Do you know which of your customers are destroying business value? Which are using more of your resources than others; continually contacting customer service, changing specifications, creating amends/rework, repeatedly returning product, etc.? Understanding customer profitability helps you manage your business's profitability through greater insight and better-informed decision making, recognising why specific customers or segments are more or less valuable than others.
Many companies that believe that they understand customer profitability are working with the wrong information. Most use aggregate measures such as gross margin or lifetime value which exclude difficult to measure costs or those challenging to attributed to individual customers. Simply applying a fixed cost-to-serve or overhead cost across all customers will not pick up the nuances and variation across your customer base.
Organisational decisions need to focus on optimising profitability for the business's longevity. Profit is critical as it supplies the capital for future activity. Profit is the results of the company's performance and, ultimately, the customer's feedback on how the business meets their needs, wants, and expectations.
Increasing sales nearly always means sacrificing short-term returns, while growing profits practically always means sacrificing long-term sales. Optimising is about balancing short and long-term profit objectives ensuring investment in the company's future whilst delivering for today.
What is meant by customer profitability?
Customer profitability evaluates the various activities and expenses incurred in serving a particular customer; it focuses on analysing profit per customer rather than profit per product. This shift of focus from product to individual customer profitability is crucial for customer-centric businesses to understand the value exchange between the organisation and its customers.
Kotler (1997) defines a profitable customer as "A person, household or company that, over time, yields a revenue stream that exceeds by an acceptable amount the company's cost stream of attracting, selling and servicing that customer."
Profitability is the measurement of how well the business meets its customer's requirements. Increasing the profitability of existing customer and recruiting higher value customers is essential for a sustainable business.
How to measure customer value
Customer value management is a key to business success, and there are many ways to calculate customer value, here we look at Average Revenue Per User, Customer Lifetime Value and Customer Profitability.
1. Average Revenue Per User (ARPU) identifies the revenue generation from subscribers or customers within a segment or group of customers over a defined period, usually annually. Consumer communication, networking, digital media, subscription services and SaaS companies commonly use ARPU.
ARPU = Total Revenue for a group / average # of users within the group
ARPU provides the organisation with insight into the average revenue of a group of customers. A starting point for businesses to consider value in their decision making. However, ARPU does not account for how long the company expects to hold onto the customer or the entire cost of providing the service or product.
2. Customer Lifetime Value (LTV, CLV or CLTV) calculates the net value a business can reasonably expect to receive from a customer or group of customers over the expected lifetime of the customers. It should incorporate cross-sell/up-selling opportunities, retention rates and apply a discount rate to future cash flows.
*CLTV = ((Profit t1 x Retention Rate t1 )/(1+r)) +…+ ((Profit tn x Retention Rate tn) /(1+r)n)
CLTV helps organisations find a better balance between short-term gains and long-term value. Ensuring the focus is on the more valuable customers during customer management, retention and recruitment activities.
3. Customer Profitability (CP) analysis builds on CLTV, providing a more in-depth insight into which customers or customer groups create or destroy value in your business.
CP can be challenging to implement, detailed and resource-intensive, depending on the available information and its accessibility. It builds on CLTV by incorporating costs-to-serve and other overhead costs attributing these to customers. These additional costs can be the difference between a profitable and unprofitable customer.
When developing CP, align the calculation period with the business's planning horizon.
The complexity can soon mount up, so consider the granularity your organisation requires and can work with.
Start small, focusing on a business unit, product line or proportion of revenue streams.
Keep it simple, do some digging, identify existing sources of overhead and cost-to-serve granularity, piecing together data to support a proof of value development.
Use the increased profitability from your proof of value to fund further improvements in the modelling. Enhance the sophistication of the model, introducing more detailed and accurate costing via Activity Based Costing analysis.
Regularly run the customer profitability analysis and monitor the impacts of business decisions and initiatives.
Customer profitability analysis:
Provides insights into the full cost of serving customers
Identifies resource utilisation by different customers or customer groups
Helps you identify operational inefficiencies
Identifies any dependence on customers or segments. Which you want to retain, attract and grow
Identifies ways to adapt your service to serve customers better and increase their profitability
Helps you identify which customers are likely to be targeted by competitors
Improving profitability
Customer profitability is more than purely knowing customer value. It enables an increased level of awareness and knowledge across the organisation. Understanding which customers are improving your bottom line and by how much, which are destroying value, and which are just breaking even allows you to re-evaluate your business and undertake initiatives that improve its performance.
Loss-making customer
Understanding that a customer is loss-making is the start of making them profitable and increasing the profitability of your business. Your organisation will need to identify, evaluate and prioritise initiatives to change the loss drivers. Some considerations could include:
Moving customers to lower cost to service channels
Increase self-serve capability – evaluate current self-serve processes, simplify, improve and increase awareness within target groups
Streamlining inefficient/high-cost processes
Automate high volume processes such as customer to cash or customer verification
Up-sell or x-sell other products/services to improve revenue
Standardise or charge for customisation
Re-evaluate your discount, rebate, promotion and compensation payment strategies
Review sales force behaviour
Review stock-holding requirements
Revise delivery and returns policy and processes
…
Identify the drivers that make your customers loss-making or less profitable and take this insight as a catalyst for change and increased profitability.
Most valuable customers
While these customers are currently your most valuable, you need to ensure that you don't dilute their value. Be aware of the law of diminishing returns; concentrating resources on this group may slightly increase income but erode profitability. The focus should be on how you protect and develop these customers and segments, which could include:
Increasing retention focus - understanding the level of profitability allows you to evaluate retention investment for a customer or segment
Increasing the level of customer service - preferential treatment (whilst still offering outstanding service to your other customers)
Attaining/recruiting similar customers - build personas of your most valuable segments and target prospects. Run a recommendation programme
Introducing a loyalty programme to reward these customers and increase tenure
…
While all customers are not equal, they all contribute to the performance of the business, its market share, its influence in the market, customer confidence and ultimately, their buying behaviours. You want to avoid an increasing over-reliance on a smaller customer base and the resulting financial vulnerability this introduces.
Not all customers can be profitable today; some provide learning opportunities; others are strategically important; others are potentially tomorrow's high-value customers. Understanding customer profitability allows the business to prioritise initiative to optimise profitability across the whole customer base. Customer profitability is one measure; however, there are other important customer and business metrics.
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