Customer profitability analysis

Customer loyalty not only means customer retention, but also recommendations of products/services to other potential customers.

Customer profitability analysis (CPA) is based on the recognition that each customer is different and contributes differently to business profit. Its aim is to improve strategic decision making around the customer base, to focus attention on the most profitable group of customers.

The general approach is based on segmenting the customer base, to determine the revenues and costs attributable to each. Profitable segments can then be maximised, and non-profitable segments reduced or eliminated.

Customers can be unprofitable for a variety of reasons such as:

The sales team under pressure to close deals, offer discounts to secure business within the sales period.
Pricing errors, due to inaccurate estimates of time or resources involved.
A one-size-fits-all approach, leading to over-servicing where business levels don't justify it.
Loss leaders offered to customers who always shop around, expecting that profit will be recovered over the relationship lifetime.
No connection made between customers and costs. Over time some become a greater drain on resources than others

The basis for segmentation will differ across companies and industries. In some cases you may segment individual customers, but with many consumers, a broader brush can be applied.

Using activity-based costing, the drivers of cost, and consequently the cost of each activity involved in dealing with the customer, can be identified and costed. This includes directly attributable product/service costs and also hidden costs, such as inventory, order fulfilment, billing and sales and marketing activity etc.

Strategies can then be developed to maximise profits and/or activity from profitable customers and reduce or eliminate less profitable customers.

For profitable segments, this involves promoting the development of long-term customer relationships, for increased revenues, e.g. customer retention and loyalty programmes.

Less profitable groups can be eliminated by ceasing supply - no longer marketing to them, changing the product/service, or raising prices. It might be possible to make some customers profitable, by increasing revenue and/or decreasing costs, i.e. charge additional fees, or use a differential pricing strategy.

John Taylor is an author for accountingcpd. To see his courses, click here. This blog is an extract from his new course, Improving Business Profits