In the quest for owning the total customer experience, many businesses become obsessed with customer satisfaction and/or a higher NPS value. As Robert S. Kaplan, co-author and inventor of the Balance Scorecard methodology, put it, “When the customer says jump they ask how high.”
To increase the net promoter score, businesses may start offering freebies like price discounts; product or service customization; small order quantities; special packaging; expedited delivery; generous pre-sales support from marketing, technical, and sales resources; extra post-sales support for installation, training, warranty, and field service; and liberal payment terms. While all of these services create value and loyalty among customers, none of them come for free. My personal experience backs the studies that show that nearly all companies have customers that cost them cash out-of-pocket. In fact, it is clear that oftentimes 15 percent to 20 percent of a company’s customers subsidize its unprofitable customers and contribute most of the company’s net profit.
To clarify what I mean, let’s look at the profitability of a company by business units or market segments. Figure 5.3 shows a company that is is overall profitable. However, three out of eight markets in which the company is competing are losing money. The other five markets are profitable enough to subsidize the loss. Therefore, it is meaningless to state that the average profitability of the market segments is $16.875M (total profitability [135] ÷ number of market segments [8]). But this is exactly what most businesses do, and then they wonder where to find their next opportunity. Companies that do not recognize the issue of customer profitability fail to identify that despite a healthy bottom line, there can be a considerable number of unprofitable customers within their customer portfolio. This is the problem of working with averages.
Figure 5.3: Example Customer Profitability Analysis
Therefore, the quest for owning the total customer experience should be balanced with the income from customers. Putting it differently, if a business has to provide value to its customers, then the reverse is also true: The customer should provide value to the business. Customer profitability is the indicator that tells you if a customer is providing value to your business or not. Customer profitability (CP) is the difference between the revenues earned from and the costs associated with the customer relationship during a specified period.
The basic reason to care about individual customer profitability is the recognition that each dollar of revenue doesn’t contribute equally to net income. Some dollars (thus some customers) contribute more than others. Therefore, it is important to distinguish between high-profit and low- or negative-profit customers. The analysis of individual customer profitability opens a door to a new way of thinking about business. It provides routes to a clear strategy for profitable growth that have previously been unavailable.
Calculating Customer Profitability
On an intuitive level, understanding customer profitability is simple. Calculating it, however, is a bit trickier. This is because most companies don’t track their marketing, distribution, customer service, administrative and other costs at the customer level. Either they treat these costs as fixed period costs without driving them to individual customers or they equally assign these costs to each customer. For example, if the customer service department costs $1,000,000 a year and there are 250 customers, then the cost per customer is $4,000. Both of these methods are deceiving, as they hide the true cost per customer e.g., one customer may make ten calls a day while another makes only one call a month.
Ideally, your approach to calculate the business profitability should take into account:
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What your customers actually pay (after discounts, promotions, rebates, and write-offs).
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How much it costs to sell to them (including all commissions and incentives).
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What it takes to serve them (all direct and indirect costs ranging from distribution to after-sales support).
Businesses that are serious about providing an exceptional customer experience and maintaining their business profitability link all these costs to individual customers so that the sum of the profit from each customer equals the net company profits. This is a tall order. Businesses that are just venturing into the idea of customer profitability (CP) can gradually build this capability by first associating only marketing, customer service, and order returns costs to a customer while distributing the rest of the costs equally to all customers. Since a business tracks all basic parameters per customer, associating these costs with individual customers is relatively easy.
For example, you already know how much you are spending on each marketing campaign—direct marketing, promotions, advertisements, etc.—and what returns you are getting. If one of your marketing campaigns costs you $100,000 and results in 1,000 orders worth $1,000,000, then the cost per order is $100 ($100,000/1,000). Now if 500 orders worth $800,000 come from existing customers, then these orders are four times ($800,000/$200,000) more valuable than the other 500 orders. Hence, the marketing cost per existing customer is $25 ($100/4) and the marketing cost per new customer is $175.
Similarly, if your total cost of providing 24/7 customer service is $365,000 a year and your customer service department takes 100 calls a day, then your cost per call is $10 ($365,000/365/100). Thus, if you are tracking the number of support calls a customer makes, you can associate the customer service costs to them. To go to the next level of sophistication, you can start tracking the time per call and associate the costs based on time.
Along the same lines, if you receive 1,000 returns a year and it costs you $100,000 in salaries, etc. to process these returns, then your cost per order-return is $100. You can associate this cost with a customer who makes a return.
As you see, associating costs with a customer is easy. Once you establish the process of associating costs on the customer level, calculating customer profitability is very straightforward: Simply subtract all the costs for a customer from the sales for the same customer. All the leading accounting software—large or small—has the functionality to calculate customer profitability. Once you activate it, you can generate customer profitability reports with just one click. Sweet, isn’t it!
Once you have calculated the profitability value for each customer, group your customers in three categories:
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Unprofitable – Customers that are costing you money out-of-pocket
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Breakeven – Customers from whom your profit margins are less or below your average profit margins
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Profitable – Customers from whom you are making decent profits
Unprofitable customers are the pariahs of the business world, or so conventional business theory has led us to believe. Many gurus suggest weeding out bad customers and aiming loyalty programs at good ones.
On the surface, this makes sense.
But in this day and age, customers are scarce. Writing one off simply because she is unprofitable is at best rash and at worst counterproductive. Some of your unprofitable customers could be your best promoters, or some of your unprofitable customers could be the source of a big hunk of monthly cash flow, or some of your profitable customers could be detractors—unhappy customers. Therefore, the question is not how you can shed unprofitable customers, but rather how can you make money off the customers that everyone else is shunning. Just as you cannot make the right decision while looking at the net promoter score alone, you cannot make a wise decision looking only at customer profitability. You need to combine both. Next section, "Finding Treasures", explains how.
Related:
- Table of Content
- Red Queen Effect – An Introduction
- The Billionaire Code
- Cracking the Code
- Implementation Plan