This analysis is part of my answer to Essay Questions in IBM 6015 – Marketing Management (Prof. Roland Gau) Take Home Exam 1
In our class discussion we talked CLV (Customer Lifetime Value). Describe what CLV is, why it is important, and explain how it can be calculated.
Customer lifetime value (CLV) is the net present value of a customer spending on a specific product/brand, minus the net present value of cost borne by the company to acquire and serve the customer. Precisely speaking, CLV considers the lifetime revenue or contribution margin from specific customer segments, as well as the expense associated with all the transactions. The calculation is then discounted by weighted average cost of capital, to get a net present value of customer profit. Because it captures the cash flow generated by the customer purchasing the product throughout his lifetime, discounted by time value of money, the amount produced is useful for the company in assessing the long-term profit potential of the customer.
CLV is important for four reasons.
First, since it is calculated based on parameters and assumptions, it is capable of including every variable the company deems important. For instance, automobile companies may consider the driving license age limit as a critical factor as it cuts off the remaining customer value, while chain pizza restaurants do not care about it at all.
Second, CLV is transparently expressed in mathematical formula, hence it facilitates communication throughout the decision-making process. Namely, it allows different estimates of revenue and expense to be considered. Such discrepancies in estimation are common when the management is making investment choices or deciding for a long-term development of a product or customer group.
Third, it also aids in evaluating the value of loyalty increase due to short-term marketing campaigns. Despite being useful for long-term investment decisions, the methodology of CLV is capable of assessing the performance of a campaign that increases customer loyalty. For example, airliners set up limited-period frequency programs (e.g., mileage accumulated during this season will be doubled) to keep consumers closely with them, hence increasing return sales opportunities, and eventually increasing the CLV.
Finally, CLV helps the company indicate which types of customers have higher value. This implication is crucial for a company to identify its most profitable customer segments. For example, an airliner may calculate the expected revenue of young business travelers, minus the expense in acquiring, serving and retaining them, and ends up with a CLV which is higher than any other segments. Consequently, the airliner invests more in serving this valuable customer group. On the contrary, buffet all-you-can-eat restaurants may find a negative CLV of 18 years-old whose appetite is enormous, thus increasing the price charge for youth, limiting refill, proposing add-ons (e.g., wine) at extra charge, or encouraging them to dine in other restaurants.
To sum up, CLV considers net present value of revenue and expense generated from transactions with specific customer groups in their lifetime purchase, and is useful in the decision-making process of both short-term and long-term investments. It’s applicable to all kinds of business, each of them can select the variables deemed important to the calculation. The results indicate the values of different customer groups and assist the company in devising actions to ensure profitability.
Consider a situation where Starbucks is contemplating marketing strategies for two different potential target markets. Target Market “A” is a high-income, medium frequency, high product-quality consumer. Target Market “B” is a middle-class income, high frequency, medium product-quality consumer.
Assuming that both A and B are currently 30 years-old, offer an estimate, with a complete explanation of how you arrived at that estimate, for the CLV for a typical consumer in each target market, in 2020 NTD. Make sure that make your assumptions clear, as well as how you are calculating CLV.
Estimate results:
CLV for a typical consumer in target market A: NT$488,040
CLV for a typical consumer in target market B: NT$610,906
Estimate explanations:
Step 1: check Taiwan’s nationwide life expectancy for 30-year-old (ref: Dept. of Household Registration, Ministry of the Interior[1]), retrieve: 51.69 years
Step 2-1: set up time windows for 5 decades that capture the aforementioned life expectancy
Step 2-2: set up acquisition cost in decade 0 (i.e., the year of 2020)
Step 3: per macroeconomic and microeconomic factors/assumptions, estimate revenue and margin for each decade
Step 4: discount each of the aforementioned margin by interest rate (ref: Central Bank of Republic of China[2]), and produce present values (PV)
Step 5: deduct acquisition costs from the aforementioned PVs to get net present values
Macroeconomic factors/assumptions
- interest rate: 2.44 % (ref: Central Bank of Republic of China[3]), assumed unchanged
- inflation rate: 1.2% (ref: Directorate General of Budget, Accounting and Statistics[4]), assumed unchanged
- death rate: 0.73% (ref: Dept. of Household Registration, Ministry of the Interior[5]), assumed unchanged
Microeconomic factors/assumptions
- initial consumer size: 100
- retention rate (percentage of consumer who stay loyal to Starbucks): 80%, assumed unchanged
- unit price paid for high product-quality in 2020: NT$200
- unit price paid for medium product-quality in 2020: NT$150
- unit cost for high product-quality: 35% of unit price
- unit cost for medium product-quality: 25% of unit price
- Medium frequency (i.e., A): monthly consumption for every decade is 15-12-9-6-3
- High frequency (i.e., B): monthly consumption for every decade is 25-20-15-10-5
other assumptions
- Attributes of consumers from the described target market remain unchanged
- A always buys high product-quality coffee, and B always buys medium product-quality
- The purchasing behavior remains homogeneous within each decade
- Acquisition cost per middle-class income customer: one free drink (i.e., unit price paid for medium product-quality in 2020)
- Acquisition cost per high-income customer: less price sensitive, assume 50% of that per middle-class income customer is sufficient
additional section: explanation of calculations
| initial number of customers | 100 | |||||
| interest rate | 2.44% | |||||
| retention rate | 80.00% | |||||
| death rate | 0.73% | |||||
| inflation rate | 1.20% | |||||
| period | decade 1 | decade 2 | decade 3 | decade 4 | decade 5 | |
| age range | 30-39 | 40-49 | 50-59 | 60-69 | 70-79 | |
| years | 10 | 10 | 10 | 10 | 10 | |
| number of customers remained | 82 | 68 | 56 | 46 | 38 | |
| quantity consumed per month | ||||||
| A | 15 | 12 | 9 | 6 | 3 | |
| B | 25 | 20 | 15 | 10 | 5 | |
| unit price paid | ||||||
| A | NT$200 | NT$225 | NT$254 | NT$286 | NT$322 | |
| B | NT$150 | NT$169 | NT$190 | NT$215 | NT$242 | |
| revenue per 100 initial customers | ||||||
| A | NT$29,591,200 | NT$21,923,898 | NT$15,228,048 | NT$9,401,955 | NT$4,353,649 | |
| B | NT$36,989,000 | NT$27,404,872 | NT$19,035,060 | NT$11,752,444 | NT$5,442,061 | |
| unit cost (higher quality, higher cost) | ||||||
| A | NT$70 | NT$79 | NT$89 | NT$100 | NT$113 | |
| B | NT$38 | NT$42 | NT$48 | NT$54 | NT$60 | |
| margin per 100 initial customers | ||||||
| A | NT$29,465,200 | NT$21,810,327 | NT$15,132,078 | NT$9,329,870 | NT$4,313,040 | |
| B | NT$36,876,500 | NT$27,303,470 | NT$18,949,373 | NT$11,688,082 | NT$5,405,803 | |
| present value (PV) per 100 initial customers | ||||||
| A | NT$23,153,342 | NT$13,466,998 | NT$7,341,951 | NT$3,557,073 | NT$1,292,126 | |
| B | NT$28,977,038 | NT$16,858,792 | NT$9,194,069 | NT$4,456,157 | NT$1,619,503 | |
| summation of PV per 100 initial customers | ||||||
| A | NT$48,811,491 | |||||
| B | NT$61,105,558 | |||||
| acquisition cost (decade 0) per customer | ||||||
| A | NT$7,500 | |||||
| B | NT$15,000 | |||||
| NPV per customer | ||||||
| A | NT$488,040 | |||||
| B | NT$610,906 | |||||
What additional information should Starbucks consider, before making either A or B the primary focus of its marketing efforts?
Most important:
- relative sizes of A and B: whether they are large/profitable enough to be the primary focus, compared to other consumer groups (e.g., C, D, etc.)
Drivers of consumer behavior:
- marriage: for married consumers, Starbucks needs to watch closely the retention rate (e.g., loyalty) of both consumers. Because losing one consumer may end up bringing the other altogether.
- family: if they have children, their disposable income and time are likely to decrease drastically for at least 20 years
- size of consumers’ companies: if the companies they work for have more employees, they are more likely to buy more coffee
- competition within neighborhood: more the competition, less the sales is estimated
- whether consumers own cars: having a car implies greater mobility, thus dilute one consumer’s contribution within an area (e.g., they may instead purchase from convenient stores where parking is more readily available), therefore less sales forecast for Starbucks
- nationality: given there are nearly 800 thousand foreign nationals living in Taiwan, and an annual growth rate of 4.1%, Starbucks shall monitor closely if consumer behaviors (i.e., unit price, frequency, product-quality preference, etc.) across nationalities differ (ref: Directorate General of Budget, Accounting and Statistics[6])
- whether consumers own houses: having real estate usually means a stable income, thus a stable employment. On the one hand it allows Starbucks to better forecast revenue from this type of consumer. Still, owning a house may also raise the possibility of owning a personal coffee machine, which may decrease in-store purchase. Starbucks can test on this by selling beans and instant coffee to assess the impact.
- whether consumers possess Costco memberships: having a membership of Costco usually implies greater purchasing power, which signals an appetite for higher product-quality offering. Similar assessment can be applied to top notch credit card holders, too.
Other behavior variables:
- whether consumers switch to online delivery easily: the more easily they switch, the more competition Starbucks may face, therefore the less retention rate and revenue estimate.
Environmental factors that affect variable cost:
- stability of sourcing: to fulfill orders of both high and medium product-quality, Starbucks must assure itself with stable supplies. Risks are global climate change, strike, and trade barriers which drive its cost higher, and inevitably decrease the profit potential.
- labor cost increase: Starbucks also needs to ensure itself with human resources at reasonable cost. Because labor cost contributes to the most portion of variable cost per cup of coffee, it is crucial for the company to maintain productive relationships with union and retain its employees.
Financial environment factor that affects cost of capital
- financing risks: Although the interest rate is currently low, it may increase in the future. Starbucks can leverage its financing risk with instruments such as options and future, proactively manage its financial prowess to access capital with lower cost.
Although A and B are different, they may not be 100% mutually exclusive. Before the final decision of primary marketing efforts focus was made, Starbucks should maximize its effective segmentation substantially, such that its market focus appeals to both the strong majority of a primary segment and several portions of the segments nearby. Eventually, Starbucks may arrive at the largest segment with highest homogeneity as well as profitability, where a tailored marketing program justifies its cause.
[1] https://www.moi.gov.tw/files/site_node_file/8604/108%e5%b9%b4%e7%b0%a1%e6%98%93%e7%94%9f%e5%91%bd%e8%a1%a8web3.pdf
[2] https://www.cbc.gov.tw/tw/cp-371-1040-5C7A0-1.html
[3] (as above)
[4] https://www.dgbas.gov.tw/point.asp?index=2
[5] https://www.moi.gov.tw/stat/news_detail.aspx?sn=12250
[6] https://www.stat.gov.tw/public/Data/9729162630MKFOK1MR.pdf