Unlocking the Power of Membership Programs in Retail

Imagine running a grocery store where customers sometimes come in to buy, but at other times, they head to the store across the street. Why does this happen? Customers simply say, “I entered because I happened to pass by.” As the store owner, you might suggest, “Lower the prices, and I’ll visit more often.” In response, you declare, “If you’re a regular, I’ll definitely offer better prices.”

Customers express, “If you offer lower prices, I’ll become a regular,” while businesses counter, “If you become a regular, I’ll lower prices.” Both sides wish the other would make the first move, stepping back on prices or committing to consistent purchases. How do we resolve this deadlock?

To address this dilemma, let’s dive into the essence of this seemingly simple yet profoundly embedded commercial issue.

We’ve all come across the fundamental concept of “balancing price and quantity.” Customers and businesses alike understand the logic of “more quantity, lower price; lower price, more quantity.” But customers might think, “You lower prices first, and I’ll increase my purchases,” while businesses might consider, “If you increase your purchases, I’ll lower prices.”

At its core, this issue is a strategic “game” where neither customers nor businesses are willing to take the risk of offering lower prices or committing to increased purchases first.

So, what’s the solution? You might consider establishing a special relationship with your customers: a membership program.

What exactly is a membership program? You might be a member of an airline, a hotel chain, a supermarket, or even a salon. But what lies at the heart of a membership program? What are the economic principles and business essences behind it?

The essence of a membership program is akin to a collective buying agreement: “I promise to spend more at your establishment, and you promise to offer me greater benefits in return.”

Consider an example.

The renowned U.S.-based membership warehouse club, Costco, has established a similar “collective buying agreement” with its customers. In this arrangement called a “membership program,” customers pledge to purchase more at Costco, and in return, Costco pledges to offer lower prices.

However, what if a customer defaults and doesn’t frequently visit? Costco collects a $120 “membership fee” from each member, essentially functioning as a “performance bond.” If you’re a frequent visitor, this “performance bond” is refunded to you through the price difference in discounted products. But if you default, the deposit is forfeited.

If Costco defaults by not offering discounted prices, customers have the option to terminate their partnership, cease paying the next year’s “performance bond,” or $120 membership fee. Such a situation could lead to significant economic and brand losses for Costco.

Data reveals that Costco’s “collective buying agreement” in the form of a “membership program” has been executed remarkably well. Customers uphold their commitment, paying an annual $120 performance bond, with around 90% renewing their membership annually. Meanwhile, Costco maintains its commitment by controlling the overall product gross margin at around 6%, ensuring that no product’s margin exceeds 14%.

So, what should you do? You can create your own “collective buying agreement” with customers for your grocery store, establishing your own “membership program.” How can this “collective buying agreement” be enacted? There are two ways: entrance barrier contracts and escape cost contracts.

Entrance Barrier Contract:
Costco’s membership program is a classic “entrance barrier contract.” They offer extremely discounted prices as an incentive. Over the past few years, tens of millions of members have proved this effective. They wield bargaining power, hence, setting an “entrance barrier” for members: a $120 membership fee, serving as a “performance bond.”

A pharmacy, following Costco’s footsteps, has also adopted an “entrance barrier contract.” Their medications are genuinely cost-effective, giving them the confidence to charge a high membership fee of up to a hundred dollars. Customers voluntarily paying to join the pharmacy’s membership have kept their commitment. Among them, 50% spend $5000 annually, while 40% spend $3000. Simultaneously, the pharmacy diligently keeps its promise, keeping the gross margin on member medications within 10%, resulting in a win-win scenario.

Escape Cost Contract:
But what if customers have more choices? “I won’t charge a ‘membership fee.’ Just come, and all purchases accumulate points. These points can be exchanged for rewards such as vouchers, airline tickets, or hotel stays.” As consumption increases, the accumulated points become the customer’s “escape cost.”

As a member of the Marriott Bonvoy program, after staying 25 times in a year, I get a free upgrade to a suite regardless of the room I booked. This benefit is highly appealing to me, compelling me to stay more nights, furthering my quest to reach platinum status. In our “collective buying agreement,” my escape cost keeps rising as I stay more.

In conclusion, what is a membership program? It’s a “collective buying agreement” between businesses and customers. In this agreement, businesses gain repeat purchases, while customers benefit from discounted prices. Membership program designs vary widely, but fundamentally, they fall into two categories: entrance barrier contracts where businesses hold the advantage and escape cost contracts where customers have the upper hand.