The Importance Of Analyzing Customer Profitability

The Importance of Analyzing Customer Profitability

BADM 603

July 30, 2007

Every for-profit business has one main goal: to maximize profits by selling as much of its products or services to as many customers as possible. It seems logical to think that the more customers that a business has, the more profitable the company will be. However, business managers should also be aware that some customers are more profitable to the company than others. Managers should analyze their customers to determine those that are the most profitable, and most important to keep satisfied, as well as those customers that may not be contributing to the profit of the business. Once these customers are determined, a manager can develop strategies to increase the profitability of the less profitable customers while keeping those highly profitable customers happy. This is accomplished through customer profitability analysis.

What is Customer Profitability Analysis?

Determining which customers generate the largest profits and are consequently better for the company’s bottom line is critical. In a similar fashion to allocating indirect costs of production to products through activity based costing, customer profitability analysis is accomplished by allocating indirect costs for various services provided when a purchase takes place to the appropriate customer. The indirect costs of serving customers include processing multiple orders when one order for all items could be processed more efficiently; processing returns and/or exchanges; restocking returned goods, handling shipping and shipping charges, the cost associated with transferring product; and costs associated with following up on late paying customers. This allocation of costs through customer profitability analysis allows managers to classify customers into useful categories based on profitability. There is obviously no sense in focusing limited time and resources towards customers that are not profitable.

How is Customer Profitability Analysis Accomplished?

As Merrifield states, “you can never get a perfect ranking of accounts from best to worst,” due to the problem of allocating fixed, mixed and variable costs. Some costs are just not able to be accurately accounted for. However, there are several useful methods that allow for a ranking of customer profitability. Merrifield recommends calculating the estimated operating profit contribution based on the average cost per invoice over a twelve month period, using accounts that have been customers for at least one year. Matthews recommends calculating the ranking over a period of time so that trends can be identified. Managers may find it helpful to analyze certain customers or customer segments initially, before analyzing the entire customer base.

Key components of a customer profitability analysis include: revenue by customer; services delivered; services’ cost drivers; total cost by service; product costs; and overhead costs. Revenue by customer includes all sales revenue, both product and service related, while also accounting for any sales discounts or rebates. Services provided to customers should be listed individually, along with the related cost driver so that total costs can be calculated. These service costs should also include all related salary and non-salary costs. Likewise, product costs must be recognized and allotted to the appropriate purchaser. Agrawal recommends basing the analysis at the customer contribution margin level and suggests that overhead costs should be left out of the analysis. Other methods may include accounting for overhead costs. Either way, the point of the analysis is to obtain a useful ranking of customers by their contribution, or lack thereof, to the company’s profit.

When customer profitability analysis is performed, most companies will find that the bottom one percent of accounts is probably costing twenty percent of the existing operating profit. Conversely, the top one percent of the highly profitable accounts can contribute thirty-five to fifty percent of the operating profit. Usually the top ten to twenty percent of customers provide eighty to ninety percent of profits.

How do Companies Use Customer Profitability Analysis?

Before beginning the process, managers need a clear statement of their profitability goals. They also need to be certain to educate the sales force and other related personnel, on why the analysis is taking place and how it will be used. Customer profitability analysis allows businesses to effectively rank their customers based on their contribution to profit margin. This ranking shows which customers are positive contributors and which customers are negative contributors to the company’s profit. Managers need to be aware that not all customers contribute positively to the company’s bottom line. Merriman outlines three �truths’ to keep in mind when reviewing the results of the profitability analysis:

“1. The only way an account can be at the top of the report is to have huge annual margin dollars and relatively few transactions. These are strong winners no matter what cost-shifting and activity-cost assumptions are tried.

2. The only way an account can be at the bottom of a CPR [Consumer Profitability Ranking] report is to have huge transactional activity and relatively low margin dollar contribution….

3. If anyone wants to use incremental cost assumptions, the rest of the overhead costs assigned to the accounts in dispute must be reassigned to all other accounts. This makes the super losers even bigger losers.”

According to Coffey and Palm, “once you have determined your most valuable accounts and customers, the best thing you can do is to retain them by offering additional services to cement the relationship.” Based on profitability analysis, Agrawal suggests managers can develop strategies to “target the most profitable customer segments; price services to maximize gross margins across customers; discount sales to specific customers; and design promotional bundles and service bundles.” Managers can work with sales personnel to determine which additional services and/or products these highly profitable customers are purchasing and what is making those products desirable. The profitability data can also provide trends in the customer base, such as “certain segments, certain size businesses, certain stages of a businesses’