Customer Profitability Analysis | How to Calculate CP?
Successful companies must focus on each and every aspect of their businesses. While organizations focus heavily on profitability, they often disregard the importance of customer profitability analysis. Profitability ratios help you analyze the profitability of a product but customer profitability analysis allows you to estimate the profitability of a customer. Customer Profitability is a significant factor that affects the expenses and revenue of a business.
For instance: What if you are spending a considerable chunk of your budget on marketing, but you’re just not getting the results? You might think that there’s something wrong with your products, but what if there’s something wrong with your marketing strategy. Maybe you’re marketing your products to the wrong customers who are not profitable.
To develop a profitable strategy for your business, it requires much more than just analyzing your financial statements and balance sheets. This is where customer profitability comes into play.
What is Customer Profitability Analysis?
Customer Profitability Analysis is a management accounting tool that focuses on a customer’s profitability rather than a product’s profitability. It helps businesses estimate the net profit generated by each customer. The net profit is calculated by subtracting the cost spent on each customer from the revenue each customer generates. The cost includes all the expenses involved in customer services, such as marketing cost and sales cost in addition to manufacturing and distribution cost.
How to Analyze Customer Profitability?
Analyzing Customer Profitability requires a lot of time and effort. Customer Profitability Analysis can be difficult to implement, but it can still provide useful insights to help your business maximize its profit.
The steps involved in customer profitability analysis are:
- Identify Channels of Contact with Customers: Start your customer profitability analysis by identifying the channels of contact with your customers. Determine the cost associated with each channel. This includes costs such as customer service contact cost, social media contact cost, marketing cost, and shipping cost in addition to products/services cost.
- Segment your Customers into Groups: The next step in the customer profitability analysis is to segment your customer group and categorize them based on specific criteria. They can be defined by the size of the business unit they buy from, their buying behavior, etc. An easy way to segment and define groups is to create a buyer persona. HubSpot defines a buyer persona as “a semi-fictional representation of your ideal customer”. This persona is based on market research and real data about your existing customers.” Segmenting your customers will help you to analyze and identify profitability based on customer behavior and background.
- Determine How Much Each Segment Costs and Spends: After you’ve segmented your customer into different groups, you’ll need to explore the relevant data. You need to find data based on channels of contact that you identified for each group. This data will give you the average costs per customer. These costs include average customer service cost, shipping cost, return rate cost and so on. Compiling average costs per transaction for each group will give you these results.
- Calculate Customer Profitability: Based on all the data you have collected, let’s assume that you have two buyer personas (segments).
- Persona A with a lower average revenue per transaction
- Persona B with a higher average revenue per transaction
By looking at this, Persona B looks like a more profitable customers’ group than Persona A. However, when you calculate customer profitability, you see that Persona A is relatively a more profitable group because it costs less than Persona B.
Let’s simplify it:
|Persona A||Persona B|
|Average Revenue per Transaction||$80||$100|
|Customer Service Cost||$8||$12|
The net profit generated by Persona A is $40, while the net profit generated by Persona B is $33. Persona A is a more profitable group than Persona B, even though it didn’t appear to be that way at first.
Customer Profitability Analysis is a complex task, and it can take you some time to get acquainted with the process. You can use our 80/20 Power Grid tool if you’re struggling to organize your customer profitability analysis project.
Why is Measuring Customer Profitability Important?
It is important to measure customer profitability because it helps you cut costs, which, in turn, increases gross profit. The primary goal of every business is to increase revenue and generate profit, and this is where customer profitability analysis comes into play.
Here are three ways how calculating customer profitability can benefit your business:
Identification of Unprofitable Customers
Customer Profitability Analysis helps you identify unprofitable customers. Some customers might be generating high revenue, but costing you even more than the revenue they are generating. On the other hand, some customers might be generating low revenue but costing you less than the revenue they’re generating. Customer Profitability Analysis helps you identify and eliminate or reduce the cost spent on customers that are not generating profit for your business.
A truism today is that 20% of your customers account for 80% of your profits. A question to ask yourself is what percentage of your customers are actually costing you money.
It has become fashionable today to talk about “Firing your Customers.” That’s not only a bit rude; it is also wrong-ended. It puts the focus and fault on the customer. Focus on what you can change. Ask yourself, what are my “worst practices” – what policies and procedures – are costing you money.
The odds are, if you have a profitable customer you are simply underpricing due to neglecting to fully account for all of the costs required. If by “firing your customer” you mean “raise your prices” then, by all means…
Shift your Focus to Profitable Clients
When you eliminate the clients that are costly and unprofitable, you have more time and money to invest in profitable customers. This will help you increase your company’s revenue and cut down on the cost significantly, which in turn will generate profit.
Improve your Marketing Strategy
Customer Profitability Analysis can improve your marketing strategy by targeting the right customers/audience. Based on the profitable customer group or persona, you can target potential customers that possess similar characteristics. This will help decrease your marketing budget and increase the profitability of your business.
Customer Profitability Analysis is crucial to the success of your business. It helps you refocus your attention and re-allocate your budget to the right customers who are more likely to generate profit.
However, there are many other significant aspects that contribute to the success of the business. Your business needs to have a purpose that aligns with the products or services you provide in order to become profitable. Follow our 7 step plan to bring meaning and purpose to your business.