What is the Right Question to Ask About Customers and Profit?
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.

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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.

Most firms if pushed will admit to having some unprofitable customers. In a recent workshop , out of 30 CEOs, only one was adamant that all his customers were profitable. Once he understood a little more about Customer Profitability Analysis, or CPA, even he caved in.

The first question that you might ask is: Are all customers profitable? Or 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.

Many people rely on the received wisdom from Vilfredo Pareto that 80 percent of revenue comes from 20 percent 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 percent of the customer base. What they also found was that in many cases 20 percent of customers provide over 100 percent of the profits and in one case over 200 percent. Needless to say, these results came as something of a shock to some of the participants of the study.

Issues with Customer Profitability
It seems self-evident that Customer Profitability Analysis is a useful approach, so why isn’t it in common use? Here are nine reasons:

1. 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 enumerate.

2. Accurate customer information can be difficult to get hold of, so any results are open to question.

3. Identifying contributory costs calls for cross company collaboration to build a complete picture of the customer. There is often resistance to such an exercise.

4. Uncertainty about how to capture and portray the figures.

5. In business to consumer markets in particular the scale of the exercise is often too daunting.

6. A lack of a recognized method and doubt about the results

7. That CPA provides an historic picture and fails to take in to account the future potential profitability of a customer.

8. Over allocation or under allocation of costs based on proxies, in the absence of accurate data.

9. Even if a reasonable picture is developed, there is concern about what to do with the results.

Is Customer Profitability Analysis Worth the Effort?
John Murphy found that where organizations 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 Customer Profitability Analysis 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 a recent workshop, one of the managing directors of a services firm realized that it was a lack of consistency in the whole bid process, which often drove customer profitability. It wasn’t the customer’s fault.

Murphy identified five reasons why customers can be unprofitable. They are:

1. The sales force is under continual pressure to close deals and offers discounts to secure business within the sales period.

2. Pricing errors due to incorrect estimates of time.

3. A one-size-fits-all approach to serving customers leading to over servicing where the business levels does not justify it.

4. 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.

5. 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?
Murphy and his colleagues recommend that before getting started the senior management have to realize that they have an issue with customer profitability.

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

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.

Second, 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.

Third, 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.

Fourth, 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 visualize the relative profitability of customers and it soon becomes apparent which customers are critical to the business.

Fifth, before taking any decision on non-profitable customers, make sure that you have strong retention activities in place to secure your most valuable customers.

Sixth, 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?
Murphy 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 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.