Customer Lifetime Value

Customer lifetime value (CLV) is the amount of income a company can expect to earn from a customer over the life of their relationship with that customer. The amount calculated represents the present current value of future earnings the customer is expected to generate for the company. The amount of revenue a company can expect to realize from a particular customer will dictate what the company is willing to spend to attract and retain a certain customer.

There are three pieces of information needed to determine the CLV of a particular entity in its most basic form. These pieces of information include (1.) the per-period cash margin per customer ($M), defined as sales revenue minus variable costs and other cash expenditures needed to retain the customer; (2.) the retention rate (r), referred to as the per-period probability that the customer will be retained and (3.) the interest rate (i) used for discounting future earnings (Kerin, R., & Peterson, R. (2010). The formula for calculating CLV by utilizing the previous three values can be written as:

Customer Lifetime Value = $M (1 / 1 + i r)

We can imagine a company that has a customer with an annual margin of $1000. The average retention rate for this hypothetical company is 85 percent. The interest rate used for discounting future cash flows is 10 percent. This would be calculated as:

Customer Lifetime Value = $1000 (1 / 1 + .10 - .85)

Or

Customer Lifetime Value = $4000

A perfect example of a company who has most likely taken its CLV results into careful consideration is Amazon.com. The online retailer recently threw its hat into the tablet computer ring by debuting its Kindle Fire, a rival to the already launched Apple iPad. Amazon is selling its version of the tablet computer for just under $200 even though it is rumored that the company is actually losing money selling the tablets at such a discounted rate. Amazon is willing to take a loss up front as it...

Statement of the Problem How can Starbucks increase customer satisfaction while growing at the same time? Recommended Course of Action After evaluating each alternative (Exhibit 2), we recommend that Starbucks invest $40 million per year to increase labor hours per store in order to solve the problem with the quality of service. Starbucks should also set up an internal strategic marketing team. This will allow Starbucks to have a proactive feedback of customer satisfaction and hence faster improvement. We also noticed that labor cost is high for Starbucks' North American operations. To keep labor cost at reasonable level, Starbucks should reduce waste in making drinks, keep consistency in drinks, and improving productivity. We recommend the company invest more money in automated espresso machines. Currently, sales of coffee beverages account for 77% of total sales, and therefore, we recommend Starbucks increase its sales on food items and whole-bean coffees, and develop non-retail sale channels, which do not require as much special training as making coffee beverages. We also suggest Starbucks capture the new customer base to be its second permanent loyal segment. Rationale for the Proposed Actions Due to an increase in number of Starbucks' customers and highly customized drink demand, the workload per worker is very high. This fact results in a decrease in service time and conversation between Starbucks baristas and the customer, and more stress on baristas. Moreover, the research found that a large number of customers emphasize that "treated as a valuable customer", "friendly staff" and "fast service" are the most important factors in creating customer satisfaction. Investing $40 million annually will help eliminate the problems of service time and customer satisfaction by reducing the bottleneck of labor time and increasing customer satisfaction at all levels. This, in turn, will generate a stream of additional revenues for the lifetime value of each customer with respect to his/her shifting from unsatisfied to satisfied and satisfied to highly satisfied status. According to financial analysis (Exhibit 3), the NPV of investment is $4,109.50 per store for one cycle of a customer's lifetime. However, the predicted incremental profit is $12,644.76 per store per one customer lifetime, assuming

that the investment will satisfy all the customers' complaints associated with the service time. We believe that spending the $40 million will not only improve Starbucks' services, but also increase customer satisfaction, which in turn, will increase its revenues.

Starbucks' newer customers tend to be younger, less educated, and in a lower income bracket. They view the Starbucks brand very differently from the existing loyal customers. Younger consumers are not yet loyal to the brand' and since they do not fit the general demographic of a typical Starbucks customer (willing to pay a premium price, know the importance of quality coffee), this presents a marketing opportunity for Starbucks to capture this additional market segment by stressing Starbucks' benefits over their low-priced competitors where the consumers normally buy coffee (gas stations, McDonalds). Starbucks should capture this new customer base to be their second permanent loyal segment via means of advertisements and promotional campaigns that emphasize on Starbucks' premium coffee and quality brand image. Using the quality emphasis will not only increase awareness of Starbucks' superior service and quality to all its customers, but also capture the new consumers' segment appropriately to make this the key reason they chose Starbucks versus lower price competitors. Starbucks serves a wide range of beverages that take a relatively long time to make. We feel the company needs to reduce total number of steps to make beverages, and increase the number of beverages made by automatic machines. This will increase productivity and quality, while also reducing the total waiting time for the customers, as well as the workload of store employees. It is indeed important for Starbucks to keep a large variety of drinks, as this is one of their differentiating factors, and one that they score and focus well on. Starbucks' strong distribution network will keep the company very competitive in the future. We strongly believe Starbucks should utilize its distribution network to expand sales to non-retail channels that have great growth potential. We also noticed that there are internal problems within Starbucks specifically the lack of a strategic marketing group. The consumer retail business needs a strong marketing department to analyze market data and make strategic plans. It is crucial for Starbucks to streamline its marketing department. With its own marketing team, Starbucks can continuously understand their customer's needs and react quickly if necessary. The addition of a marketing team will also allow Starbucks to deploy a suitable strategy (if at all) to capture new customers in existing and new markets. Starbucks has focused on various aspects in order to deliver excellent customer satisfaction. The key factor that they need to recognize is that they need to realize how they are serving their customer. Starbucks does have other factors that it ranks high in, but that is only part of the picture. Customer service is the key to Starbucks being recognized as the industry leader in gourmet coffee and coffee drinks for years to come. Exhibit 1 Situational Analysis

Nature of Demand o o o o o o o Lots of Americans drink coffee Many people want customizable drinks Going to Starbucks is an experience, not just a cup of coffee The aspect of customer service has strongly to do with the experience of the customer The myriad of drinks that could be made slowed down the customer focus Many places for Starbucks to grow to Direct link between customer satisfaction level and brand loyalty

o Established customers (1st visited 5+ years ago) affluent, well-educated, white-collar (skewed female), age of 25-44. o o o o New customers younger, less well-educated, lower in income. Customers tend to use the store the same way. Coffee consumption was on the rise in the United States Half of the U.S. population drinks coffee everyday

Extent of Demand o o New customers were more picky about customer service People expected to have a continued interest/demand for gourmet coffee in the coming years

o If people are paying for the atmosphere (as Starbucks customers do) then they expect personal service with a smile o Starbucks had demonstrated that they are the number one retailer of coffee they just can't get too confident about themselves and they have to continually have to look at how they are doing with customer service o o o o Specialty coffee market share 27%(2000), 31%(2002E), 41%(2005E) Starbucks share of Specialty coffee market share 38%(2000), 42%(2002E), 50%(2005E) Overall retail market would grow less than 1% per annum. Growth in specialty coffee category CAGR of 9-10%

Starbucks projected to grow at a CAGR of 20% top-line revenue growth.

Nature of Competition o The "corporate" feel of the stores has increased from 53% to 61% in 2001

o Problem in that Starbucks was building stores primarily in high income areas with higher wages, and in the past year, the new customers it was attracting were lower income, younger; where were the new residents of that area getting their coffee? o Small-scale specialty coffee chains, e.g. Caribou Coffee (differentiate on store environment), Peet's Coffee & Tea (offering freshest coffee) o Independent specialty coffee shops offer wide range of food, televisions or Internet, and deliver highly personalized service significant difference between Starbucks and the independent specialty coffee houses o o Donut and bagel chains Dunkin Donuts. Overall competition is very severe

Environmental Climate o o o o o o o o Demand for specialty coffee products on the rise Lowest employee turnover rates (70%) All seniors' managers are trained from the low level positions Customer loyalty was related to customer satisfaction (key attributes and customer expectation) New customers tended to be younger, less well-educated, lower income Starbucks needs to do more to attract higher income customers once again Focus back on service Frequent buyer card

Stage of Product Life Cycle o Middle still much more growth available for Starbucks as of 2002

o life. o

Customer life depends on customer satisfaction the more satisfaction, the longer customer

Overall retail market Maturity

o Specialty coffee category Growth The marketing is still growing, - more than one third of all US coffee consumption place outside the home, 109 millions people drank coffee every day, only 7 states had more than 100 Starbucks location

Cost Structure of the Industry o Financially strong net income has grown tri-fold from 1998 to 2002

o Labor/store operating expenses have also increased by 267% - this leads to the true problem of the case we are spending more money on store operations, yet customer satisfaction ratings are decreasing o o o o o The largest expense is on labor Sales CAGR of 40% Net earnings CAGR of 50% Low employee turnover rates Net income (2002) $215.1 millions

Skills of the Firm o o o o o Convenient locations Highly customizable drinks Lots of variety in types of drinks Clean stores Loyal customers

o Some of the stores must be providing quality service the number of 4-star quality stores grew from Q4 2001 to Q3 2002 o Trained partners (both hard and soft skills) Hard skills- specific steps to serve customers; Soft skills-connect with customers

o o

Pre-specified process associated with each drink ensure product quality. Creating an "experience' around the consumption of coffee

o Three component of experiential branding strategy: coffee itself, service(customer intimacy), atmosphere o o They believe that partner satisfaction leads to customer's satisfaction Partner's satisfaction hovered in the 80% to 90% range.

o Have one of lowest employee turnover rates (just 70%, compared with fast-food industry averages as high as 300%) (Manager stability is key - "Our goal is to make the position a lifetime job") o Two type of training hard skill (how to use the cash register and how to mix drinks) and soft skill (connect with customers) o Consumer snapshot basic criteria (service, cleanness, product quality, speed of service three minute is excellent service) o o o Legendary service Retail expansion SVC (stored-value card): cardholder tended to visit twice as often as cash customers

Financial Resources of the Firm o Public company - $25 million (1992)

o To implement plan, they need $40 million annually, which allow each store to add the equivalent of 20 hours of labor a week. o o Starbucks was enjoying its 11th consecutive year of 5% or higher comparable store sales growth. No much ad budget, far less than the industry average

Distribution Structure o o Independently owned stores Franchise-owned stores

o o o o o

Product line ice cream, frappuchino drinks Its own store located in high traffic, high visibility settings, drive-through (experiment) Sold through non-company-operated retail channels (Specialty Operations 15% of net revenues) North American food-service accounts sold to hotels, airlines, restaurants, etc. 27% domestic retail store licenses 18%

o others 55 % including international licensed stores, grocery stores and warehouse (market and distribute by Kraft Foods) o Joint venture with Pepsi-Cola for sale of retail products

o Starbucks purchased green coffee beans directly from growers and controlled distribution to retail stores around the world o Location: high traffic, high visibility settings

o Product mixes tended to vary depending on a store's size and location, but most stores offered a variety of pastries, sodas, and juices. o Beverages (77%)

o Specialty operations accounted for 15% of revenue, 27% of these revenues came from North American food-service accounts, another 18% came from domestic retail store licenses, remaining 55% came from a variety of sources o "We want to reach customers where they work, travel, shop, and dine." = Third home for customers besides home and work

Problems o o o Customer satisfaction declines. Lost connection between satisfying customers and growing business. Starbucks' brand image has some rough edges.

o Little image or product differentiation between Starbucks and smaller coffee chains in the mind of customers. o o Changing customers and their behavior It lacks a strategic marketing group

Brand meaning

Opportunity o o o o o o o Specialty-coffee market growth of 9-10% a year Traditional coffee drinkers reduce and shift to drink specialty coffee Increase in coffee consumption in the U.S. (50% of population) 2 of 3 coffee consumed per day is outside the living residence Existing expansion potential since there are still 8 untapped U.S. states Unsaturated existing markets allowing for further penetration (South East region) Indefinite expansion opportunity for international markets

Exhibit 2 Alternative Recommendation

Pros

Cons

1. Outsource its employees during peak hours in order to reduce the service time. Hiring part-time employees to help during peak hours would be an outsourcing solution.

Increase % utilization of labor per store as well as increase customer satisfaction higher revenues without the need to spend additional money. It is oblivious though that this strategy would require a careful analysis of day-to-day activity for each and every store to determine which ones needs part-time workers and during which time of the day. If they chose to deploy this strategy, store managers must keep in the mind the need to constantly monitor peak hours and reschedule part-time worker hours accordingly to stay upbeat with the market.

2. Consider shifting its employees from stores with low traffic to stores with high traffic during peak hours.

Service time can be reduced at high-traffic stores Require a careful analysis of day-to-day activity for each and every store to determine which one has high/low traffic and during which time of the day. If they chose to deploy this strategy, store managers must keep in the mind the need to constantly monitor peak hours and shift workers accordingly among the stores. 3. Invest $40 million per year to increase labor hour. - Help eliminate the problems of service time and customer satisfaction by reducing the bottleneck of labor time and increase customer satisfaction at all levels - Don't need to do the analysis of day-to-day activity that can be imprecise and hence can damage the business. - In a short run, dividend for shareholders will decrease due to the investment; however in a long run, this investment would give a positive return.

Exhibit 3 Financial Analysis

Starbucks was considering investing $40million to increase 20 labor hours per week per store. The objective of the investment is to increase customer satisfaction and hence the number of visits per month per customer.

In order to calculate all the numbers, our group assumes the additional assumption in each table and the following basic assumptions: 1. The investment of $40million will continue every year and can solve all the complaints associate with the service satisfaction in the marketing research 2. store The consumption of the coffee is in the steady stage which has the 570 transaction per day per

3. Out of 570 transaction, 11% are from unsatisfied customer, 27% are from satisfied customer and 62% are from highly satisfied customer 4. Customer visit frequency, contained Starbucks' transactions and customer percentage, reflects Starbuck's Customer Behavior, by Satisfaction level. (Figure A. and Exhibit 9) 5. Customer will shift to more satisfaction group according to percentage of service improvement

6. Ratio between customer number and transaction number in each satisfaction group are constant

Profit made per customer

Assumption Focus only over-counter sale. Average Ticket price is $3.85. Expenses Revenue Average, Assumption: Every ticket has the same proportion on expense and revenue Average, Unsatisfied Average, Satisfied Average, Highly Satisfied

Per Ticket Co-Owned North American

Per Ticket 2,583.80

Per Ticket 3.56

Per Ticket

Co-Owned International209.1 0.29 Total Company-Operated Retail 2,792.90 Net Revenues 2,792.90 Cost of Goods Sold Gross Profit Expenses Store Operating Expense Other Operating Expense 1,008.99 114.48 0.16 1.39 0.16 1.4 0.17 0.26 0.26 2.17 0.14 1.47 0.18 0.27 0.29 2.36 0.29 1.6 3.85 3.88 1.67 2.19 3.85 4.06 1.69 2.29 4.42 1.77 2.5 1.92

1,215.00 2.18

1,577.90

Depreciation & Amortization Expense General & Admin Expense Operating Expenses Operating Profit

185.04 0.26 0.25 2.07 0.13

181.89 0.25 2.05 0.12

1,490.40 87.5 0.12

Overall assumption: Focus only on over-the-counter sales and not including the "specialty services" The revenue is calculated to the proportion that the "specialty services" is remove from the income statement Average ticket price is assume to be $3.85

Customer's assumption: Every ticket has the same proportion on expense and revenue; this is based on the given information in the exhibit 9, we used the information to calculate to the same proportion of expense and revenue

Customer Lifetime Value CLV per customer in each level of satisfaction

CLV = NPV function of lifetime(lifetime * retention rate * number of Starbucks visit/ year) Assumption Customer Retention Rate = 75% Discount Rate = 5% Profit for each ticket categorized by customer satisfaction Unsatisfied Customer Customer Customer Satisfied Highly Satisfied All Customer 3.9 51.6 4.06 4.4 4.3 86.4 4.42 8.3 7.2 61.60 4.12 4.60 5.13 $0.12 $0.13 $0.14

Number of Starbuck Visits/ Month Number of Starbuck Visits/ Year 46.8 Average Ticket Size/Visit 3.88

Average Customer Life (Years) 1.1

Profit generated, per customer 4.69 CLV 5.16 89.25 529.21 109.93

21.66 74.48 25.63

CLV per store: The calculated number will be in the following topic (Analysis of the $40 million investment for one cycle of customer lifetime)

The equation, which the group is using, is:

Analysis of the $40 million investment for one cycle of customer lifetime

Assumption Customer visit frequency, contained Starbucks transactions and customer percentage, reflects Starbuck's Customer Behavior, by Satisfaction level. (Figure A. and Exhibit 9) Additional 40$ mil. Investment will solve three customer complains Customer will improve 31%, according to 3 services complain percentage Customer will shift to more satisfaction group according to percentage of service improvement

Unsatisfied Customer Customer Customer Profit 0.12 0.13 0.14 13.2 52.8 99.6 Satisfied Highly Satisfied

Lifetime (month) Q1)

Less than $50 0 customers revenue 58617.59

year 0 year 1 year 2 year 3 year 4 year 5 1 4657 2 4046 3 1918 4 970 5 927 820 71418.95 68788.16

148278.9

151464.8

109129.4

Profit (without mailing cost) 28891.03 24619.39 mailing cost net profit -3322.61 discount npv profit -2063.08 cumulative 105664.2 3958.45 58318.68

62277.13

63615.22

45834.33

29995.96

27942 27942 27942 27942 27942 35673.22 17892.33 2053.959 949.0272

0.1

0.1

0.1

0.1

0.1

0.1 1543.17 648.1983

58318.68

32430.2

14787.05

58318.68

90748.88

105535.9

107079.1

107727.3

customer LTV 22.68933

12.5228

19.48655

22.66178

22.99315

23.13234

Q2)

Greater than $50 0 customers revenue 65503.62 1 3296

year 0 year 1 year 2 year 3 year 4 year 5 2 2875 3 1653 4 866 5 761 623 89091.25 71684.16

314932.8

334213 182311.3

Profit (without mailing cost) 30107.35 27511.52

132271.8

140369.4

76570.73

37418.33

mailing cost net profit 7735.52 discount rate npv profit 4803.15 cumulative 311152.9

2801.6 19776 19776 19776 19776 19776 129470.2 120593.4 56794.73 17642.33 10331.35

0.1

0.1

0.1

0.1

0.1

0.1 13254.94 7056.449

129470.2

109630.4

46937.79

129470.2

239100.6

286038.4

299293.3

306349.8

customer LTV 94.40319

39.281 72.54265

86.78349

90.80501

92.94592

Q3)

Customer Acquisition Cost Number of Customers total number of catalogs sent Total Cost Cost/Customer 293915.2 36.95652 7953 345782.6

Customers Whose Initial Purchase is > $50:

From the table in Q2 we see that Tuscan is making a profit of $57.44 per customer over a 5-year period. From Exhibit 2 of the case we see that the majority of purchases for this category are made in years 1 and 2. Tuscan may be able to increase per customer profits in this category by maintaining the same mailing frequency (8 catalogs per year) for the first 2 years and then decreasing the frequency (to say 4 per year) in subsequent years thereby decreasing the mailing costs while still maintaining relatively the same response rate from customers. Also we see from exhibit 2 that the number of multiple sales in a year is relatively high which seems to indicate that these may be loyal customers. A referral reward system may be used to incentivise these customers to try and rope in more customers.

Customers Whose Initial Purchase is < $50:

From the table in Q1 we see that even after a 5-year period, customers in this category still do not produce a profit for Tuscan. We see from Exhibit 1 of the case that from year 2 onwards the response rate of customers in this category falls rapidly. Also noted is the fact that the number of buyers who purchase only 1 item compared to the other category. This seems to indicate that customers in this category are only trying out the catalog service as a fad or one time thing and do not see any incentive to re-order. A gift card or a rewards system may provide enough incentive for repeat customers.

Q4) The 5-year time period does not provide a large enough data sample to provide an accurate picture of consumer behavior. It only provides information about the average consumer or a very broad segment of consumers which is not very helpful if we want to target our marketing efforts at say our most profitable customers. It would be much more useful if we had data for customer responses for say every period in which a catalog was mailed.

Q5) Since the company is essentially marketing household items targeted at a women of a certain profile, it may be useful to have data on the number of consumers who are home owners, consumers who have recently purchased a new home, number of consumers that are house-wives, number of consumers that are repeat customers etc. Basically we are looking for information that would enable us to take the entire customer base and divide it into segments which can then be analyzed using cost/profitability and resource allocation considerations so that marketing efforts are more efficient.

Q6) The time of purchase would provide valuable information. If customers made most of their purchases during the holiday season, marketing efforts could be focused on this part of the year instead of wasting effort on sending catalogs throughout the year. Data that provides a period by period history of purchases would provide a better picture of buying patterns. This can also indicate the level of dormancy of a customer or customer segment. Also, product data may prove useful. If most of the customers are interested in only a certain product or product category, the catalog itself may be modified for

$40 million investment breakdown Customer group based investment ($40 million) 4,400,000 10,800,000 24,800,000

NPV of investment over customer lifetime in each group 4,837,992.26 NPV of investment over customer lifetime in each group per store 4109.45

44,504,026.61 176,217,259.34 88.14 810.82 3,210.49

2002 CLV per store calculation Starbuck Transactions (2002) NPV of Profit (2002) per store 11.000000% 2,264 27.000000% 62.000000% 135188.44

23,256 109,669

2002 with 40$ million investment CLV per store calculation for break even Starbuck Transactions (with $40 mil. Investment) Profit (with $40 mil. Investment), per month per store Profit incremental from $40 mil. Investment 10.650017% 2,192 27.351322% 64.192872% 139297.89

23,559 113,548 4109.45

minimal customer shift for break even -0.349983%

0.351322%

2.192872%

This table describes break-even point, where requires shift of customer satisfaction group. Based on information, each store approximately has customer about 570 per day on average. Investment was distributed into each categories of customer, weighted by number of transaction in each group Net Present Values of investment in each customer group are calculated based on lifetime of each group. E.g. - Starbucks invests in unsatisfied customer about $4,400,000 dollar per year and the lifetime of the group is 13.2 months. So, NPV for unsatisfied customer is about 4,837,992.26 dollar (calculating by using 13.2 month for the time in present value equation) or 88.14 dollar in each store every month.

o Then, with the current proportion of customer satisfaction, we can calculate Customer Lifetime Value of store. E.g. for unsatisfied customer, CLV of store is Profit * Lifetime * % transaction for unsatisfied customer * Retention Rate * average customer visit * 30. = .12 * 13.2 * 10.650017 * 75% * 570 * 30 = $2,192 dollar With above calculation, the break even point can be calculated by equalizing incremental of Customer Lifetime Value of store, after invested $40 million dollar, and the NPV of the investment per store. As a result, minimal customer shift is showed in above table, as unsatisfied customer can be reduced about 0.349983%

Predicting incremental profit

Unsatisfied Customer

Satisfied Customer

Highly Satisfied Customer

Relocation of customer satisfaction group Starbuck Transactions 11% Customer percentage 42% 27% 37% 62% 21%

Customer complain on services Friendlier, more attentive staff 19% Faster more efficient service Better Service 2% Total 31% 10%

Customer satisfaction shift by 31% % of shifted customer in each group

13% 37%

11% 38% 0.23

Ratio of customer percentage & transaction

3.818182

1.37037

0.33871

% of shifted transaction in each group 9.57% 27.42% 69.11% Outcome of 40$ million investment 1,969 23,616 122,248 -1.43% 0.42% 7.11% 147833.2 12644.76

Predicted incremental profit from $40 million Investment

With $40 million investment, there are 3 areas from service, as listed, that can be improved with additional staff and machine. Those suggestions accounted for 31%; therefore, the additional investment would partly or completely reduce and transfer customer from one group to a better group. As a result, if the investment succeeded, customer satisfaction will be shifted to 37%, 38%, and 23% respectively as satisfaction level. Then, with the same ratio of customer percentage and transaction, shifted transaction can be calculated. Consequently, the outcome is unsatisfied customer's transaction was reduced and both satisfied and highly satisfied customer increased. Hence, Customer Lifetime Value of store for actual $40 million dollar investment is 147833.20, which mean additional profit about 12644.76 per store every month. By compare additional profit with minimal break-even, the $40 million investment is worth doing!

Financial Analysis Summary On average the profit per ticket per unsatisfied, satisfied and highly satisfied are $0.12, $0.13 and $0.14 respectively The Customer Lifetime Value per customer of unsatisfied, satisfied and highly satisfied are $5.16, $89.25 and $529.21 respectively The Customer Lifetime Value per store is $135,188.44 NPV of investment over customer lifetime in each group per store is $4,109.45 The predicted value of the profit after the investment is $147,833.2 The predicted incremental profit from the investment is $12,644.76 According to the financial analysis, Starbucks should invest $40 million to increase the labor hour in each store