tose tird-party service agents in Type A-III model ave replaced te traditional LRP ost enterprises (e.g., airline companies or retail companies) to become LRP osts temselves. Meanwile, in order to compete effectively, LRP osts ave started to offer products and services in different categories troug partnersip wit oter non-lrp firms (e.g., Hofer, 2008). Terefore, Type B and Type C structure models (see Figure 2.3) ave appeared in recent years and ave become more and more popular in large-scale LRPs. Type B Multi-sponsor LRPs Type C Joint LRPs Type B-I Type B-II Type B-III Type B-IV Figure 2.3: Organizational structure models, Types B (I, II, III, IV) and Type C Type B models (I, II, and III) are extensions of Type A models (I, II, and III). In tese Type B models, LRPs follow te same ownersip and management structures as tose in Type A models, but ave multi-redemption and/or multi-accumulation partners/sponsors. Type B-IV model represents te structure were LRP and related services are te focal business of te ost firm (e.g., Aeroplan, Air Miles). Type B LRPs are known as multi-sponsor programs or coalition programs. Te "more inclusive company-specific program" in Kadar and Kotanko (2001) is similar to a Type B-I LRP. 15

28 In contrast to tese structure models, Type C model represents te structure in wic an LRP does not belong to any individual firm (i.e., no sole ost) and is formed wen a number of firms band togeter to develop a joint program, known in te literature as joint LRP program 1 or crosscompany program (e.g., Kadar and Kotanko, 2001). In Types B and C, customer loyalty is no longer built around a product or a company but around te LRP program and te associated reward system. Suc programs not only possess significant advantages in operational scale and offer a wide range of benefits to members, but more importantly tey can leverage teir customer bases for cross-selling (Kadar and Kotanko, 2001). In tese LRPs, eac company brings different capabilities to te table and eac may take away a different form of value. In tis way, tey are structured as win-win solutions for bot LRP ost and LRP partners. Typology Dimension Two Redemption (and Accumulation) Sceme Te second dimension of te typology framework is based on redemption (and accumulation) sceme. Redemption (and accumulation) sceme primarily defines te relationsip between LRP members and te LRP. It is also identified in te literature as an element tat is essential to te administration and positioning of LRPs. Fundamentally, tere are two strategies for designing redemption (and accumulation) scemes: static and dynamic. Te term 'static' refers to tose scemes tat do not cange over time. Tey usually take te form of "one sceme applicable for all LRP members". Tis type of sceme is 1 "A tang of bitter-sweet loyalty". Brand Strategy, Oct

29 used quite often in large retailing industries suc as Te Bay, Soppers' Drug Mart, and Loblaws. Common rewards offered to LRP members are cas back and gift cards. Tese firms ave a large customer base and tey essentially deal wit products. Teir marginal cost and revenue per customer are low. In tese firms, LRPs are viewed purely as marketing tools. Dynamic reward scemes are quite often used by enterprises tat specialize in LRPs or large service-industry companies tat ave a large number of partners. Te pricing, type, and timing of redemption (and accumulation) in tese scemes cange over time, and are structured differently for different member segments. Dynamic reward scemes offer LRP members more accumulation and redemption coices. On te oter and, members need to put in muc more effort in order to take advantage of te 'ever-canging' scemes. Altoug te design and administration costs are iger, dynamic scemes ave muc more flexibility and capability to improve te profitability of LRPs. Compared to te dynamic scemes, te static scemes are muc simpler, requiring lower design and administration costs, and lesser learning effort on te part of members. Overall, LRPs can be classified as eiter using a static sceme strategy or using a dynamic sceme strategy. In addition, no matter wic design strategy is used, an LRP can be furter classified based on four oter sceme-related criteria: reward medium, redemption (and accumulation) timing, reward type, and redemption (and accumulation) grid. Reward medium. In many LRPs, te relationsip between a member's purcase effort and a final outcome is mediated by te presence of an intermediate currency known as 'reward medium' or 'loyalty unit' (i.e., points or oter excange units). As Duffy (1998) pointed out, te 17

30 communication between an LRP ost and LRP members may get confusing wen no proper unified medium is used. Points, miles, or voucers are te most popular reward mediums tat are used to link members' spending to rewards. Most existing LRPs use a single-medium (e.g., expenses -> points -> rewards), te rest are eiter no-medium LRPs (e.g., expenses -^ rewards) or multi-medium LRPs (e.g., expenses -> points -> voucers -^ rewards). Hence, reward medium refers to weter a program currency is used or not and wic program currency is used. Te paper by Si and Soman (2004) was te first study to examine te effectiveness of an LRP from te reward-medium perspective. Tey proposed an analytical model to formulate customer valuation on single-medium (i.e., points only) and multi-medium (i.e., points and voucers) LRPs and conducted laboratory experiments to compare te impact of single-medium vs. multi-medium on member valuation of LRPs. Tey found tat te multi-medium LRP is more attractive to LRP members, wic in turn results in a positive effect on member purcasing beavior. In real-life LRPs, altoug most of te programs use at least one reward-medium, tere are a few programs in wic LRP members are rewarded witout using any reward-medium (e.g., M&M Max, Reservation Rewards, ETR Rewards, see in Appendix A.l). In tose programs, LRP members are rewarded directly based on teir spending. Terefore, LRPs can be classified based on reward medium as: no-medium LRPs, single-medium LRPs, or multi-medium LRPs. Reward type. Reward type refers to te type of rewards offered by an LRP. Tis criterion as been studied in previous LRP literature. Dowling and Uncles (1997) classified LRPs into eiter direct-reward LRPs or indirect-reward LRPs. A direct-reward LRP refers to an LRP offering 18

31 rewards tat directly support te value proposition of te products and/or services tat te LRP ost or sponsors provide (e.g., gift card, free tickets). Te main purpose of offering a directreward is to keep customer loyalty on a single product, one company, or one LRP brand (e.g., Aeroplan). An indirect-reward LRP is defined as an LRP presenting rewards tat indirectly cause te LRP members to buy products or services. Tis type of reward as no linkage wit products/services. Usually, tis type of reward is money-oriented. Discounts, rebates, and casback are te typical formats of indirect rewards. As te money tat customers get back can be used elsewere, indirect rewards in most cases cannot lock a customer to furter purcases or to use te products or services provided by an LRP. Following Dowling and Uncles' classification, Kim et al. (2001) examined te decisions on selecting direct- or indirect- rewards (i.e. firm's own products/services vs. cas) wen te firm faces different customers (eavy vs. ligt users or price sensitive vs. insensitive users). In today's marketplace, fewer LRPs offer indirect-reward solely because it is believed tat direct-reward is more appropriate for creating loyal customers. Some LRPs offer bundles of direct- and indirect- rewards to teir members (Nunes and Park, 2003). Terefore, under tis criterion, LRPs can be grouped into LRPs offering indirect rewards, LRPs offering direct rewards, or LRPs offering mixed rewards (i.e. bundles of direct- and indirect- rewards). Redemption (and accumulation) timing. Redemption (and accumulation) timing is used by some researcers to refer to weter an LRP offers immediate or delayed rewards (e.g., Dowling and Uncles, 1997, Zang et al, 2000; Yi and Jeon, 2003; Ke and Lee, 2006). Delayed rewards are benefits and incentives tat are obtained or are redeemable at a later date from te point of 19

32 sale. Conversely, immediate rewards refer to benefits tat are experienced at te point of transaction. Examples of immediate rewards include direct-mail coupons, discounts, or price cuts offered to customers at te point of transaction (Dowling and Uncles, 1997). However, as immediate rewards do not relate to a customer's cumulative purcasing beaviour over time, tey are less effective in retaining consumers tan delayed rewards (Zang et al, 2000). From our point of view, redemption (and accumulation) timing involves te variable of time in te redemption (and accumulation) sceme. For example, in some LRPs, points accumulated or rewards available for redemption expire after some days. Obviously, using redemption (and accumulation) timing can increase flexibility in LRP operations; owever, it creates time pressures on LRP members. Members must remain active in order to keep teir status in te program. For instance, members are required to acquire or redeem points, sometimes up to a certain minimum level witin a certain time period. Tis type of requirements may ave negative impact on members' valuation of te program. Atak (2005) found tat te potential of an LRP to attract members is determined by te value of te rewards it offers, as well as by te timing of te rewards available. In reality, weter to use redemption (and accumulation) timing or not depends on an LRP's overall strategy. Some LRPs use redemption (and accumulation) timing eavily, wile oters coose not to use it at all 1. Terefore, based on te redemption (and accumulation) timing criterion, LRP can be classified into two categories: LRPs using reward timing or LPRs not using reward timing. Wells, Jennifer, "Exporting te Loyalty Business: Hoarding, Frustrating, Winning," ttp:// [Accessed Sept. 30, 2008] 20

33 Redemption (and accumulation) grid. Redemption (and accumulation) grid refers to te detailed reward prices (and accumulation options) offered for members. Redemption (and accumulation) grid can be stated in terms of number of points or miles, amount of LRP members' spending, members' purcase frequency, or members' portfolio. Here portfolio refers to, for instance, te combination of members' spending, product category, and membersip 'status' or 'tier'. Terefore, based on tis criterion, LRPs can be classified as LRPs using an amount-based grid, LRPs using a frequency-based grid, or LRPs using a portfolio-based grid. To our knowledge, earlier researc work as not discussed tis criterion formally. Organizational _ structure Single-sponsor: Type A (I, II, m) Multi-sponsor: Type B (I, II, in, IV) Joint: Type C LRP typology framework Redemption (and accumulation) - sceme Design strategy static dynamic no-medium Reward medium j. singfe-medium multi-medium Reward type Redemption (and accumulation) timing direct indirect mixed use not use Redemption (and " based on amount accumulation) grid - based on frequency. based on portfolio Figure 2.4: Typology framework for LRPs Based on te above discussion, we present a two-dimensional typology framework in Figure 2.4 below. Tis framework elps researcers and practitioners to distinguis different facets of LRPs 21

34 systematically and to identify te key caracteristics tat are important for LRP design and implementation. Due to te large number of LRPs in today's marketplace, a sample of tirty-nine well-known LRPs in Canada (see Appendix A.l) is surveyed according to tis typology framework. Among te tirty-nine LRPs, seventeen programs are of Type A, twenty programs are of Type B and te two remaining programs are of Type C. In te table of Appendix A. 1, we also pointed out weter eac LRP runs as a profit center or a cost center. Generally speaking, te LRP tat runs as a profit center is an independent business entity and its management focus is on creating revenue directly troug te program and te associated business. Taken in tis sense, only Type B-IV and Type C LRPs can be profit centers, and te oter types of LRPs are eiter cost centers or semi-cost centers. In a cost center LRP, management focus is on te LRP's contributions to te ost firm's focal business. In a semi-cost center LRP, te management focus remains te same as tat in a cost center LRP; but te ost firm also attempts to create extra revenue troug LRP operations directly. For example, te LRP ost may sell points or offer LRP-related services to commercial partners (Nunes and Dreze, 2006) Literature Review of LRPs In tis section, we provide a brief review of LRP literature from tree perspectives: researc topic, researc metodology, and types of LRPs tat ave been examined. 22

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