Customer Profitability Analysis

•  (CP) is the profit the firm makes from serving a customer or customer group over a specified period of
time, specifically the difference between the revenues earned from and the costs associated with the
customer relationship in a specified period.
• According to Philip Kotler,"a profitable customer is a person, household or a company that overtime,
yields a revenue stream that exceeds by an acceptable amount the company's cost stream of
attracting, selling and servicing the customer."
• Calculating customer profit is an important step in understanding which customer relationships are
better than others.
• Often, the firm will find that some customer relationships are unprofitable.
• The firm may be better off (more profitable) without these customers.
• At the other end, the firm will identify its most profitable customers and be in a position to take steps to
ensure the continuation of these most profitable relationships.
• However, abandoning customers is a sensitive practice, and a business should always consider the
public relations consequences of such actions.
• Companies commonly look at their performance in aggregate.
• A common phrase within a company is something like: “We had a good year, and the business units
delivered $400,000 in profits.” When customers are considered, it is often using an average such as
“We made a profit of $2.50 a customer.”
• Although these can be useful metrics, they sometimes disguise an important fact that not all customers
are equal and, worse yet, some are unprofitable.
• Simply put, rather than measuring the “average customer,” we can learn a lot by finding out what each
customer contributes to our bottom line.
• Quite often a very small percentage of the firm’s best customers will account for a large portion of firm
profit.
• Although this is a natural consequence of variability in profitability across customers, firms benefit from
knowing exactly who the best customers are and how much they contribute to firm profit.
• At the other end of the distribution, firms sometimes find that their worst customers actually cost more
to serve than the revenue they deliver.
• These unprofitable customers actually detract from overall firm profitability.
• The firm would be better off if they had never acquired these customers in the first place.
• The first fundamental component for understanding customer-by customer profitability is to know the
revenue and the costs for each customer.

• However, most companies’ accounting systems do not allocate costs on a customer-by-customer

basis.

• To turn CRM data into a customer profitability model, a company must switch from activity based cost
accounting to customer-based cost accounting.

• This means allocating costs by customers.

• The second component is to move away from a brand management focus to a customer management
focus.

• In a brand management model at a bank, for example, one manager manages mortgages, other
checking accounts, and other credit cards.

• The managers don’t know how any one customer interacts across the entire business.
• For each product, a customer may be a low value customer, but he may be very valuable across the
entire organization.

• Yet because the brand managers cannot know this, they may under-invest in the customer.

• If the bank followed a customer manager model, however, the customer’s true value would be
apparent and could be managed accordingly.

• It’s important to be able to change the focus so that brand or property or departmental managers don’t
manage customers and their information, but rather, the central organization of the company does.

• The real reason is the push for marketing to be more accountable.

• The typical response of a marketing manager used to be, “I will improve customer satisfaction.”

• Knowing customer satisfaction levels is fine and important, but it’s no longer enough.

• Now senior management wants to know the return on that investment so they can understand exactly
how much they should be spending to improve satisfaction.
• Revenue comes from customers buying products.

• If you can value one customer, you can value the entire customer base of a company.

• Then you can project at what rate the company is acquiring customers and at what rate they are
leaving.

• Combining those components enables a company to derive the projected value of the customer base,
which should be close to the value of the firm.

• Research shows that customer value provides a strong proxy for market value of several firms. CEOs
and senior management both care about the market value of the firm.

• Typically market value is estimated as discounted cash flow.

• The critical component in this approach is the projection of future cash flow. What is the basis for
projecting cash flow?
• A common approach is to use past data for this projection

• Marketing takes a bottom-up approach. Our premise is that cash flow is a result of customers buying
products.

• Therefore, we can project cash flow and build the ultimate value of the company from the bottom up by
looking at each customer as a building block.

• Historically, when marketing talked about customer profitability, the notion was “How do I provide value
to the customers? How do I make my product more valuable to the customer?”

• What customer profitability talks about is the flip side of customer value – which is how valuable the
customer is to the company.

• So you can think of it as two dimensions – how do I provide value to the customer and how does the
customer provide value to me?

• If I don’t provide value to the customer, he won’t buy anything.

• On the other hand, if he doesn’t provide value to me, then should I spend valuable resources on
pursuing his business? In marketing, we say the customer is the king – which we have to provide value
to the customer
• In finance, cash is king – how much value do I get from this particular customer?

• Customer profitability brings together these two dimensions?

• Revenue is easier to track because it looks at how much a customer actually gives a company.

• Customer cost is a harder measure to track because most companies’ accounting systems were not
designed to track customer-by-customer costs.

• Unfortunately, this means that acquisition and marketing costs are grouped together and averaged.

• Slowly, companies are beginning to allocate costs by customers because they can see how many times
a customer uses an ATM or frequent flyer cards and so on
Steps in CPA

1.The first step of CPA is to create a simple model of revenue by customer on the one hand, and total
business unit costs and overheads on the other. 

2.Subtract the direct product and service costs from each customer (costs of good sold/cost of sales) to
arrive at a gross margin per customer.

3.It should be possible to identify other costs specific to the customer such as a particular sales campaign
or servicing and retention costs. Orders of magnitude will do rather than getting hung up on 100%
accuracy.
4. Determine the ARPU ( Average Revenue Per User) which is Total Revenue / Total No. of subscribers.
The CLV ( Customer Lifetime Value) which is the projection of the entire net profit from a customer over
their entire relationship with the company

5.Sort customers by net profit and draw a cumulative profitability curve starting with the most profitable to
the least. This is an effective way to visualise the relative profitability of customers and it soon becomes
apparent which customers are critical to the business.

6.Before taking any decision on non-profitable customers, make sure that you have strong retention
activities in place to secure your most valuable customers.
7. Get behind the real reasons why some customers are unprofitable and determine the appropriate
strategies and tactics to enhance the profitability of your customer portfolio. Thought about sacking
customers, should be put to one side until you have gained a clear understanding of the reasons.

There are lots of reasons for being unprofitable, and it is important to think ahead to potential value over
time, not just recent history.

What might you do with the results?

• Do not to jump to simple conclusions about the results. Some might be tempted to sack the non
contributors or profit takers, however there may be very good reasons why these customers are
unprofitable such as:

• A reference customer that provides access to a market of strategic importance.

• A customer with whom you invest to co-create some new product or service which will yield more
opportunities for higher margin business.
• It’s your fault not the customers’.
• It is a new customer and the acquisition costs have not yet been fully absorbed, and the customer
is likely to buy more from you in time.