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According to the International Financial Reporting Standard (IFRS) 15, the actual value of a firm’s Loyalty program’s deferred revenue will be based on three elements:
- The total number of outstanding points
- The value of a point (Cost Per Point = CPP)
- Breakage (this is the percentage of issued points that are expected to never be redeemed by members)
From a balance sheet and profit & loss (P&L), perspective, as soon as the Loyalty points are issued to members, the costs associated with the "potentially redeemable" points are incurred.
From a cash flow perspective, Loyalty is a great solution as the rewards are not redeemed at the point of purchase, but later at a future purchase or time, therefore, cash flow is maximized.
In general, reward points represent expenses, in the sense of the "reward" which the consumer will convert. These expenses have to be presented in the P&L report of a company at the time when the rewards are offered.
The way to present these expenses differs between the International General Accepted Accounting Principles (GAAP) such as IFRS/US GAAP, and the more prudent GAAPs, which are primarily used on a local basis in Europe.
Whereas International GAAP follows the approach that the expenses are embedded in the revenue and therefore part of the revenue has to be deferred to the time when the consumer convert their points, the prudent GAAPs leave the revenue unchanged and an expense has to be accrued.
Both GAAPs lead to a balance sheet liability and therefore impact the P&L.
Estimation of CPP and Breakage
Here are the methods for calculating:
Cost per points (CPP)
These are the expected expenses for the reward divided by the number of issued points.
This is the number of unused (removed) points divided by the number of issued points.
Impact of FX
FX risks can occur when expenses are calculated in a different currency than the value of the reward.
The CPP, and the expenses incurred, are tax-deductible and therefore not related to a tax risk.
Some countries demand a separate filing report of "points movement", which means their status and number (sometimes also the CPP) at the beginning of a fiscal year, the converted and non-converted numbers of points (expenses) during the year and the number (expenses) at the end of a year.
How to minimize the CPP while maintaining perceived value?
- Set an expiration time for your points
- Reward low-cost, but high-perceived-value gifts
- Reward exclusive access (exclusive product/sale)
In addition, align to current discount standards of your business to ensure post-loyalty rewards are no more than pre-loyalty rewards.
- Tier benefits
The reward cost should align with the required spend for that tier (e.g. ask yourself, how much you would discount today a customer with a yearly spend of $1,000). You should most probably reduce the cost of the tier benefits.
- Points benefits
The reward cost should reflect your current average discount on a purchase. For example, if this is 5%, and $1 = 1 point, you should ensure that your CPP is no more than $0.05.