Profit sits at the heart of any business model, but there are multiple approaches to increase it. If your business deals with customers, you may assign a customer lifetime value to each client. Another option is to examine the revenue that each customer generates using a customer profitability analysis. There are multiple benefits to understanding customer profitability, which we’ll explore below.
In today’s competitive business landscape, companies need to closely track and analyze the profitability of their customers. A customer profitability analysis allows businesses to determine how much profit each customer generates compared to the costs of acquiring and serving that customer over time. This enables companies to identify their most valuable customers and optimize their marketing and service strategies. In this comprehensive guide, we will explore what customer profitability analysis entails, why it matters, and how to conduct one for your business.
What is Customer Profitability Analysis?
A customer profitability analysis, also known as a customer profitability score, is a financial metric that compares the revenue generated from a customer to the total costs associated with acquiring and serving that customer. It provides an objective measure of the net monetary benefit obtained from the customer over the lifetime of the business relationship.
Specifically a customer profitability analysis considers factors such as
- Revenue contributed by the customer from purchases/transactions
- Costs of raw materials and labor to produce goods/services purchased
- Commissions, discounts, or incentives offered to the customer
- Marketing costs to acquire the customer initially
- Expenses for sales and service efforts for the customer
- Administrative and general overhead costs
By deducting these costs from the revenue attained, companies can calculate the net profit for each customer. Customers who yield higher profitability are obviously more valuable to the company.
Why is Customer Profitability Analysis Important?
Conducting a customer profitability analysis provides numerous benefits:
Identifies the most profitable customers
The most obvious advantage is that it enables businesses to segment customers according to profitability. Companies can then classify customers into distinct tiers such as platinum, gold, silver, and bronze. This helps identify the most profitable customers who generate the highest margins.
Helps optimize resource allocation
Since companies have limited marketing budgets, a customer profitability analysis helps allocate resources effectively. Businesses can channel more investments towards acquiring and retaining high-value customers. Lower priority can be given to less profitable segments.
Aids pricing decisions
The analysis also provides vital data to set optimal pricing for products/services for different customer groups. More discounts and incentives can be offered to high-lifetime-value customers to grow the relationship.
Enables targeted marketing
Segmentation by profitability allows customized marketing for each tier. Companies can craft promotions, loyalty programs, and other initiatives keeping in mind the needs of the most valuable customers.
Measures effectiveness of strategies
A periodic customer profitability analysis indicates whether marketing efforts such as referral programs, social media engagement, etc. are successfully boosting profitability. Corrective actions can be taken if certain strategies fail to provide results.
Identifies risks
The analysis highlights risks such as dependence on too few customers for a large proportion of sales. Companies can then mitigate risks through wider customer diversification.
Drives long-term growth
While acquiring new customers is important, retaining existing high-value customers is equally essential for long-term stable growth. Customer profitability analysis provides the data to develop customer loyalty and retention initiatives.
How to Conduct a Customer Profitability Analysis
Now that we have a clear understanding of this concept, let us examine the key steps involved in performing a customer profitability analysis:
Step 1: Identify and Segment Your Customers
This lays the groundwork for an actionable analysis. Develop specific customer segments or buyer personas based on common characteristics like demographics, psychographics, buying behavior, etc. For a retail business, segments can be under-35 urban females, over-50 suburban luxury shoppers, price-conscious middle-aged males, etc.
Step 2: Collect Customer Data
Compile historical data for each segment related to sales transactions, product/service costs, acquisition costs, servicing costs, overheads, etc. Sales data can come from CRM software, invoices, accounting systems, etc. Supplement with market research data if required. Maintain a standard structure for easy analysis.
Step 3: Calculate Customer Revenues
Determine the total revenues collected from each customer segment. This includes income from one-time purchases, recurring payments, service/maintenance fees, etc. A subscription business can calculate Average Revenue Per User (ARPU) for each segment. Exclude any revenues not attributed to customers like interest income, non-operating income, etc.
Step 4: Calculate Customer Costs
Identify both direct and indirect costs associated with each customer segment:
- Direct product/service costs (raw materials, packaging, shipping)
- Acquisition costs (advertising, promotional offers)
- Servicing costs (customer support, returns/replacements)
- Administrative overhead costs (salaries, software, facilities)
Allocate overhead costs to each segment based on usage. Remove any costs not linked to customers.
Step 5: Calculate Customer Profit Margins
For each segment, deduct total customer costs (Step 4) from total customer revenues (Step 3). The balance is the net margin obtained from that segment.
Higher net margins indicate greater customer profitability. Rank and compare profitability across segments. This highlights your most valuable customers.
Step 6: Analyze and Interpret Results
With clear data on revenue and costs for each segment, analyze the key findings and insights revealed:
- Which are the most/least profitable segments? Why?
- Do costs to acquire vs. retain vary significantly?
- Are certain marketing channels more effective?
- What are the trends in profitability over time?
- What are the reasons behind high/low-profitability segments?
Step 7: Leverage Insights to Formulate Strategies
Use the customer profitability analysis results to make informed strategic decisions:
- Realign marketing budgets towards highly profitable segments
- Develop retention strategies for high lifetime value segments
- Adjust pricing approaches based on segment profitability
- Refine ineffective marketing channels and campaigns
- Implement targeted promotions for each segment
- Develop initiatives to improve profitability of low-margin segments
Regularly updating your customer profitability analysis provides the insights needed to keep enhancing profitability across your customer base. The small upfront investment is well worth the long-term rewards.
Real-World Examples of Customer Profitability Analysis
Let’s see how leading companies have effectively adopted customer profitability analysis:
-
Netflix – By segmenting subscribers based on streaming plans, Netflix can determine that premium subscribers who pay for 4 screens and 4K streaming deliver higher margins. These customers receive special loyalty promotions to improve retention.
-
Amazon – Amazon catalogs customers into categories like occasional bargain hunters, fleeting one-time shoppers, and big-spending loyalists. High-value Prime customers get perks like free, fast shipping to boost profitability.
-
HubSpot – The inbound marketing platform performs multi- dimensional segmentation across various customer types, geographies, usage behavior, etc. This revealed mid-market agencies were 5x more profitable than enterprise customers. Resources were realigned accordingly.
-
Starbucks – Customer profitability analysis showed that complex customized orders reduced profit margins for the coffee giant. By nudging customers to pre-configure orders via mobile apps, labor costs and waiting times dropped.
Key Takeaways on Customer Profitability Analysis
- It helps identify your most valuable customers based on net profitability.
- Enables optimal allocation of marketing resources towards high-margin segments.
- Provides data to refine pricing approaches and formulate targeted initiatives.
- Measures effectiveness of sales/marketing activities on profitability.
- Assesses risks and opportunities within the customer base.
- Drives growth by retaining profitable customers and improving less profitable relationships.
- Requires collecting and analyzing historical revenue and cost data across customer segments.
- Should be conducted periodically to adjust strategies based on updated insights.
In today’s customer-centric business environment, companies cannot afford to overlook customer profitability analysis. Leveraging these analytical insights can directly boost your bottom line and strategic performance. The above guide covers everything you need to know to unlock the power of customer profitability analysis for your organization.
Why should you calculate customer profitability?
Once you’ve calculated profitability using the formula above, what can you do with it? There are several benefits.
- CPA enables cost-based customer segmentation. You can group customers into segments based on the value they generate. While it’s still important to focus business efforts on groups that generate lower profits, there may be some that actually cost more than the revenue generated. In these cases, it might be more financially viable to cut these customers loose.
- You can market services more effectively. In addition to eliminating clients that don’t generate any profit, you can focus your marketing efforts on those customers that generate the highest profits. Spend more time analyzing this group to attract similar high-revenue customers through marketing.
- Boost your customer retention strategy by tailoring your efforts to each segment. Higher-profit customers should be given the highest-quality services. With a profitability analysis, you’ll have a better understanding of the costs involved in building customer loyalty.
Understanding customer profitability analysis
A customer profitability analysis (CPA) looks at the revenue (or profit) that each individual customer generates. While activity-based costing examines individual cost drivers to determine the profitability of a product, a customer profitability analysis applies this same approach to customers. Typical costs for customer retention include things like marketing, customer service, fulfillment, and other operations expenses.
In other words, you can look at the cost of providing service to a customer. With CPA, a profitable customer would be one that generates revenue greater than the cost of these expenses. It’s often a useful approach for service providers or SaaS companies, which focus more on customer acquisition rather than product sales. This type of profitability analysis can often yield surprising results. It’s not always the biggest customers who generate the highest revenues. Customer benefits can come from smaller clients with brand loyalty.
Customer Profitability Analysis (Activity Based Costing)
What are the steps in a profitability analysis?
Let us know all the steps in depth here. The base for a profitability analysis is customer segmentation. This will differ across industries and companies. It can be demographic- based on customer age, income, area, etc. It can also be psychographic that is based on customer needs, behaviours, values, interests, and attitude.
What is Customer Profitability Analysis (CPA)?
Customer Profitability Analysis (CPA) is a financial management tool. It helps businesses to understand the profitability of their customers and customer segments. The basic idea is to identify the costs of acquiring and servicing each customer. After that, compare those costs to the revenues generated by each customer.
Why do you need a customer profitability analysis?
A thorough customer profitability analysis can be central to an efficient sales strategy. By segmenting your customer base and identifying the most lucrative opportunities, you can better understand which prospects will help your business the most and tailor your sales efforts accordingly.
How to calculate customer profitability?
To calculate customer profitability, you need to track customer behavior and activity. The market is, however, subject to changes and different resources. All this makes it necessary to reduce errors in calculating customer profitability as much as possible. Customer profitability analysis requires you to assume every product is different.
