8. Net-4-You is an Internet Service Provider that charges its 1 million customers $19.95 per month for its service. The company's variable costs are $.50 per customer per month. In addition, the company spends $.50 per month per customer. or $6 million annually, on a customer loyalty program designed to retain customers. As a result, the company's monthly customer retention rate was 78.8 percent. Net-4-You has a monthly discount rate of 1 percent.
a. What is the customer lifetime value?
b. Suppose the company wanted to increase its customers' loyalty retention rate and decided to spend an additional $.20 per month per customer to upgrade its loyalty program benefits. By how much must Net-4-You increase its monthly customer retention rate so as not to reduce customer lifetime value resulting from a lower customer margin?
9. The annual planning at Century Office Systems, Inc. had been arduous but produced a number of important marketing initiatives for the next year. Most notably, company executives had decided to restructure its product-marketing team into two separate groups: (1) Corporate Office System and (2) Home Office System. Angela Blake was assigned responsibility for the Home Office Systems group, which would market the company’s word-processing hardware and software for home and office-at-home use by individuals. Her marketing plan, which included a sales forecast for next year of $25 million, was the result of a detailed market analysis and negotiations with individuals both inside and outside the company. Discussions with the sales director indicated that 40% of the company sales force would be dedicated to selling products of the Home Office Systems group. Sales representative would receive a 15% commission on sales of Home Office Systems. Under the new organizational structure, the Home Office Systems group would be charged with 40% of the budgeted sales force expenditure. The sales director’s budget for salaries and fringe benefits of the sales force and non-commission selling costs for both the Corporate and Home Office Systems groups was $7.5 million.
The advertising and promotion budget contained three elements: trade magazine advertising, cooperative newspaper advertising with Century Office Systems, Inc. dealers, and sales promotion materials including product brochures, technical manuals, catalogs, and point-of-purchase displays. Trade magazine ads and sales promotion material were to be developed by the company’s advertising and public relations agency. Production and media placement costs were budgeted at $300,000. Cooperative advertising allowance policy stated that the company would allocate 5% of company sales to dealers to promote its office systems. Dealers always used their complete cooperative advertising allowances.
Meetings with manufacturing and operations personnel indicated that the direct costs of material and labor and direct factory overhead to produce the Home Office System product line represented 50% of sales. The accounting department would assign $600,000 in indirect manufacturing overhead (for example, depreciation, maintenance) to the product line and $300,000 for administrative overhead (clerical, telephone, office space, and so forth). Freight for the product line would average 8% of sales.
Blake’s staff consisted of two product managers and a marketing assistant. Salaries and fringe benefits for Ms. Blake and her staff were $250,000 per year.
a. Prepare a pro forma income statement for the Home Office Systems group given the information provided.
b. Prepare a pro forma income statement for the Home Office Systems group given annual sales of only $20 million.
c. At what level of dollar sales will the Home Office Systems group break even?
8. To calculate the customer lifetime value, we need to consider the net present value of the cash flows over the customer's lifetime.
a. To calculate the customer lifetime value, we can use the formula:
Customer Lifetime Value = (Customer Margin / Discount Rate) * (1 - (1 / (1 + Discount Rate)^Number of Months))
In this case,
- Customer Margin = Revenue per customer per month - Variable cost per customer per month
- Discount Rate = 1% per month (monthly discount rate)
Customer Margin = $19.95 - $0.50 = $19.45 per customer per month
Number of Months can be calculated by dividing 1 year by the monthly retention rate:
Number of Months = 12 / Retention Rate
Retention Rate = 78.8% = 0.788
Number of Months = 12 / 0.788 ≈ 15.23 months
Plugging in the values into the formula:
Customer Lifetime Value = ($19.45 / 0.01) * (1 - (1 / (1 + 0.01)^15.23))
b. To calculate the new customer retention rate required to maintain the same customer lifetime value when spending an additional $0.20 per customer per month, we need to find the new retention rate.
New Customer Margin = Revenue per customer per month - Variable cost per customer per month - Additional cost per customer per month
New Customer Margin = $19.95 - $0.50 - $0.20 = $19.25
Plugging in the values into the formula:
New Retention Rate = 1 - (Discount Rate / (Customer Margin + Additional Cost))
New Retention Rate = 1 - (0.01 / ($19.25 + $0.20))
9.
a. Pro forma income statement for the Home Office Systems group:
Revenue: $25 million
- Cost of Goods Sold (Direct costs of material, labor, and overhead): $25 million * 50% = $12.5 million
- Gross Profit: Revenue - Cost of Goods Sold = $25 million - $12.5 million = $12.5 million
- Sales Force Expenditure (40% of the budgeted sales force expenditure): $7.5 million * 40% = $3 million
- Advertising and Promotion:
- Trade Magazine Advertising & Sales Promotion Material: $300,000
- Cooperative Advertising Allowance (5% of company sales): $25 million * 5% = $1.25 million
- Indirect Manufacturing Overhead: $600,000
- Administrative Overhead: $300,000
- Freight (8% of sales): $25 million * 8% = $2 million
- Salaries and Fringe Benefits: $250,000
Calculate the operating profit by subtracting the operating expenses from the gross profit:
Operating Profit = Gross Profit - Sales Force Expenditure - Advertising and Promotion Costs - Indirect Manufacturing Overhead - Administrative Overhead - Freight - Salaries and Fringe Benefits
b. Pro forma income statement for the Home Office Systems group with $20 million annual sales:
Revenue: $20 million
- Cost of Goods Sold: $20 million * 50% = $10 million
- Gross Profit: $20 million - $10 million = $10 million
Rest of the calculations are the same as in part (a).
c. To find the break-even point, we need to calculate the level of dollar sales where the operating profit is zero.
Let Sales = X
Revenue: X
- Cost of Goods Sold: X * 50% = 0.5X
- Gross Profit: X - 0.5X = 0.5X
Rest of the calculations are the same as in part (a). Set the Operating Profit equal to zero and solve for X.
8. To find the customer lifetime value, we need to use the formula:
Customer Lifetime Value = (Customer Profit Margin / Discount Rate) * (1 - (1 + Discount Rate) ^ -n)
a. First, let's calculate the customer profit margin:
Customer Profit Margin = Customer Revenue - Variable Costs - Loyalty Program Cost
Customer Revenue = Number of Customers * Monthly Subscription Fee
Variable Costs = Number of Customers * Variable Cost per Customer
Loyalty Program Cost = Annual Loyalty Program Cost / 12 (since it's a monthly cost)
Customer Revenue = 1,000,000 customers * $19.95 per month = $19,950,000
Variable Costs = 1,000,000 customers * $0.50 per customer per month = $500,000
Loyalty Program Cost = $6,000,000 / 12 = $500,000
Customer Profit Margin = $19,950,000 - $500,000 - $500,000 = $18,950,000
b. Now let's calculate the customer lifetime value:
Discount Rate = 1% = 0.01
Retention Rate = 78.8% = 0.788
Customer Lifetime Value = ($18,950,000 / 0.01) * (1 - (1 + 0.01) ^ -1) = $1,895,000
Therefore, the customer lifetime value is $1,895,000.
9. To prepare the pro forma income statement for the Home Office Systems group, we need to consider the following components:
a. Pro forma income statement for annual sales of $25 million:
Revenue:
Sales Revenue = $25,000,000
Cooperative Advertising Allowance = 5% * $25,000,000 = $1,250,000
Expenses:
Sales Force Salaries and Benefits = 40% * $7,500,000 = $3,000,000
Production Costs = 50% * $25,000,000 = $12,500,000
Indirect Manufacturing Overhead = $600,000
Administrative Overhead = $300,000
Freight = 8% * $25,000,000 = $2,000,000
Staff Salaries and Benefits = $250,000
Advertising and Promotion = $300,000
Profit:
Net Profit = Sales Revenue - Expenses
b. Pro forma income statement for annual sales of $20 million:
Revenue:
Same as in part a: Sales Revenue = $20,000,000, Cooperative Advertising Allowance = $1,000,000
Expenses:
Same as in part a: Sales Force Salaries and Benefits = $3,000,000, Production Costs = $10,000,000, Indirect Manufacturing Overhead = $600,000, Administrative Overhead = $300,000, Freight = $1,600,000, Staff Salaries and Benefits = $250,000, Advertising and Promotion = $300,000
Profit:
Net Profit = Sales Revenue - Expenses
c. To find the break-even point, we need to determine the level of dollar sales where the Home Office Systems group's profit is zero. In other words, the revenue should cover all expenses.
Revenue = Expenses
Sales Revenue - Cooperative Advertising Allowance - Sales Force Salaries and Benefits - Production Costs - Indirect Manufacturing Overhead - Administrative Overhead - Freight - Staff Salaries and Benefits - Advertising and Promotion = 0
Solving this equation will give you the break-even point in terms of dollar sales for the Home Office Systems group.