How to crack customer profitability analysis

Apart from the financial services industry, profiling customer profit contribution or potential for profit at the individual level is rarely practiced. Modern accountancy practice doesn’t demand this knowledge and most marketing or CRM practitioners are unsure how to go about it.

In his book Converting Customer Value, Professor John A Murphy and his colleagues looked at this in some detail. I spoke to him about it and he agreed to let me pick out some of key elements from the opening chapter in the book – the Customer Profit Conundrum:

• What it is.
• Value in performing it.
• What it entails.
• Issues and barriers.
• Tools.
• What to do with the results.

The right question to ask about customers and profit

Most firms, if pushed, will admit to having some unprofitable customers. In a workshop I was involved in with colleagues Jan Kitshoff and Robin Gleaves, out of 30 CEOs only one was adamant that all his customers were profitable. Once he understood a little more about customer profitability analysis (CPA), even he caved in.

The first question that John Murphy considers you might ask is: Are all customers profitable? He then suggests that a more insightful question might be: Are you making a profit from all of your customers? The subtlety behind the second question is that quite often customer profitability is not the fault of the customer, but the way the firm serves him or her. This is revealed through the discipline of CPA.

Most firms though, cannot answer either question because they have no formal mechanisms in place to do this, relying instead on traditional accounting methods based on overall revenues and gross profits attributable to products or services. Not customers.

Be wary of Pareto

Many people rely on the received wisdom from Vilfredo Pareto that 80% of revenue comes from 20% of customers, and by implication a similar picture is likely to be true for profits.

Benchmarking research by John Murphy and his team at Manchester Business School, across a range of industries and leading firms, showed that following a detailed CPA, the Pareto principle seldom applied. His team found that in many cases unprofitable customers made up over 50% of the customer base.

What they also found was that in many cases 20% of customers provide over 100% of the profits and in one case over 200%. Needless to say, these results came as something of a shock to some of the participants of the study.

'The flaw of averages'

A common approach is to allocate costs in proportion to revenue contribution, but the research found that some customer-related costs were actually 'super-variable, that is they increase at a faster rate than sales'.

In one of the examples in the book, the average revenue per customer was £22,229; however, this masked the range which went from £210,724 down to as little as £16. Overheads were allocated as a percentage of revenue, thus the smallest customer attracted just £8.63 in overheads, whereas the true cost to serve was nearer £12,000.

Issues with customer profitability

It seems self-evident that CPA is a useful approach, so why isn’t it in common use? John offered these reasons:

• A lack of skills. One of the challenges associated with CPA is that it calls for hybrid skills - forensic accountancy grafted on to marketing or CRM. Few CEOs or financial directors ask for this kind of information and marketers are notoriously innumerate.
• Accurate customer information can be difficult to get hold of, so any results are open to question.
• Identifying contributory costs calls for cross company collaboration to build a complete picture of the customer. There is often resistance to such an exercise.
• Uncertainty about how to capture and portray the figures.
• In business to consumer markets in particular the scale of the exercise is often too daunting.
• A lack of a recognised method and doubt about the results.
• That CPA provides an historic picture and fails to take in to account the future potential profitability of a customer.
• Over allocation or under allocation of costs based on proxies, in the absence of accurate data.
• Even if a reasonable picture is developed, there is concern about what to do with the results.

Is it worth the effort?

John Murphy found that where organisations do take the time and trouble to understand customer profitability at the individual level they are in a much stronger position to make informed judgements about how they would like their customer portfolio to develop.

The degrees of difficulty may vary form one company to another, but he concludes that the ‘process and discipline of carrying out CPA will stimulate a customer profitability mindset, which can lead to positive results being achieved.’

So what might it reveal?

The basic purpose of CPA is to help firms work out which customers they would ideally like to attract, keep and grow. Unless they do this, they may spend considerable effort on attracting customers who will never be profitable. Not all firms have a choice regarding customers and ultimately it’s often the customer who makes the choice. Nevertheless, the results of such an exercise can reveal major operational weaknesses that would otherwise be hidden from view.

In the workshop run with Jan and Robin, one of the managing directors of a services firm realised that it was a lack of consistency in the whole bid process which often drove customer profitability. It wasn’t the customer’s fault.

John Murphy identified several reasons why customers can be unprofitable:

• The salesforce is under continual pressure to close deals and offers discounts to secure business within the sales period.
• Pricing errors due to incorrect estimates of time.
• A one-size-fits-all approach to serving customers leading to over servicing where the business levels do not justify it.
• Loss leaders are offered to customers who always shop around for a deal, in the expectation that profit will be recovered over the lifetime of the customer.
• The connection between customers and costs is not made and over time some become a greater drain on resources.

So how should you go about CPA?

John Murphy and his colleagues recommend that before getting started the senior management have to realise that they have an issue with customer profitability.

Without the right level of sponsorship CPA cannot be done, especially as it crosses departmental boundaries.

1. The first step of CPA is to create a simple model of revenue by customer on the one hand, and total business unit costs and overheads on the other. 
2. Subtract the direct product and service costs from each customer (costs of good sold/cost of sales) to arrive at a gross margin per customer.
3. It should be possible to identify other costs specific to the customer such as a particular sales campaign or servicing and retention costs. Orders of magnitude will do rather than getting hung up on 100% accuracy. Be consistent if applying any proxy.
4. Sort customers by net profit and draw a cumulative profitability curve staring with the most profitable to the least. This is an effective way to visualise the relative profitability of customers and it soon becomes apparent which customers are critical to the business.
5. Before taking any decision on non-profitable customers, make sure that you have strong retention activities in place to secure your most valuable customers.
6. Get behind the real reasons why some customers are unprofitable and determine the appropriate strategies and tactics to enhance the profitability of your customer portfolio. Thought about sacking customers, should be put to one side until you have gained a clear understanding of the reasons. As we’ve seen, there are lots of reasons for being unprofitable, and it is important to think ahead to potential value over time, not just recent history.

The whale curve

The whale curve is an excellent way of presenting the relative and accumulative profitability of individual customers. By sorting customers staring with the most profitable to the least, it is easy to see which customers are critical to current profitability of the company.

What would happen to the business in the short-term if these customers defected? Who is looking after these customers? Many firms assume that the largest revenue contributors are the most profitable, but that is often not the case. The whale curve helps management see how vulnerable they may be to customer defections.

What might you do with the results?

John advises not to jump to simple conclusions about the results. Some might be tempted to sack the non contributors or profit takers, however there may be very good reasons why these customers are unprofitable such as:

• A reference customer that provides access to a market of strategic importance.
• A customer with whom you invest to co-create some new product or service which will yield more opportunities for higher margin business.
• It’s your fault not the customers’.
• It is a new customer and the acquisition costs have not yet been fully absorbed, and the customer is likely to buy more from you in time.

It’s a method not an end in itself

Customer profitability analysis provides a method to help firms see and understand the profitability of their customers. It takes effort and management sponsorship to make it feasible and worthwhile. It is a method and not an end in itself, but without it that investment in slick technology might not be such a good idea if it only speeds up your ability to attract the wrong customers. Your allocation of resources to customers may also be based on erroneous information.

As John Murphy says in his book, if you have this understanding it uncovers new options for profitable growth and can help you work out which customers to attract, which to really hang on to at maybe greater cost. To help decide which to grow, CPA must be augmented with an understanding of potential lifetime value.

This might be business as usual for many financial institutions which have accumulated information on some of us for decades, but any firm is likely to benefit from the discipline of CPA, and though it can be tough to do, it is certainly worthwhile.

Recommended reading: Converting Customer Value from Retention to Profit by John A. Murphy, Jamie Burton, Robin Gleaves and Jan Kitshoff © John Wiley & Sons Ltd 2006.