Just like other businesses you also need to evaluate business success based on top-level metrics like annual profits. If you detect a problem with profitability, you consult the income statement and balance sheet.
Question remains. While these bits of paper are valuable, do they actually provide detailed information about consumers – the lifeblood of your business?
We can almost hear you thinking — how is that relevant to measuring Customer Profitability Analysis?
Point often overlooked, when your business is hyper-focused on products and profits– which sits at the heart of every business model– it makes you skimp on your customers. Sometimes, you even have to bear the cost of maintaining unprofitable customers, which hurts your bottom line.
This is where Customer Profitability Analysis (CPA) can help you. With CPA, your business can uncover two critical pieces of information about your customers (1) Which consumer category generates maximum revenue? (2) Which consumers are a lost cause and better to be discarded?
Professor John A Murphy examined the topic in-depth in his book – Converting Customer Value: From Retention To Profit,
- What customer profitability entails
- Values in conducting Customer Profitability Analysis
- Process of Customer Profitability Analysis
- Potential issues with CPA
- Implications of CPA
So, in this article, we’ve shed light on the aforesaid concepts and delved into its purpose to help you have a better grasp on this topic.
Organizational profitability vs. customer profitability (what’s the difference?)
This may get you thinking: why is it necessary to consider customer profitability separately from overall profitability? A financial statement doesn't portray which group of customers and products are profitable and which are not.
To better fathom the importance of it, consider that your business has five product categories. Do you report each of these segments separately in your income statement? Do you gather pieces of data tied to every single touchpoint in the customer journey? The answer is most likely to be no.
Customer Profitability is generally the profit earned across all of the consumer's interactions with your brand, including customer service interactions, refunds, and custom fulfillment expenses.
In order to determine annual profit per customer, your business can use this formula:
Annual profit = (total annual revenue the customer generates) - (total annual expenses used to serve the customer)
When determining total revenue, every business factor in
- Recurring revenue
- Cross-buying relevant products
- Upgrades to premium plans
And, expenses can be incurred from the following sources:
- Operational cost
- Expenses related to attracting and retaining customers
- Cost of customer service and customer success team
- Loyalty perks
What is customer profitability analysis?
In layman’s terms, Customer Profitability Analysis is a formula that businesses use to understand how much profit an individual customer generates for their organization over time.
It is a metric based on the fact that each customer is unique. Therefore, not every penny of revenue or expense generated by the customer contributes equally to a company’s profitability.
In the book Killer Customers: Tell The Good From The Bad and Crush Your Competitors, it is estimated that the top 20% of customers (by profitability) generate more than 120% of a company’s profits. Meanwhile, the bottom 20% account for losses exceeding 100% of profits.
On this matter, Customer Profitability Analysis will help you to segment your customers based on their profit contribution to your brand, allowing you to focus your operational costs, marketing, and customer service expenses on the most profitable ones.
It is mentionable that your company can calculate the CPA on a customer level or for an entire customer group. The Customer Profitability Analysis formula is:
Customer profitability analysis = (annual profit) x (number of years a customer stays with a business)
Customer profitability analysis example
Here’s an example to illustrate how to measure Customer Profitability Analysis. Let's say Jane placed 10 orders in the previous quarter and returned 3 of them. She called your customer service department 6 times to handle product-related difficulties, consuming 50 minutes of call time in the process.
Smith, on the other hand, placed five orders and only returned one. He also used 15 minutes of your customer support department's time by calling twice to settle a variety of concerns.
So, who do you think is the profit-generating angel and who do you think is the profit-depleting monster?
At first glance, Jane seems the most profitable, right? But in reality, the net profitability of Smith exceeds that of Jane. This is because, while running a Customer Profitability Analysis, the hidden costs come to light.
As you can see, the high revenue segment is actually costing you a hefty sum of money. Under this circumstance, you'd be better off shifting your strategy and resources to the low-revenue segment.
Perks of conducting a customer profitability analysis
The importance of Customer Profitability Analysis is manifold. Your company can use this information to determine which customer segments to invest in and which to abandon.
Targeting the right customer segment
Customer Profitability Analysis opens up possibilities for segmentation and targeting strategies. For example, once you've identified your most profitable markets, you can devise tactics to reach out to more potential customers who suit your target demographic.
Cost minimization and operational efficiency
Customer Profitability Analysis helps you to understand the true costs of each customer segment, including non-production costs, which can often exceed manufacturing costs.
By identifying the costs associated with each market segment, businesses can establish strategies for cost reduction. For example- they can stop servicing less profitable markets and increase investment in more successful customer segments. This is because customer loyalty is crucial for businesses and they will leave no stone unturned to retain those customers.
Simply put, CPA helps identify areas where process improvements are required resulting in better operational efficiency.
How to measure customer profitability analysis
Once you have a framework in place to measure CPA, it becomes easy to analyze customer profitability. This is how you can go about it:
1. Identify customer touchpoints
The first step is to identify all the channels via which a customer might connect with your business. After you have done so, you may begin evaluating the associated expenses. This includes not just the cost of the goods or services your consumers purchase, but also any additional charges like
- Costs of advertising
- Costs of customer service
- Costs associated with shipping and return shipping
- Costs associated with social media engagement
- Costs associated with returns, such as restocking
2. Segment your customers
Market segmentation is the first step in calculating customer profitability analysis. To segment a market, you split it up into groups that have similar characteristics.
To do so, certain companies may rely on demographic information while others may place a greater emphasis on psychographic or behavioral characteristics. Indeed, businesses can combine several segmentation techniques to gain a holistic view of their clients and the influence their purchase patterns have on their business.
If your business does not yet have clearly defined consumer segments, you can do so today. Start off defining…
- What types of customers do you have?
- Why do they purchase from you?
- What do they buy and what is your share of their wallet?
By answering these questions, you can create your ideal buyer persona and put yourself in a position to identify profitability based on customer behavior and background.
3. Gather revenue & cost data for each segment
After segmenting your customer base, you need to gather data on customer profitability. You need to specifically determine how much revenue your personas generate and how much money they cost your firm. Adjustments such as discounts and service fees should be included when estimating the revenue for each market.
In this stage, consider the following questions:
- Can you identify customers who consume an excessively high amount of sales time, customer service time, or warehouse activities such as delivery frequency, returns, and backorders?
- Can you identify the customer segment who requests a difficult-to-ship product mix from you, or who increases the number of vendors you must keep to serve the orders?
4. Analyze the profitability of each segment
After calculating the CPA for each of your market segments, classify your segments based on profitability. To gain a better understanding of how each section contributes to your overall goals, you might categorize your markets as high profitability, moderate profitability, or low profitability.
How can you use the results of CPA
The next step is to create appropriate strategies for each segment. For instance, elimination of least profitable customers, re-engineering customer groups into profitable ones by increasing revenue and decreasing costs.
“You can find more profitable ways to grow your business if you know how CPA works. It can also help you figure out which customers to attract and which to keep for longer at a higher cost.” - John Murphy, Converting Customer Value: From Retention To Profit
Now, let's depict customer profitability using a Whale Curve, which can offer businesses with insights on how to improve customer profitability.
The Whale Curve
In a whale curve, customers are ranked by profitability, from highest to lowest. Customers are plotted on the X-axis while the Y-axis reflects accumulated profit.
Generally, in whale curve economics, the top 20% of clients tend to be clear profit makers, contributing between 150% and 300% of net profits. The middle 60% tend to be profit neutrals and the bottom 20% tend to be profit takers.
As shown in the whale curve, 20 percent of your most profitable customers are generating 180% of your overall profitability. As such, any future business actions that have the potential to marginalize this niche should be rejected.
Rather, businesses should dig into this 20 percent of customers to gather insights about how they can replicate it for all customer segments.
- What proportion are they of your total business? Could they be bigger, and how?
- What are the factors that led to these customers being the most profitable?
- Are there any opportunities to provide additional services to these customers?
In this case, the center region of the whale curve captures 60% of customers that are breaking even on profitability. The money generated by these clients is offset by the costs invested in serving them. Consider the following questions to gain a better knowledge of their profit margin:
- What are the customer attributes?
- What products are they buying?
- What incentives can you offer them to make profit out of them?
Businesses must delve into this customer segment to determine why they are draining overall profits.
Remember that you should not sacrifice all other consumer groups in favor of the most profitable group. Asking the following questions will help in identifying the root cause of any lagging customer segments and restoring profitability:
- Is there anything that can be added to the sales process to help steer customers to a product/service that fulfills their expectations better?
- Are there policies that should be put in place to avoid some of these costs?
Wrapping it up
Most companies will admit to having some unprofitable customers. However, when you take the time and effort to understand customer profitability at an individual level, you will be in a far better position to make informed decisions about how you want your customer portfolio to evolve.
So, establish your CPA framework. Think about how you can better connect the different parts of your business to support this metric.