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.

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