Monday, June 8, 2009

Not All Customers Are Created Equal; Understanding Customer Profitability

Although Customer Profitability is nothing more than the result of applying the business concept of profit to a customer relationship, measuring the profitability of a retailer’s customers or customer groups can often deliver useful business insights. Quite often a very small percentage of the retailer’s best customers will account for a large portion of the retailer’s profit. Although this is a natural consequence of variability in profitability across your customer base, retailers can benefit from knowing exactly who their best customers are and how much they contribute to the retailer’s profit.

At the other end of the distribution, retailer’s sometimes find that their worst customers actually cost more to serve than the revenue they deliver. These unprofitable customers actually detract from overall profitability. The retailer would be better off if they had never acquired these customers in the first place.

The analysis of customer profitability is a useless exercise unless the retailer utilizes the insights derived to modify business strategy. For example, segmenting customers based on nominal or percentage profitability may direct marketing efforts to higher profit segments resulting in increased return on marketing investments. Additionally, the analysis may identify unprofitable customer clusters that drain customer service resources, thus limiting the service levels delivered to the most profitable customers.

The biggest challenge in measuring customer profitability is the assignment of costs to customers. While it is usually clear what revenue each customer generated, it is often not clear at all what costs the retailer incurred serving each customer. Activity Based Costing can sometimes be used to help determine the costs associated with each customer or customer group. For components of cost not directly related to serving customers, the calculation of customer profit must use some method to fully allocate these costs to customers if the total of customer profit is to match the operating profit of the retailer. If the retailer decides not to allocate these non-customer costs to customers, then the sum of customer profit will be greater than the operating profit of the business.

Like other profit measures, customer profitability is historical. It is a financial summary of what happened in a previous period. And although the past is often indicative of the future, it is easy to imagine situations in which relationships that were unprofitable in the past might become profitable in the future (and vice versa). The forward-looking measure of the value to be derived by serving a customer is called customer lifetime value. Unprofitable customers can have high customer lifetime values (and vice versa).

Those retailers who recognize the value of customer profitability and customer lifetime value and make the investment to analyze their customer base on a regular basis will have a durable competitive advantage. The insights derived will enhance strategy development and enable improved return on marketing investments. The results, a more strategic approach to cost management, more operating profits for the retailer and improved retention of key customers.

Understanding Product Profitability

If you’re like the majority of retailer’s you have a pretty good idea of your business’s gross profits and the grow margin and/or markup of each of the products you offer for sale. Unfortunately, if you’re like most retailers you do not have an accurate understanding of the profitability of each product taking into account ALL expenses related to the operation of your retail store. How do you allocate rent, utilities, sales staff, back office personnel, advertising and promotion, capital expenditures and other overhead expenses? If you’re smoothing those expenses across all products by revenue generated, the accuracy of your product profitability picture is suspect.

A more detailed analysis of your product portfolio and the allocation of ALL business expenses to each product will provide valuable insights into resource allocation and product portfolio optimization. You may be selling products that are not as profitable as you think. You may be allocating floor space, inventory space and advertising dollars to the wrong product lines. Your overall store profitability is likely under-achieving as a result of a limited view of your true cost structure and an inaccurate methodology of cost allocation.

Now before your eyes roll back in your head and you start to dose off, remember this is about a more strategic approach to product management that delivers money directly to your pocketbook. This is not just a boring accounting exercise, but a laser like approach to identifying the winners and losers in your product selection. Some basic activity based cost accounting is required to be applied, but if you don’t have the skills yourself, seek out professional help. An objective outsider, with an understanding of retail principles and the ability to ask the right questions will rapidly be able to create a product profitability picture of your business. The application of cost pools, drivers, allocation methodology and volume variance analysis are some of the steps required to accurately assess product profitability to aide your strategic decision making.

In the end, a deeper, more robust understanding of product profitability will allow you to make the correct strategic decisions that enhance bottom line results, generating incremental profits you can take home or reinvest in the business. Embrace the numbers, don’t fear them. The ability for you to approach your retail business from a disciplined quantitative perspective will allow you to make better strategic choices, improve customer satisfaction and retention, increase competitive advantage and drive profitable growth.

Increasing Profit, One Penny At A Time

Let's face it. We've entered some very tough times around the entire globe. Profits in tough times can be enhanced with reductions in overhead.

The initial lens to assess overhead is the customer's. Classify expenses that contribute to the customer experience and those that do not. Obvious examples of the former would include store signage and merchandising strategies. An expense that would not enhance the customer experience might be an expensive subscription service to a specialized newsletter that comes month after month that everyone stopped reading a long time ago. If you look around your store or chain, you'll find many things that may be reduced or eliminated to cut costs without compromising the customer experience.

Here are some examples:
  • The watering service that comes weekly to water your plants in the stores and the office
  • The collection of subscriptions to trade magazines and newsletters that no one bothers to read any more
  • The delivery costs you pay for to get your office and store supplies delivered
  • Your courier account that everyone uses for all those emergencies
  • The high premiums you pay on your company vehicles because of your low deductibles
  • Hiring professional painters to paint the staff area when perhaps some employee or employee's spouse can paint it for a third of the cost
  • Equipment that racks up unnecessary electrical expenses such as the shipping terminal that's on all the time, the terminal in the manager's office and the stereo system that runs all night after the store is closed
  • The window washing service that could be done by a staff member in 10 minutes
  • Buying a new printer cartridge for $45 every month when you can refill the current one up to 20 times for about one quarter of the cost
  • Adopting a cheaper third party long distance service to replace the pricy one attached to your current phone
  • Evaluating your current store cleaning schedule and changing the frequency to cleaning every other day and carpet cleaning to every 6 weeks instead of monthly

Opponents to trimming costs can rationalize that every expense enhances the customer experience. Today's retailer can trim many expenses like the examples outlined that really don't affect the customer experience directly. What does it all mean?

It means that in these tough times, a little extra effort by everyone on your team can go far to trimming unnecessary expenses without compromising the customer experience or the motivational level of the employees. Trimming those trivial expenses that have crept in over the years can help ensure survival and prosperity in these tough times. In the short term you’ll see an immediate improvement in your bottom line profitability with no negative impact on revenues or the customer experience. In the long term, your business will operate more leanly and provide positive incremental profitability on an ongoing business as wasted overhead is permanently removed from the business.

Take Action Today

  1. Develop a list of those unnecessary expenses that have crept into your business at all levels
  2. Brainstorm with all staff and build a prioritized list of expenses that can be eliminated; focus on big rewards and ease of implementation in your prioritization exercise
  3. Offer rewards to staff that suggest additional unnecessary expenses that can be eliminated thus improving the bottom line; be careful to emphasize that the cuts cannot negatively impact customer experience
  4. Get staff to put in the extra effort when these expenses are eliminated by setting an example yourself. Roll up your sleeves!