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Customer profitability part 1: The importance of customer profitability

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7th Jun 2004
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Customer profitability must be understood

I was recently party to a heated discussion between two Sales Vice Presidents from the same corporation attending a European business development conference. The subject under discussion was customer profitability. One manager was suggesting that it was a waste of time to look at customer profitability because the calculation was always inaccurate and in any case he was at the mercy of the market and the competition: if the competitor reduced a price then he felt bound to match it in order to retain the business. He believed that provided the overall business showed a profit then the details were not important.

The other manager was incredulous and took the polar opposite view. His belief was that without a clear understanding of the profit generated by each customer then he could not manage the business properly: the business would manage him. His argument was that if the profitability model was inaccurate then get a better model. This seemed to me to be a sensible approach yet there were clearly many other managers at this meeting who saw profitability analysis as simply a piece of internal bureaucracy that adds no value and that produces results that defy the realities of the market.

Yet my sympathy was with the second manager. Were I to be in his position, I could not understand how I would negotiate with a customer if I did not know if we were making any money. Indeed how can any decisions that relate to customers be taken if we do not know what the cost and profit implications are?

The reality is that in today’s highly competitive environment, brushing the issue of customer profitability under the corporate mat on the grounds that it is too complicated is just not sensible and is likely to lead to significant problems over the medium term.

One of the key questions that any manager must address is – “Where do we make money in this business?” Without this understanding it is hard to see what the manager is really managing.

Richard Ilsley
[email protected]
7 June 2004

Replies (9)

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By admin
11th Jun 2004 12:41

Richard Ilsley is exactly right when he says that the first thing to do is to figure out where the business actually makes money. I don't disagree with the other consultants who have made comments but the reality is that few companies that I have worked with have even a basic grasp of customer profitability so to try to apply sophisticated analysis as some have suggested is just not realistic. Get the basics right first.

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By timfitz
10th Jun 2004 11:07

There are 3 types of customers -
Profitable clients whose return on capital employed in servicing them is at a level that your company is satisfied with. We call this profit in pounds, shillings, and pence. Shareholders love these.
Profit enhancing clients whose business may not be as profitable as the above, but whose presence as a client has an influencing effect on gaining more clients. i.e. a few "blue chip" clients in your portfolio adds credibility and enhances your position in the market place. (Shareholders love these also)
Non profitable clients - those whose demands outstrip your abilities and whose costs are greater than the return on capital. Even if they're "blue chip" - get rid of them. (Let your competitors shareholders embrace them).
So in essence there are 3 types of client -
those who make you money; those who will help you make money from other clients; and those who you give to your competition.
Sounds basic but it works

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By AnonymousUser
14th Jun 2004 09:12

Customers do not come with profits or losses attached to them like labels. Profits or losses (more correctly cash flows, as profits are an accounting opinion) are generated during transactions with customers.

If a customer generates a loss with a particular transaction for an individual customer, it is because the COMPANY is un-profitable, not because the customer is. All customers occasionally generate unprofitable transactions, but if a customer does this regularly it is generally a sign of a deeper underlying business problem.

This suggests that the company itself has the ability (and duty to shareholders) to change the revenue and cost side of the profit equation, to try and make the customer profitable.

In turn, this implies that the company needs to understand where and how cash flows, if it is to serve the customer profitably. Developing this understanding should precede any attempt to assign so-called profitability to customers. Indeed, without this understanding, it is unlikely that a company would be able to do much in response to 'unprofitable customers' other than increase its prices or risk 'firing' the worst offenders. Both simplistic responses that don't tackle the underlying problem.

So before we all think of this simplistically as a customer profitability issue, lets REALLY get back to basics and recognise that this is a business model profitability issue. For that is where most of the answers to the problem lie.

Graham Hill
Independent Management Consultant


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By AnonymousUser
09th Jun 2004 09:55

I think there is little serious dissent from the view that understanding something about customer profitability is important in managing a business profitably.

But it isn't just as case of calculating customer profitability over their lifetime (irrespective of the method used). That is much too broad brush. You actually need to understand three core components of the customer profitability equation to manage a business properly.

The first of these is short-term cashflows. Measured over a three to five year period, this component allows a business to focus on how it should manage customers in the short-term. For example, it should be used to influence this year's marketing budget allocations and to drive three year customer management strategy.

The second is longer-term growth options. Measured over a five plus year period, this allows a business to think about where it wants to be in the future and how it is going to create value from transacting with customers. Some of this will feed back into the shorter term, for example, if the business decides it needs to learn about customer analytics for the longer-term by making a few small analytics investments in the short-term.

The final component is risk. Risk eats away at the other two values. A business needs to identify what drives risk to customer valuze and to try and remove or mitigate it as much as possible.

You can drive your business without understanding customer profitability. But it is becoming a high risk approach to business. Your shareholders won't like it...be warned

Graham Hill
Independent Management Consultant

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avatar
By hakimaly
08th Jun 2004 19:32

I could not agree with you more on the importance of measuring customer profitability. However, care must be taken in how you measure profitability. Specifically, customer profitability should reflect choices and decisions made by the customer, and not the organization or a result of competitive pressures. In the context of financial institutions(which is the space I operate in), this means removing the impact of basis risk (e.g. priceing based on the Prime Rate but whose cost of funds is based on a different index such as Libor), and applying a predetermined spread for fixed rate products.

Hakim Aly
Independent Consultant

Thanks (0)
avatar
By timfitz
10th Jun 2004 11:07

There are 3 types of customers -
Profitable clients whose return on capital employed in servicing them is at a level that your company is satisfied with. We call this profit in pounds, shillings, and pence. Shareholders love these.
Profit enhancing clients whose business may not be as profitable as the above, but whose presence as a client has an influencing effect on gaining more clients. i.e. a few "blue chip" clients in your portfolio adds credibility and enhances your position in the market place. (Shareholders love these also)
Non profitable clients - those whose demands outstrip your abilities and whose costs are greater than the return on capital. Even if they're "blue chip" - get rid of them. (Let your competitors shareholders embrace them).
So in essence there are 3 types of client -
those who make you money; those who will help you make money from other clients; and those who you give to your competition.
Sounds basic but it works

Thanks (0)
avatar
By hakimaly
08th Jun 2004 19:32

I could not agree with you more on the importance of measuring customer profitability. However, care must be taken in how you measure profitability. Specifically, customer profitability should reflect choices and decisions made by the customer, and not the organization or a result of competitive pressures. In the context of financial institutions(which is the space I operate in), this means removing the impact of basis risk (e.g. priceing based on the Prime Rate but whose cost of funds is based on a different index such as Libor), and applying a predetermined spread for fixed rate products.

Hakim Aly
Independent Consultant

Thanks (0)
avatar
By AnonymousUser
09th Jun 2004 09:55

I think there is little serious dissent from the view that understanding something about customer profitability is important in managing a business profitably.

But it isn't just as case of calculating customer profitability over their lifetime (irrespective of the method used). That is much too broad brush. You actually need to understand three core components of the customer profitability equation to manage a business properly.

The first of these is short-term cashflows. Measured over a three to five year period, this component allows a business to focus on how it should manage customers in the short-term. For example, it should be used to influence this year's marketing budget allocations and to drive three year customer management strategy.

The second is longer-term growth options. Measured over a five plus year period, this allows a business to think about where it wants to be in the future and how it is going to create value from transacting with customers. Some of this will feed back into the shorter term, for example, if the business decides it needs to learn about customer analytics for the longer-term by making a few small analytics investments in the short-term.

The final component is risk. Risk eats away at the other two values. A business needs to identify what drives risk to customer valuze and to try and remove or mitigate it as much as possible.

You can drive your business without understanding customer profitability. But it is becoming a high risk approach to business. Your shareholders won't like it...be warned

Graham Hill
Independent Management Consultant

Thanks (0)
avatar
By AnonymousUser
14th Jun 2004 09:12

Customers do not come with profits or losses attached to them like labels. Profits or losses (more correctly cash flows, as profits are an accounting opinion) are generated during transactions with customers.

If a customer generates a loss with a particular transaction for an individual customer, it is because the COMPANY is un-profitable, not because the customer is. All customers occasionally generate unprofitable transactions, but if a customer does this regularly it is generally a sign of a deeper underlying business problem.

This suggests that the company itself has the ability (and duty to shareholders) to change the revenue and cost side of the profit equation, to try and make the customer profitable.

In turn, this implies that the company needs to understand where and how cash flows, if it is to serve the customer profitably. Developing this understanding should precede any attempt to assign so-called profitability to customers. Indeed, without this understanding, it is unlikely that a company would be able to do much in response to 'unprofitable customers' other than increase its prices or risk 'firing' the worst offenders. Both simplistic responses that don't tackle the underlying problem.

So before we all think of this simplistically as a customer profitability issue, lets REALLY get back to basics and recognise that this is a business model profitability issue. For that is where most of the answers to the problem lie.

Graham Hill
Independent Management Consultant


Thanks (0)