SEA - Practical Application of Science Volume II, Issue 1 (3) / 2014

Raluca-Daniela RIZEA The Bucharest University of Economic Studies, Romania Roxana SARBU The Bucharest University of Economic Studies, Romania Elena CONDREA „Ovidius” University of Constanta, Romania Faculty of Economics Sciences

HOW COMPANIES Case study CAN STAY COMPETITIVE

Keywords Trends in the coffee industry Coffee industry partnerships Coffee taste test, surveys Sustainable coffee Best practice benchmarking Competitive strategy.

JEL Classification M19; Y90

Abstract

The coffee shop industry in the U.S. includes 20,000 stores with combined annual revenue of about $11 billion. The industry is highly concentrated at the top and fragmented at the bottom: the top 50 companies have over 70 percent of industry sales. The U.S. is the world’s largest importer of green coffee beans and the largest consumer of coffee. The main objective of this study is to investigate the competitive strategies that U.S. coffee franchise companies adopt considering customers’ expectations and industry best practices. In order to achieve this objective, a best practice benchmarking analysis was performed taking into account the top U.S. coffee companies. This analysis showed that product and service innovation are necessary in order to stay competitive in the market and attract new or to keep existing customers successfully. Coffee shops have to establish a unique image that prevents customers from buying products from another shop or use home-brewing systems which are also on the rise in American households.

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Introduction include , Dunkin’ Donuts, Caribou, The coffee shop industry in the U.S. includes Coffee Bean and Tea Leaf, and Diedrich 20,000 stores with combined annual revenue (Gloria Jean’s). The industry is highly of about $11 billion. Major companies concentrated at the top and fragmented at the include Starbucks, Dunkin’ Donuts, Caribou, bottom: the top 50 companies have over 70 Coffee Bean and Tea Leaf, and Diedrich percent of industry sales. (Gloria Jean’s). The industry is highly Coffee is one of the world’s largest concentrated at the top and fragmented at the commodities. The top green coffee bottom: the top 50 companies have over 70 producing countries are Brazil, Colombia, percent of industry sales. Coffee is one of the and Vietnam. Many grower countries are world’s largest commodities. The top green small, poor developing nations that depend on coffee producing countries are Brazil, coffee to sustain local economies. The U.S. Colombia, and Vietnam. Many grower is the world’s largest importer of green coffee countries are small, poor developing nations beans and the largest consumer of coffee. that depend on coffee to sustain local With the exception of Hawaii and Puerto economies. The U.S. is the world’s largest Rico, the ’ climate cannot importer of green coffee beans and the largest support coffee trees. consumer of coffee. The main objective of The next paragraphs present benchmarking this study is to investigate the competitive definitions and detail how this type off strategies that U.S. coffee franchise analysis was applied in the current case. companies adopt considering customers’ Benchmarking received many different expectations and industry best practices. In definitions from various organisations and order to achieve this objective, a best practice authors even though there seems to be a benchmarking analysis was performed taking consensus regarding its goal. The most into account the top U.S. coffee companies. widely accepted definition is the one that This analysis showed that product and service Xerox gave at the end of 80s which is „the innovation are necessary in order to stay continuous process of measuring our competitive in the market and attract new or products, services and practices against the to keep existing customers successfully. toughest competitors or those companies Many customers focus on the special recognized as industry leaders” (Cano et al., atmosphere each store has and which is 2001). characterized by the location, music, interior The American Productivity and Quality design, seating or whether internet access is Center also contributes to the definition of provided. Particularly for specialty coffee benchmarking by saying that „benchmarking shops it is important not to sell only the is the process of continuously comparing and beverage but the whole experience. Coffee measuring an organisation against business shops have to establish a unique image that leaders anywhere in the world to gain prevents customers from buying products information which will help the organisation from another shop or use home-brewing take action to improve its performance” systems which are also on the rise in (Kozak, 2002). In addition, Spendolini (1992) American households. In addressing the states that “benchmarking is a continuous increased level of competition, every systematic process for evaluating the company’s focus should be on differentiating products, services and work of organizations from the rest of the market in every possible that are recognized as representing best business segment (products, atmosphere, practices for the purpose of organizational location, image etc.). improvement.” 1.Literature review: Definition of Industry Coffee consumption is highest in the The coffee shop industry in the U.S. includes Northeast, where over 60 percent of the 20,000 stores with combined annual revenue population consumed coffee daily in 2005, of about $11 billion. Major companies according to the National Coffee Association

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(NCA). Per capita consumption is highest in 3,000 square feet, with an average store 1,200 the Central U.S., where coffee drinkers to 1,600. For small spaces like airports and average 3.7 cups per day (First Research grocery stores, some chains offer a kiosk Industry Profile). format, without seating. Major products sold by coffee shops include Retail prices for coffee shop beverages vary. beverages as well as complimentary food The retail price for an espresso-based drink items. Beverages include brewed coffee and can exceed $4. Due to the cost volatility of tea; espresso drinks (cappuccinos, cafe lattes); green coffee and dairy, retail prices often cold blended beverages; bottled water; soft fluctuate. A pound of roasted coffee beans drinks; and juices. Food products include may retail for between $10 and $20. A pound pastries, bakery items, desserts, , of high-end or “reserve” coffee, like some and candy. Many coffee shops sell whole or Peet’s , can retail for between $50 and ground coffee beans for home consumption. $80 per pound (First Research Industry Some coffee shops sell coffee or espresso- Profile). making equipment, grinders, mugs, and other Coffee shops depend highly on part-time accessories. Most coffee shops serve high- employees, and most workers require few quality, premium coffee known as specialty skills. Many employees make just above the coffee. minimum wage, and pay can be significantly The typical and most committed coffee below the average for all U.S. workers. drinkers are 25 to 45 year old, affluent, Starting wages for Starbucks’ employees are educated adults. While baby boomers have about $8 an hour. Some Starbucks’ driven the success of coffee shops, specialty employees are forming unions to negotiate coffee appeals to a diverse adult better wages, hours, and benefits. demographic, including college students and A typical chain coffee shop may have one young adults. Larger companies may also manager and 10 to 15 workers; independents sell coffee beans wholesale to commercial have six to seven. New employees may go customers, such as grocery stores and through training courses and receive in-store restaurants(htp://findarticles.com/p/articles/m training to ensure superior customer service i_m4021/is_2001_June_1/ai_76579399). and product consistency. Master roasters Consumer taste and personal income drive oversee coffee roasting to develop trademark demand. The profitability of individual blends and flavors. Baristas receive training companies depends on the ability to secure to operate commercial grade espresso prime locations, drive store traffic, and machines used to make specialty drinks. deliver high quality products. Large Sales are seasonal, with a peak during fourth companies have advantages in purchasing, quarter, driven by the winter holiday. In finance, and marketing. Small companies can addition, poor weather can affect sales by compete effectively by offering specialized decreasing store traffic. For large companies, products, serving a local market, or providing inventory amounts to between 40 and 80 days a personal level of customer service. The sales. Accounts receivable runs between 20 industry is extremely labor-intensive: average and 30 days sales, mainly due to commercial annual revenue per worker is $40,000. customers. Accounts payable runs between 30 Coffee shops depend greatly on customer and 60 days sales. Companies may use traffic and are most often located in areas contracts to buy green coffee and dairy with convenient access for pedestrians or products. Gross margins range between 40 drivers. Typical locations include downtown and 60 percent, and higher commercial sales or suburban retail centers, shopping malls, tend to decrease margins. Chains use office buildings, and university campuses. comparable store sales to measure growth. Store format and size vary by site, as some Most companies lease store locations for a locations offer more space than others. fixed term. Rent for coffee shops in malls Caribou Coffeehouses range from 200 to may include a fee for shared area

512 SEA - Practical Application of Science Volume II, Issue 1 (3) / 2014 maintenance. Companies compete for prime operations and to selectively pursue other locations, sometimes with other retailers, and opportunities to leverage the brand through negotiating power may be limited. Chains the introduction of new products and the periodically close underperforming stores, development of new channels of distribution. and set aside a reserve for remaining lease In continuance with its history of payments. partnerships, Starbucks and Concord Music Franchise and license agreements typically Group announced on March 12th of this year include an upfront fee, payments or royalties the formation of a new record label “Hear based on percentage of sales, and renewal Music” which will distribute recordings at options. Master license agreements may allow Starbucks locations. This partnership is licensees to grant sublicenses to third parties another step in Starbucks’ entertainment within a territory. strategy that links to the company’s focus on atmosphere and image (In February 2007 2. Competitive positions and possible Howard Schultz (Starbucks’ chairman) wrote strategic moves of key companies a memo to top company managers of the 2.1. Starbucks company that soon became public. He Starbucks, the world’s number one coffee lamented the cumulative effect of company retailer, has over 13,000 coffee shops in more decisions associated with expansion: more than 35 countries. The outlets offer coffee efficient automatic machines that diminish drinks, food items, beans, coffee accessories the “romance and theatre” of the earlier-era and teas. Starbucks owns about 17,500 of its and block the visual sight line the customer shops, which are located in about 10 countries previously had for the intimate experience (mostly in the U.S.) while licensees and with the barista. -“The Starbucks Stops franchisees operate the remaining outlets. Here”). Starbucks does 78% of its store volume in Last fall, addressing McDonald’s attempts to beverages, with 12% in food, and 5% in lure customers away, Starbucks announced its whole beans. The companydoes not compete plans to offer hot breakfast sandwiches in an on price but rather on the complete appeal to fans of the Egg McMuffin and experience customers get while visiting the establish them also in the breakfast and coffee shop. Embracing its value beyond afternoon snack segment (“Supersize that extraordinary coffee, Starbucks tries to make Latte? McDonald′s to Offer Upscale Coffee a business out of human connections, and Drinks” - celebration of diversity and culture. http://retail.seekingalpha.com/article/28359 Starbucks focuses its retail selection on the 1 McDonalds’ Homepage;). “best places in town” and its outlets can be 2.2 McDonald’s found in the centre of almost every famous McDonalds (which history began in 1954) is city in the world ranging from Cologne to Los the leading global foodservice retailer with Angeles. As mentioned, the firm focuses on more than 30,000 local restaurants serving high-traffic, high-visibility locations. While nearly 50 million people in more than 119 Starbucks selectively locates stores in countries each day. In 2006 the company shopping malls, it tries to focus on places that reached a record high of $21.6 billion in provide convenient access for pedestrians and revenues. McDonalds competes on price, drivers (Starbucks’ Financial Statements ubiquity, convenience, service and through 2004). offering quality food products. Starbucks’ strategy Besides McDonalds is also proud Starbuck’s overall goal is to establish its on its hot coffee and believes that the high brand as one of the most recognized and temperature (brewed at 195-205°F) is a major respected ones in the world. Therefore the reason for the billion cups sold per year for enterprise plans to continue the rapid $1.35 each. expansion of its retail ~ and grow its specialty McDonald’s’ strategy

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Recent strategic changes within McDonald’s development, improved operational are increasing its potential for rivalry with effectiveness and talent acquisition. Dunkin’ pure coffee house retailers like Caribou and Donuts retail outlets are operated in a Starbucks. First, McDonald’s improved the franchise format either through operating quality of its coffee and launched a premium agreement, license agreement or joint roast version on March 6th 2006. venture. Furthermore McDonalds is looking into “day- Dunkin’ Donuts’ strategy parts” penetration as a growth strategy. While The company’s current plans are to widen its currently owning the breakfast segment the specialty coffee offerings and offer them on a company wants to take over the afternoon broader basis nationally. Therefore Procter & segment. That is also the reason why, on Gamble signed an agreement with Dunkin’ March 1st 2007, McDonalds has announced Brands on March 1st 2007, to launch Dunkin’ that it will serve specialty coffee beverages Donuts coffee at U.S. retailers (e.g. grocery like vanilla lattes and caramel cappuccinos at stores, mass merchandisers, club stores). outlets across the U.S. It is pricing espresso- Additionally Dunkin’ Brands CEO Jon based drinks between $2 and $3, undercutting Luther emphasizes the company’s strategy to Starbucks offerings. This move is consistent be a faster, cheaper, user-friendlier alternative with McDonald’s overall strategic shift away to Starbucks. He is convinced that there is a from its traditional burger-and-fries offerings market opportunity especially among a and toward more “upscale” food. The younger audience that is enamored with specialty coffee drinks will be served from Starbucks frothy beverage menu but daunted push-buttons machines, which are faster than by its prices. Addressing this issue Dunkin’ Starbucks’ labor intense hand-made Donuts installed espresso machines in prime approach. Even further threatening to coffee locations, capable of delivering inexpensive competitors is McDonald’s recent ability to coffee in 44 seconds. The company purposely increase its service and improve its stores by leaves the fancy CD burning stations, mood slowing down its expansion and reallocating lighting and comfortable chairs to the funds. competition and focuses, instead, on speed. 2.3 Dunkin’ Donuts The company tries to reach a rate of one shop Dunkin’ Donuts (founded 1950, headquarter to every 15,000 - 20,000 people in their target in Canton, Massachusetts) is the world’s markets. According to the CEO Dunkin’ largest coffee and baked goods chain, serving Donuts coffee business industry is basically a over 3 million customers a day. 2006 the “game” that relies on ubiquity. However, that enterprise had revenues of $4.7bn ($4.3 bn in is an important, but not the most critical, issue the U.S.). There are more than 7,000 shops because high margins in the coffee business worldwide (5,300 in the U.S.). The company will allow the company to buy key sites is opening 700-1000 additional shops every Additionally the enterprise aims at improving year. its level of service and cross shop consistency Dunkin’ Donuts has forged a b identity as a in service; a goal that is especially coffee destination with ample seating and a challenging because of the franchising diverse menu that grows incrementally structure. CEO Luther in 2003 to his 2700 following its slogan: “America runs on franchisees: " We′re changing this game, Dunkin”. Already, 57% of the chain′s sales, we′re raising the stakes, if you don′t like it, and the most profitable product group, are get out." beverages. The company sells about 500 2.4 Caribou Coffee million cups of coffee a year for $1.65 each. Caribou Coffee was founded in 1993 and its Dunkin’ Donuts is pursuing the following key headquarters is located in strategies: multi-branding concept (). Today it is the second largest development, Dunkin’ brand vitalization, specialty coffee company in the U.S. with product innovations, accelerated brand 416 outlets (2005) in 18 states and the District

514 SEA - Practical Application of Science Volume II, Issue 1 (3) / 2014 of Columbia. The revenue in 2005 totaled as kosher, the company has opened several $198 million. Caribou′s cafes feature locations in that area. mountain-lodge-style decor with exposed 2.5 Peet’s Coffee beam ceilings, leather chairs, and roaring Peet’s Coffee, whose headquarter is situated fireplaces. The company’s motto is " Life is in Emeryville, , was founded in short. Stay awake for it." Caribou Coffee 1996. In 2005 the company had 120 outlets successfully competed against the and revenue of $175 million. Peet′s strength omnipresent Starbucks in a number of U.S. is the taste of its coffee, which appeals to java states. connoisseurs. The company roasts its beans in Caribou’s strategy small batches, replaces brewed coffee every The company emphasizes the quality and 30 minutes, and never re-steams milk. " freshness of their products (Coffee is Peetniks" often drink Peet′s at home too, and packaged immediately after roasting, and it is about half the company′s sales come from not sold more than 21 days after roasting or whole beans, which carry higher margins. more than seven days after the opening of the Peet′s beans are also sold in more than 4,000 package). Caribou competes by offering a grocery stores. slightly different roast of coffee and a Though no chain has approached Starbucks warmer, more relaxing in-store environment global scale, the coffee shop industry is compared to the Starbucks shops with a rather increasingly competitive. While many sleek, urban atmosphere. consumers still favor Starbucks coffee, it’s The Middle East is the first region Caribou rather the in-store experience than the product Coffee is seeking to expand internationally. portfolio that makes the company stand out. The company believes that there is a small With the coffee selection improving but growing market for American branded elsewhere it is unclear how many customers coffee houses(Caribou’s Financial Statement; will continue to pay premium prices if that 2006). Another strategic approach has been to experience is no longer unique. develop partnerships with other retailers, such Experts expect the price-value equation of the as Eatzi′s, or building stores next to competitors to change in the future. Bruegger′s Bagels, Blockbuster Video and Border′s Books. The company also sells its 3. Key factors that determine success in the coffee in upscale grocery stores, such as future Lund′s and Byerly′s in the Twin Cities and 3.1 Product and Service Innovation in the Heinin′s in Cleveland. Furthermore, Frontier Future and Maxjet airlines serve Caribou coffee, and Several key factors within the coffee shop the company recently inked a deal with Life industry are essential components that will Time Fitness („Grinding Out Success Next to likely lead to success or failure of market Starbucks”). participants. As already highlighted in the 2.5 Coffee Bean & Tea Leaf “Driving Factors” product and service Coffee Bean & Tea Leaf was founded in innovation are necessary in order to stay 1963, with its headquarter is located in Los competitive in the market and attract new / Angeles. In 2005 the company had 400 keep existing customers successfully. Many outlets and revenues of $150 million. The customers focus on the special atmosphere strategy of Coffee Bean is “Keep each store has and which is characterized by Innovating”. The company is known for its the location, music, interior design, seating or extensive selection of coffees and teas, as whether internet access is provided. well as its reputation for innovation, e.g. the Particularly for specialty coffee shops it is ice-blended coffee drink and the chai latte. important not to sell only the beverage but the Coffee Bean has also made a push overseas, whole experience. Coffee shops have to finding niches in Starbucks-free markets such establish a unique image that prevents as Israel. With nearly all of its drinks certified customers from buying products from another

515 SEA - Practical Application of Science Volume II, Issue 1 (3) / 2014 shop or use home-brewing systems which are marketing deals. Finally such partnerships also on the rise in American households. In might become tickets to the “global game” as addressing the increased level of competition, Coca-Cola and Microsoft already proved. every company’s focus should be on 3.5 Quality Control, Consistency differentiating from the rest of the market in Besides the cooperation with other partners in every possible business segment (products, the industry the coffee shop companies have atmosphere, location, image etc.) to ensure that the quality of products and 3.2 Technology services as well as the cleanliness of the Furthermore it is important to have state-of location are consistent and at the desired level the art technology in the shop in order to from shop to shop (including especially serve high quality and differentiated products. franchisees and licensees) so that the Advantages of high level technology and consumers can build trust in the brand. machines are shorter waiting times for the Furthermore the role of the “barista” should customers and the ability to create a variety of not be underestimated and great commitment fresh, new and unique flavors. should be recognized and rewarded. The On the other hand it is essential that the level barista is the personality and sole of automation and machinery is well chosen representative of the specialty coffee supply and that there is a clear plan how to integrate chain to the consumer. They not only can the new machinery into the business. Even make drink suggestions or recommendations, though there is an increase in efficiency it but their skill can be the difference between might mean a loss of identity and an everyday latte and an amazing specialty differentiation for some stores, such as coffee experience. Starbucks, which focuses on a special spirit in 3.6 Meeting Demand their shops In addition to that companies in the coffee (http://www.forbes.com/business/2007/02/26/ shop industry have to make sure that they can starbucks-dunkin-donuts-biz- meet the increasing future demand. Per capita cx_tvr_0227starbucks.html) consumption of total volume is predicted to 3.3. Education About Coffee reach 2.9kg by 2010, up from 2.8kg in 2005. Coffee shop companies should start or Constant value retail sales are expected to continue to educate the consumers about grow 10% over the forecast period to reach coffee, its ingredients, quality differences, over U.S.$ 6.5 bn. Therefore the market and about the movements in the market, such participants should support their suppliers in as “Fair Trade” or “organic coffee”. This providing differentiated, quality beans and could be beneficial for developing a focus on business strategies that try to prevent relationship with the customers which in turns farmers from running into debt and poverty. leads to greater brand loyalty. Informed In addition to that companies are supposed to customers are able to make educated pay attention to the growing demand for decisions and will be less likely to switch just specialty coffee, which means they have to based on gut feeling. Furthermore this ensure that the right product innovations are education might motivate coffee buyers to added to the revised product portfolio at the pay a higher price for better products. right time. The compound annual growth rate 3.4 Cooperation 1992-2002 was 10% for specialty coffee and Several companies have proven already that a therefore over 3 times the rate of the total key factor in the future will be the ability and coffee production (2.9%). However, shifting willingness to cooperate with other market into the specialty segment is no panacea, participants without losing control of the since it is a rather small part of the overall business. Therefore it is important to pursue a market – only 7.8% of the total production full range of alliance opportunities: volume in 2002. partnerships for innovation and cost reduction but also geographic expansion and co-

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3.7 Role of Regulations Starbucks’ stock price in the last 5 months The trend of stricter regulations in the coffee (www.finance.google.com): industry started already, e.g. with new This strategy has commoditized its high price organic rules (Organic coffee is grown point product and likely will drive consumers without prohibited synthetic substances. The to other competitors such as Dunkin’ Donuts regulations require an organic plan, correct who offer a more favorable consumer price- use of land and a very strict, detailed record value ratio. Therefore the other “big” market keeping. Retailers have to change their labels participants, who now offer a similar and identify their certifier. The financial load experience at a lower price, will be able to per pound could be 2 to 4 cents up towards 17 increase their market share and lure away cents for a small roaster. The organic rules Starbucks’ customers. went into full effect in Oct 2002. Customers One can also say that there exist a strong will now have a higher level of confidence in competition within the industry for new knowing the product is organic. - customers, premium locations, etc. but overall www.foodnavigator.com/news/ng.asp?id=453 the industry is saturated, settled and stable 24-organic-rules-impact) and is expected to which allows almost all of the competitors to become even more severe in the future which yield very good margins (40 to 60 percent). underlines the fact that coffee shops have to Regarding the bariers to entry in the coffee cooperate with their suppliers in order to industry we can conclude that there exist control the quality of their products along the small barriers to entry for small regional value chain. Companies should participate chains / cafés, but their expansion is relatively mainly for ethical reasons in campaigns such slow due to the increasing speed of the as “Fair Trade” expansion of the major players. But also exist (www.foodnavigator.com/news/ng.asp?id=45 high barriers to entry into the industry for big 324-organic-rules-impact). In addition to that, players due to high industry concentration on if these social movements gain more attention top, huge brand recognition of major brands in the market, the companies could also and high up-front investments are needed. benefit from the positive public relation associated with the social commitment and 5. References engagement. [1] Kozak, M. (2002), Destination Benchmarking - To sum it up, coffee shops have to target their Annals of Tourism Research Vol 29 quoting American Productivity and Quality Center - What is Best customers effectively in terms of product Practice? http://www.apqc.org/apqcfaq.htm [accessed portfolio, company image and atmosphere as July 2013] well as advertising and coffee shop location [2]First Research Industry Profile, while paying attention to the partners along http://www.firstresearch.com/, December 28,2006 the value chain and look out for beneficial [3]htp://findarticles.com/p/articles/mi_m4021/is_2001 cooperation within and between industries. _June_1/ai_76579399 [4]“The Starbucks Stops Here”; http://www.slate.com/id/2161504/entry/2161505?nav= 4. Conclusions tap3 Based on the analysis above we conclude that [5]“Supersize that Latte? McDonald′s to Offer Upscale the coffee shop industry is a very attractive Coffee Drinks” http://retail.seekingalpha.com/article/28359 market (high margins, growing demand) for 1 McDonalds’ Homepage; the companies that are already established, [6] Homepage Dunkin’ Donuts such as Starbucks or Dunkin’ Donuts, (https://www.dunkindonuts.com) however, smaller independent companies [8]Caribou’s Financial Statement; 2006 may not be able to compete significantly. [9]www.foodnavigator.com/news/ng.asp?id=45324- As indicated, Starbucks brand is likely to organic-rules-impact weaken in the future due to its high growth and efficiency focused strategy which eliminated the “romance” of coffee brewing.

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