Loyalty glossary · 2. Accounting and finance (25)
Cost Of Rewards
Cost of rewards is the financial obligation a loyalty programme carries for the points it has issued, measured as the expected cost to fulfil redemptions. It is recognised as a liability on issue and reduced when members redeem, not when points expire.
Under accrual accounting, cost of rewards is not the cash paid when a member redeems. It is the estimated liability recorded at the moment points are issued. A loyalty programme cannot recognise the full sale price as revenue because a portion of that sale price is an obligation to provide a future reward. This is the core of ASC 606 treatment, where points are a separate performance obligation and a corresponding contract liability sits on the balance sheet.
The estimate is where the trouble starts. Cost of rewards depends on three assumptions: the redemption rate, the cost per point, and the timing of redemption. Each of these is set by the operator, and each can be moved without changing a single member behaviour. A high redemption rate assumption raises the liability and depresses current profit. A low redemption rate assumption does the opposite. This makes the cost of rewards a managed number, not an observed one.
Award availability drives the real redemption cost. If a programme restricts the number of seats or rooms available for points, it lowers the cash outlay per point redeemed, but it does not reduce the number of points outstanding. The liability remains, while the actual cost to settle shrinks. That mismatch is invisible in a raw accrual, because the accrual uses the assumed cost, not the cash cost that would apply if every point could be redeemed.
Work the arithmetic. A programme issues 1 billion points in a year and sets the redemption cost at 0.8 cents per point, so it records a cost of rewards of 8 million dollars. A 20 percent breakage assumption reduces that cost to 6.4 million dollars, a difference of 1.6 million dollars that never leaves the liability account. Change the breakage assumption to 25 percent and the cost drops to 6 million dollars, releasing another 400,000 dollars onto the P&L with no change in member activity.
The correct measure of cost of rewards is the expected redemption value, not the marginal cost of fulfilling the reward. Operators that book the marginal cost are understating the liability, because they are treating the points as if the member will never redeem them at full value. This is the same trap as breakage accounting: a forecast dressed up as a fact. Auditors rarely challenge the assumptions behind the number, and that is why the cost of rewards line deserves more scrutiny than it usually gets.