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The Bottom Line on “Free” Gift Cards

The key question for retailers: Do consumers use the cards to stockpile or to spend more than they planned?

(originally published by Booz & Company)

Title: Analysis of Free Gift Card Program Effectiveness (Fee or subscription required.)

Authors: Moutaz Khouja (University of North Carolina at Charlotte), Jingming Pan (University of Electronic Science and Technology of China), Brian T. Ratchford (University of Texas at Dallas), and Jing Zhou (University of North Carolina at Charlotte)

Publisher: Journal of Retailing, vol. 87, no. 4

Date Published: December 2011

Is there profit for companies that offer “free” gift cards? For large retailers there may be, this paper finds. But turning the promotion into profit requires understanding consumers’ purchasing behavior, timing the offer correctly, and having high-margin inventory that encourages customers to spend more than they otherwise would, not merely stockpile items they would buy anyway.

Although most gift cards are sold at face value, many stores have begun giving cards away when a customer’s purchase amount exceeds a certain threshold (typically with the hitch that they can’t be redeemed that day, and often with brief redemption periods). For example, during certain promotions, Kohl’s offers US$10 in “holiday cash” for every $50 purchase, and Best Buy gives a $10 gift card for a $100 purchase, $25 for a $250 purchase, and $50 for a $500 purchase.

Other promotions, such as price discounts, coupons, and mail-in rebates, have been extensively studied, but little attention has been paid to the emergence of free gift cards. The cards offer several potential advantages for retailers. Although discounts produce an immediate reduction in revenue, gift cards are designed to be used in the future — if they are used at all. The cards, whether free or purchased, frequently get lost, forgotten, or redeemed for only partial value; a 2007 study found that 19 percent remained unredeemed nine months after they were issued.

The authors of this paper sought to determine under what circumstances free gift cards could be profitable, what effect consumers’ behavior and purchase patterns had on profitability, whether these cards offered advantages for the retailers over discounts, and which kind of retailers could use the cards most profitably.

Across several models of consumer and retailer behavior, the authors’ analysis revealed that the cards can be much more profitable than more established discount schemes for two main reasons. The first is that the cards can generate additional income by inducing consumers to spend more than they otherwise would to qualify for the promotion. The second reason is that the cards encourage consumers to make additional purchases when they redeem them.

For low-margin retailers selling products that consumers can easily stockpile, however, such as grocery store items, the cards won’t be as profitable. The reason: By stockpiling the items they bought to get the card, consumers are likely to make fewer trips to the store, creating fewer opportunities to buy additional items. Ultimately, they are likely to use the card on things they would have bought anyway.

“Since gift cards have to generate incremental purchases in order to be profitable,” the authors write, “they would seem most useful for sellers of items which consumers might not buy at all otherwise, such as items of clothing, electronic gadgets, or books,” or products they would not have purchased by just using cash.

Retailers need to deploy different tactics depending on customers’ budgets, the authors suggest. For those who don’t have constraints on how much they spend, the analysis revealed that retailers would profit more by offering a single large-value gift card at a high qualifying purchase amount, which would encourage customers to spend more overall. But when targeting consumers working with a tight budget, the free cards should be offered in incremental amounts, increasing in value as the level of purchases goes up.

If consumers correctly judge the likelihood that they will redeem the card and not spend beyond its value, the cards have only a slight profit advantage (about 1.2 percent) over discounts, the difference coming from extra sales generated by the qualifying amounts. But the profit advantage can be more than 10 percent when customers misjudge how much they will spend and go beyond the card’s limit.

The authors also offer several lessons for managers, who can adjust product prices to increase consumers’ spending beyond the cards’ limit during the redemption period. By using sales data from the period when the cards were issued, managers can periodically determine the amount of dollars held in gift cards and how many customers have them. During the redemption period, stores can focus their promotion efforts on products with higher prices, thus requiring most cardholders to spend more than the value of their cards.

Limiting or expanding the cards’ redemption periods could also be useful. For example, cards issued prior to Christmas could be redeemable for one week in early January, which might increase sales during an already busy period and bring customers back after the peak season.

It’s also important to keep consumers motivated to increase their purchase amounts even if they already qualify for one or more cards. For example, a display of $30 products could promote their purchase as “free with three $10 certificates,” encouraging shoppers who already have one or two $10 cards to keep spending to qualify for one or two more.

Bottom Line:
When implemented correctly, free gift card programs may be profitable for high-margin retailers, who can use them to generate sales they otherwise wouldn’t have, especially when consumers value other items besides the ones they plan to purchase. The cards can have an advantage over product discounts because consumers spend more on additional items to qualify for them and can often be induced to spend above the cards’ limit when they are redeemed.

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