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MIP
23,4
372
Received March 2004
Accepted March 2005
Marketing Intelligence & Planning
Vol. 23 No. 4, 2005
pp. 372-381
q Emerald Group Publishing Limited
0263-4503
DOI 10.1108/02634500510603474
www.emeraldinsight.com/0263-4503.htm
The strategic value of customer
profitability analysis
Erik M. van Raaij
Eindhoven University of Technology, Eindhoven, The Netherlands
Abstract
Purpose – The aim of the paper is to show how intelligence emanating from customer profitability
analysis (CPA) can help improve strategic marketing planning. Insights into the profitability of
individual customers, as well as the distribution of profitability across the customer base, can lead to
better decisions in the areas of managing costs and revenues, managing risks and strategic market
positioning.
Design/methodology/approach – The concept and process of CPA are first explained. The heart
of the paper then discusses how the outcomes permit novel analyses related to costs and revenues,
risk, and strategic positioning. Finally, the paper explains what is needed to make the shift from
retrospective CPA to prospective CPA.
Findings – CPA delivers two types of insights: the degree of profitability for each individual
customer, and the distribution of profitability among customers within the customer base. Profitability
data at the level of the individual customer support better decision making about service levels,
marketing investments and pricing strategies. The profitability distribution curve yields information
about the vulnerability of future cash flows from customers. Further, DPA data permit segmentation
and targeting on the basis of profitability and the development of different value propositions for
different profitability segments.
Practical implications – Shareholder value is created through cash flows from customers. CPA
uncovers where these cash flows are generated. Armed with customer profitability data, marketers can
really develop and implement value-driven differentiated customer service strategies.
Originality/value – While quite a number of published papers have discussed the technicalities of
calculating customer profitability, this paper adds to the literature an overview of how the outcomes of
such calculations can help planners make better decisions, to increase the magnitude of cash flows
from customers and/or reduce the volatility and vulnerability of such cash flows.
Keywords Risk analysis, Marketing management, Profit, Customers
Paper type General review
Introduction
Aided by decreasing costs of computing power and increasingly sophisticated
methods of customer data collection, the customer database has become a core asset for
organisations of all types and sizes. It is typically used to record and store customer
details, such as name and address, and behavioural data, such as purchases made and
responses to marketing campaigns. On a tactical level, these data can be used to
improve services (for instance, a hotel can offer a personalised service on the basis of
the data it has on past customer preferences), or to improve marketing effectiveness
(such as when a charity that sends out selective appeals to its most generous donors).
In this paper, our focus is on uncovering strategic information – information that has
value for top managers – that is hidden within the customer database.
One approach to uncovering such strategic information is performing a customer
profitability analysis (CPA). The basics of such an analysis are discussed in the next
section. A CPA results in two types of insights: the degree of profitability for each Customer
individual customer, and the distribution of profitability among customers within the profitability
customer base. These two types of data enable novel analyses related to:
(1) costs and revenues;
analysis
(2) risk; and
(3) strategic positioning. 373
Each of these three areas is discussed in a separate section of this paper. CPA has its
limitations, as it is a retrospective analysis, based on historical customer data. We will
therefore also look at what is needed to make the shift from retrospective analysis to
prospective analysis, and deal with issues like customer lifetime value, and the
“strategic value” of customers. The customer base as a network of customer
relationships is one of the key market-based assets of the firm underpinning the
generation of shareholder value (Srivastava et al., 1998, 2001). CPA provides new
strategic insights in the value and the composition of the customer base and it is the
aim of this paper to highlight both strategic benefits and limitations of CPA. These
insights will benefit account managers, who need to make decisions about marketing
expenditure on individual accounts, senior marketing managers, who need to optimise
the use of a firm’s marketing resources, as well as company directors, who need to
evaluate the contribution of marketing to the generation of shareholder value.

Customer profitability analysis

“Customer profitability analysis” describes the process of allocating revenues and
costs to customer segments or individual customer accounts, such that the profitability
of those segments and/or accounts can be calculated. The calculation of customer
profitability amounts to an extensive activity-based costing (ABC) exercise (Cooper
and Kaplan, 1991; Foster and Gupta, 1994). The first step in ABC is the identification of
cost pools – i.e., distinctive sets of activities performed within the organisation (for
example, procurement, manufacturing, customer service). For all cost pools, cost
drivers are identified: units in which the resource consumption of the cost pool can be
expressed (for example, number of purchase orders, number of units produced, number
of service calls). Costs are then allocated to cost objects (such as products) based on the
extent to which these objects consume cost driver units. ABC as a cost accounting
method has revolutionised the way in which costs are allocated to products. Once it
became accepted that not every product requires the same type and same level of
activities, it was a small step to see that customers, too, differ in their consumption
of resources. The size and number of orders, the number of sales visits, the use of
helpdesks and various other services can be very different from one customer to
another. Consequently, two customers who buy exactly the same product mix for the
same prices (thus generating exactly the same profit margins on their purchases) can
have different relationship costs, leading to different levels of customer profitability.
Many companies nowadays make use of advanced customer relationship
management (CRM) systems, which will compute customer profitability figures on
the basis of sales and service data available to the system. But as these figures are only
as good as the quality and comprehensiveness of the data put into the system, it is
good to review the general process of CPA, such that the accuracy of computed CPA
figures can be evaluated. The process starts with scrutinising the list of current
MIP customers. Many customer databases contain details of customers who no longer have
23,4 a relationship with the firm (Mulhern, 1999). The first step in the CPA process therefore
deals with the identification of the “active” customers in the customer database, in
order to assure that costs are allocated to active customers only. Schmittlein et al.
(1987) and Schmittlein and Peterson (1994) have developed quite sophisticated
methods to calculate the probability of a customer being an active customer, based on
374 recency and frequency of purchases. A simpler approach would be to define active
customers as all customers that have interacted with the company during a specific
period, such as the last 12 months, either by placing an order or by receiving sales or
service calls.
The next step is the design of the customer profitability model. In this step, the
firm’s operations have to be analysed to see what activities are performed, and what
drives the costs of these activities. For example, the cost driver of sales activities can be
the number of sales visits; the driver of order processing activities can be the number of
orders. Ultimately, all relevant costs should be assigned to activities, and for each
activity, appropriate cost drivers need to be identified.
The actual calculation of customer profitability is done by supplying the model with
data. The total cost for a cost pool divided by the total number of cost driver units
consumed within a given time period, results in the cost per cost driver unit. Customer
relationship costs (for instance, sales costs, service costs, logistics costs) are calculated
on the basis of cost driver units consumed by each customer relationship. Customer
relationship costs are then subtracted from the individual customer’s sales revenues in
order to arrive at a customer profitability figure. This will be the most time-consuming
step in the CPA process. For instance, if we look at sales activities, we have to gather
the costs of all sales activities, the total number of sales visits made by all sales
persons, and the number of sales visits paid to each individual customer. The level of
detail will be determined by data availability, and by practical considerations. For
example, each sales visit could be assigned a standard cost, regardless of visit
duration, or the length of visits could be taken into account. The latter is more precise,
but it requires more effort to record. Firms who perform this analysis for the first time
will find that while many data will be available in various databases, certain data
simply is not yet available within the firm (reference suppressed). Some calculations
might be very costly to perform, as data in different formats, coming from different
databases, may have to be converted record by record.
The information produced by the CPA process is a valuable reward for all these
efforts. CPA yields aggregate and individual CPA figures, which together provide
novel insights in costs, revenues, risk, and strategic positioning. At the level of
individual customers, CPA figures provide a clear picture how buyer behaviour
(service requests, paying behaviour, and the like) and supplier behaviour (service
provision, discounts, marketing efforts, for example) compare with revenues and sales
margins. Figure 1 shows a revenue/cost analysis for two customers with identical sales
profiles but with different cost profiles. Customer B has higher sales costs (possibly
due to a higher number of sales calls and/or as a result of many small orders), has
higher service costs (possibly as a result of time-critical operations and/or wrong use of
products), and has been assigned high costs for credit (possibly due to lenient credit
terms and/or tax paying behaviour). Differences in discount structures could
exacerbate the profitability divergence even further.
 Customer
profitability
analysis

375

Figure 1.
Customer specific
relationship costs make
the difference between
profit and loss for two
customers with identical
sales

At the aggregate level, CPA figures provide insights into the distribution and the
concentration of profits within the total customer base. The two most common ways in
which CPA figures at the aggregate level are depicted are in a customer pyramid
(Zeithaml et al., 2001) or as an “inverted Lorentz” (Mulhern, 1999) or “Stobachoff”
(Storbacka, 1998) curve. A customer pyramid is used to show tiers of customers within
the customer base. Most commonly, the tiers are based on revenues, with a large group
of low revenue customers at the base of the pyramid and a small group of high revenue
customers at the apex. But, when profitability figures are available the customer
pyramid can also be drawn along the lines of profitability tiers. Figure 2 shows a
customer pyramid based on revenue tiers, but enriched with profitability data. More
examples of how customer pyramids can be constructed and used are discussed in
Zeithaml et al. (2001).
The inverted Lorentz or Stobachoff curve is drawn by lining up all customers on the
horizontal axis from highest absolute profitability to lowest (in many cases negative)
profitability, while plotting cumulative profitability on the vertical axis. Figure 3
shows a typical shape of the Stobachoff curve. In this example, the first 60 per cent of
customers are profitable, generating about 125 per cent of total profits. The remaining
40 per cent of customers are unprofitable and are consuming the profitability surplus
generated by the first 60 per cent. More extreme examples have been cited, where the
first 20 per cent of customers generate 225 per cent of total profitability (Cooper and
Kaplan, 1991). The position of the apex (to the right or to the left) and the size of the
area underneath the curve signify the concentration and distribution of profits among
customers in the customer base.
In the following three sections, we will show how individual and aggregate CPA
figures can be used to make strategic decisions in the areas of cost and revenue
management, risk management, and strategic positioning.
MIP
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376

Figure 2.
A customer pyramid with
four revenue tiers

Figure 3.
The Stobachoff curve
depicts how profitability is
distributed within the
customer base

Managing costs and revenues

The first and most obvious use of customer profitability data lies in managing both
revenues from individual customers and costs that have to be incurred to secure those
revenues. Without the allocation of marketing, sales, and service costs to individual
customers, all revenue from customers may seem good revenue, and the investments in
marketing, sales, and service to secure those revenues are difficult to justify. CPA Customer
enables account managers to bring marketing expenditures per customer in line with
current revenues per customer and with future revenue potential.
profitability
Customer relationship costs can be reduced by imposing stricter credit terms on analysis
customers and by exploring low cost alternatives for marketing, sales and service. New
developments in information and communications technologies (ICT), such as the
internet and mobile telephony have enabled companies to use low cost approaches 377
such as telesales, self-service kiosks, online ordering, and web-based product support.
Strategies for increasing revenues with existing customers include increasing
share-of-wallet, cross-selling, up-selling, and helping the customer to grow. Revenues
are also managed through pricing. There are three important issues related to pricing:
discounts, the pricing of value-added services, and discriminatory pricing. In the
absence of customer profitability data, discounts are usually based on sales volume.
This can result in large customers with particularly high service demands receiving
discounts that are larger than their customer profitability margin. Such a situation may
be sensible in the short run, for instance when a new customer is acquired and a service
investment is made in order to build the relationship, but it is untenable in the long
run. CPA will also help develop pricing strategies for valued-added services. The
analysis may show that certain services depress customer profitability to such an
extent, that they can no longer be provided free-of-charge. It can also help to develop
discriminatory pricing strategies, where certain customers, such as gold card holders,
will continue to receive these services for free, while others, such as blue card holders,
will be charged. It must be noted that customer profitability figures may inspire such
changes in pricing strategies, but that studies of customer attitudes and value
perceptions will need to be carried out in order to make sure that the new pricing
strategies are accepted in the market.
Managing risk
CPA also yields information about the vulnerability of future cash flows from
customers. The profitability distribution curve (Figure 3) contains information about
levels of dependency and subsidisation within the customer base. Subsidisation refers
to the extent to which profits generated by profitable customers subsidise losses
generated by other customers. Dependency refers to the extent to which profitability
depends on a small proportion of customers. The size of the area below the curve and
the position of the apex are indicators of subsidisation and dependency. Figure 4 shows
the shapes of profitability distribution curves in four situations with different levels of
subsidisation and dependency. In a multi-market firm, these profitability distribution
curves can be analysed for each market separately, and while the overall profitability
distribution may look low-risk, the curves for individual markets may indicate
high-risk situations.
Managers can take various courses of action to mitigate risks related to dependency
and subsidisation. In the case of high levels of dependency, two complementary
courses of action are recommended. The first course of action would be to focus on the
small proportion of profitable customers. It is imperative that these customers are
retained, and account managers would do well to review service levels, customer
satisfaction, and customer buying behaviour in order to ensure these customers stay
with the firm. The second course of action would focus on the loss-making customers.
The customer profitability data should show what cost drivers cause these losses
MIP
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378

Figure 4.
Four possible shapes of
customer profitability
distribution curves in
different situations of
subsidisation and
dependency

(these may be different cost drivers for different customer groups). Corrective measures
could then be implemented to reduce the customer relationship costs and/or to increase
revenues for these customer groups.
In situations of high subsidisation, but without high dependence, efforts can
concentrate on the loss-making customers. Some loss-making customers may be
valuable to the firm for other reasons than immediate profit, but in principle, every
loss-making customer represents an opportunity to improve profits. Again,
profitability can be improved on the cost side or on the revenue side. On the cost
side, service levels can be adjusted, or less costly service concepts (such as self-service)
introduced. On the revenue side, pricing and discounting can be adjusted, or
cross-selling and up-selling stimulated.
Because dependence within the customer base has a direct impact on the
vulnerability of future cash flows, senior management needs to have a good insight in
the distribution of customer profitability. In the absence of customer profitability data,
such insights usually come from gross margin figures, but our own analysis in an
industrial cleaning firm (reference suppressed) has shown that gross margin may
explain as little as 12 per cent of customer profitability.

Strategic positioning
The third use of customer profitability data is for segmentation, targeting and
positioning. The most common bases for market segmentation are customer needs
and customer characteristics, but customer profitability is increasingly used as well Customer
(Storbacka, 1997). Based on profitability data, customers can be classified into profitability
profitable, break-even, and unprofitable customers. The next step is to describe these
groups using descriptor variables or “profilers”. In consumer markets, these include analysis
socio-demographic, geographic, and psychographic variables; in business markets,
others such as company demographics and industry type can be used. Statistical
analyses can be used to determine, which combinations of profilers best describe the 379
membership of a particular group.
Armed with this knowledge, organisations can target more customers resembling
those in the most profitable segments. This presupposes, however, that managers have
a sound understanding of what makes these customers more profitable than others.
At the same time, customers that are alike those in the least profitable segments, can be
avoided, or at least customer acquisition investments in those segments can be
reduced. Current profitability should never be the only parameter for segment
attractiveness, however, segment size, segment growth, competitive intensity, and the
fit with company objectives and capabilities should also be taken into account.
Whether unprofitable customers should be “fired” (i.e. no further time or effort is to
be expended on their account) is an issue that requires special consideration. For many
the initial response to negative profitability figures may be to get rid of such a
customer. It is important to remember however, that customer profitability is
calculated on the basis of total cost. Even if a customer is not profitable on the basis of
total cost, the revenues generated by that customer may still outweigh marginal costs.
In that case, the customer still contributes to recouping part of the fixed costs of the
organisation. Without such a customer, and with the same level of fixed costs,
cumulative profitability would be lower. “Firing” unprofitable customers will have a
positive effect on overall profitability only when they are replaced by profitable
customers, or when such fixed costs as sales or service infrastructure are cutback.
Once customers have been segmented according to profitability and target
segments have been selected, organisations can use profitability data to develop
different value propositions for different segments. CPA provides deep insights into
the costs associated with various service levels. Combined with insights in customer
needs and company capabilities, this can be translated into segment-specific service
concepts. The smallest customers (often the least profitable) will be offered self-service
or standardised services for a fee, with the degree of customised services increasing for
customer groups with higher profitability levels. At the same time, some services that
were hitherto free of charge may only be offered for a fee, even for the largest
customers.

Customer lifetime value and the “strategic value” of customers

So far, we have mainly looked at what is called “retrospective customer profitability
analysis” – i.e. profitability analysis on the basis of historical revenue and cost data.
While retrospective CPA provides valuable insights in current dependence and
subsidisation within the customer base, its value for long term customer base
management is somewhat limited. In order to move from retrospective CPA to
prospective CPA, estimations of future revenues and future costs need to be added to
the analysis. The baseline model would be simple extrapolation of current revenues
and costs. A more advanced model would take customer life-cycle dynamics into
MIP account. Young, growing customers, and customers in growth industries would receive
23,4 higher estimates of future revenues than customers in mature or declining markets.
When an estimate of the duration of the customer relationship is also added to the
equation, customer lifetime value can be calculated, as the (discounted) sum of all
profits from a customer over the expected duration of the relationship with that
customer.
380 CPA looks only at financial positives and negatives in the relationship with the
customer. Account managers are usually quick to add, in defence of any of their
accounts with low (or negative) profitability, that non-financial measures should also
be included in the assessment of customer worth. This is often described as the
“strategic value” of a customer. Senior management should be wary of buying in to
the “strategic value” argument, however. A customer is only strategically valuable if
having this customer leads to demonstrable additional income with other customers,
now or in the near future. Three sources for such indirect revenue streams are as
follows.
.
Attraction. Some customers that are unprofitable by themselves, can serve as
reference clients for the acquisition of other, more profitable customers, for
instance when entering a new market.
.
Learning. Some customers can add value as co-development partners, leading to
new or improved products or services that can be sold profitably to other
customers.
.
Volume. Some customers can, as a result of their sheer size, absorb large amounts
of fixed costs, thus enabling the company to engage in profitable activities with
other customers, which would otherwise be financially impossible.
Both prospective CPA and the assessment of the “strategic value” of customers depend
heavily upon estimates, assumptions, and forecasts. Retrospective CPA, on the other
hand, is more fact-based. All the three methods complement each other in the quest to
value one of the most precious assets a firm may have: its customer base.

Conclusions
CPA is a potent tool for marketing intelligence gatherers and strategic planners to
understand how profitability is distributed within the customer base. But apart from
their apparent use within the marketing and sales departments, CPA outcomes should
also find their ways to the boardroom. The profitability distribution curve shows to
what degree profitability depends on a small number of accounts, as well as to what
degree profitable accounts subsidise less profitable ones. Even when the curve for the
organisation as a whole seems all right, analyses for individual markets may uncover
high-risk profitability distributions in certain parts of the customer base.
Shareholder value is created through cash flows from customers. CPA uncovers
where these cash flows are generated. In the absence of CPA, CRM strategies are
usually based on measures like gross margins and/or volumes. Research has shown
that these measures do not necessarily correlate well with customer profitability. CPA
provides a more reliable basis for decisions about service level agreements,
investments in customer relationships, and strategic targeting and positioning.
Strategic decision-makers should also be aware of the limitations of CPA. First, all
customer profitability analyses are based on a cost model, which can have varying
degrees of sophistication. Within this cost model, assumptions and decisions are Customer
built-in, with regard to how fixed and variable costs are assigned to activities, and
subsequently, to customers. Users of CPA outcomes should be aware of how the cost
profitability
model is constructed. Second, CPA, in its retrospective form, analyses past analysis
performance, and should be used with an appropriate level of caution, so as not to
steer on rear-view mirror information only. Third, low, or negative profitability for a
customer should not automatically lead to the conclusion that that customer is to be 381
“fired”. More often, it is better to look for opportunities for increasing revenue or
reducing cost.
Increasing pressure on shareholder value forces planners to search for opportunities
to increase cash flows via cost reductions and revenue increases, and to reduce the
volatility and vulnerability of cash flows. CPA provides valuable data for such cash
flow enhancements. If improved insights into the distribution of customer profitability
can be combined with the increased possibilities of ICT for low cost service delivery,
then organisations can plan realistically to develop and implement value-driven
differentiated customer service strategies.

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