As with anything worth doing, a customer profitability analysis takes time and effort. In a business, it also takes buy-in from management. The sales force may initially be reluctant to give up on a paying customer.
Imagine how the Allstate agents felt in the Florida example. There might be reluctance on people in sales to give up customers they have worked so hard for. An analysis may need some persuasion from management to see potential benefits. It may also reveal the need to make big changes to the business, which could lead to internal resistance. For example, a business may discover that low-margin items may need to be offered through more of a self-service model.
This could result in changes to sales force practices: Sometimes customers are more trouble than they are worth. They may demand special pricing, unreasonable payment terms or hard-to-meet delivery schedules. The purpose of a customer profitability analysis is to figure out which customers are making a company money and are desirable to keep.
Through the analysis, a business can also learn more about business practices and perhaps discover ways to cross-sell additional products to the parts of their customer base they want to retain. They may discover that big changes are required and those changes may be met with internal resistance.
There might also be public relations issues to deal with if a company discontinues a popular product or 'fires' a customer who then complains through social media.
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In this lesson, we'll discuss customer profitability analysis, including its advantages and disadvantages and we'll provide usage examples. What Is Customer Profitability Analysis? Advantages It is easier for a business to be successful if they don't have too many 'outliers' in the customer base. Gaining Something From The Process The process of gathering the data about customer profitability can also yield additional benefits, perhaps shining a light on an undiscovered problem or flawed process.
Try it risk-free No obligation, cancel anytime. Want to learn more? Select a subject to preview related courses: Disadvantages While there are advantages to performing a customer profitability analysis, there are drawbacks as well.
Sometimes change is necessary in a business to yield a better future outcome Lesson Summary Sometimes customers are more trouble than they are worth. Register to view this lesson Are you a student or a teacher? I am a student I am a teacher. Unlock Your Education See for yourself why 30 million people use Study. Become a Member Already a member? What teachers are saying about Study. Earning College Credit Did you know… We have over college courses that prepare you to earn credit by exam that is accepted by over 1, colleges and universities.
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Like this lesson Share. Browse Browse by subject. Enrolling in a course lets you earn progress by passing quizzes and exams. Take quizzes and exams. Earn certificates of completion. You will also be able to: Create a Goal Create custom courses Get your questions answered. Upgrade to Premium to add all these features to your account! Email us if you want to cancel for any reason. Start your FREE trial. Back in , William B. Why would a company want to know the answers to the questions about customer profitability levels?
Possibly to answer more direct questions about its customers, such as:. To be competitive, a company must know its sources of profit and understand its own expenses and cost structure. With the facts, what actions can be taken to increase profits? For outright unprofitable customers, a company can explore passive options of gradually raising prices or surcharging for extra work, hoping the customer will go elsewhere. For profitable customers, a company may want to reduce customer-related causes of extra work for its employees e.
It should no longer be acceptable not to have a rational system of assigning so-called nontraceable costs to their sources of origin. ABC is that system. ABC uses multiple stages to trace and segment all the resource expenses as calculated costs through a network of cost assignments into the final cost objects: In complex, support-intensive organizations, there can be a substantial chain of indirect work activities that occur prior to the direct ones that eventually trace into the final cost objects.
These chains result in activity-to-activity cost assignments, and they rely on intermediate activity cost drivers traced to consuming activities in the same way that final cost objects rely on activity cost drivers to reassign costs into final cost objects based on their diversity and variation.
Making indirect costs direct costs is no longer an insurmountable problem as it was in the past. Integrated ABC software allows intermediate direct costing to a local process or to an internal customer or required component that is causing the demand for work. It further allows tracing costs among the final cost objects.
ABC software is arterial in design, so it flows costs flexibly and proportionately. This visibility aids in identifying where to focus improvement efforts. Examine the ABC cost assignment network in Figure 1 that consists of three modules connected by cost assignment paths. Imagine the cost assignment paths as wide pipes and thin straws where the diameter of each path reflects the amount of cost flowing.
The power of an ABC model is that the cost assignment paths and their destinations trace costs from beginning to end — from resource expenses to each type of customer and optionally to each specific customer.
To understand why customers are the origin for costs, mentally reverse all the path arrowheads in Figure 1 from bottom to top. This polar-opposite switch reveals that all expenses originate with a demand-pull from customers—and the calculated costs simply measure the effect in the reverse direction. Resources, at the top of the cost assignment network in Figure 1, provide the available capacity to perform work. Cash is exiting the treasury. Examples of resources are salaries, operating supplies, or electrical power.
Amortized cash outlays, such as for depreciation from a prior period, can also be modeled. One basis for tracing or assigning resource expenses is the time e. Work is performed by employees or assets, and resources are converted into some type of output in the work activities module. Activity cost drivers are the mechanism to accomplish this assignment. An example in a warehouse is the number of stocked items picked.
A bonus from ABC is the unit-level cost consumption rates, which are useful for comparative benchmarking studies as well as for projecting future expenses and costs such as with rolling financial forecasts, what-if scenario analysis, and outsourcing decisions.
These concepts are not discussed in this article, but they are important ones. Final cost objects, at the bottom of the cost assignment network, represent the broad variety of outputs and services where costs eventually accumulate. Customers are the final-final cost objects.
They create the need for resource expenses to be supplied. Yet that type of work activity is valuable to the organization because it enables the company to function in a proper legal manner. The key to a good ABC system is the design and architecture of its cost assignment network. The network with its nodes delivers the utility and value of the data for decision making. Customers are rank-ordered from the most profitable to the least profitable, including those who are unprofitable i.
The graph illustrates how a substantial amount of unrealized profits can be hidden because of inadequate existing and traditional cost allocation methods and incomplete costing below the product gross profit margin line. Managers usually believe that the curve would be relatively flat. The broad averaging of traditional noncausal overhead cost allocations is crushing the cost accuracy and results in this flat-curve belief.
ABC information usually shocks executives and managers the first time they see it because they have typically presumed that almost all but a few of their customers are profitable. Instead, they have large profit makers and profit takers. The shape of this graph is typical for most companies. From left to right, the graph line reveals the company earns a substantial amount of profit from a minority of customers, roughly breaks even on some, and then loses profits on the remainder.
For business-to-consumer B2C companies, such as banking and telecommunications, customers pass through life cycles. This difference shifts attention from the current run rate of past-period profit levels from their consumers to their future potential profit level. This provides sales and marketing the ability to apply return on investment ROI measures to evaluate which customers can achieve the highest profit increase from actions. The crucial challenge is not to use ABC just to calculate valid customer profitability information from transactional data but to really use the information—and use it wisely.
The benefit comes from identifying the profit-lift potential from customers and then realizing the potential with smart decisions and actions.
The metaphor for this consumption sequence is the predator food chain where large mammals eat small mammals and small mammals eat plants. The final-final cost object—the customer—ultimately consumes all the other final cost object costs, except for the business sustaining costs.
Within each of the major final cost object categories e. Figure 4 is an example of an individual customer profitability statement. They are a mix of high- and low-product-profit-margin purchases, based on their own unit costs and prices, as a composite average.
Managers also can drill into details about the product-mix profit margins for more visibility. In addition, within each product or standard service line, the user can further examine the content and cost of the work activities and materials for each product and service line.
Although customer satisfaction and loyalty are important, a longer-term goal is to increase corporate profitability for the shareholders derived from increasing profits from customers as if each customer were an investment in a stock portfolio. Figure 5 combines these two layers as a two-axis grid: Figure 5 debunks the myth that customers with the highest sales volume are also generating the highest profits. The objective is to generate more profits from all customers regardless of their intersection location.
This is represented by driving customers to the upper-left corner of the grid. Examples of actions that will do this are surcharge pricing, up-selling, and cross-selling. For example, if customers have purchased items A and B, they often also purchase item C. With that insight, companies can recommend offers to customers who have only purchased items A and B.
Knowing where customers are located on the matrix requires ABC data. A critical reason for knowing where each customer is located on the profit matrix is to protect the most profitable customers from competitors.
Because so few customers typically account for a significant portion of the profits, the risk exposure from losing them is substantial. What does a company do with the customer profit information?
In other words, what actions can an organization take to increase profits from its customers? Although this is only a partial list, a company can increase profitability by doing the following:. Much has been written about the increasing role of CFOs as strategic advisors and their shift from bean counter to bean grower.
They can support sales and marketing by helping them to target the more attractive customers to retain, grow, and win back and to acquire the relatively more profitable and valuable ones. Very comprehensive assessment of the state of customer profitability and CLV from a financial perspective. A lot of useful options. For me, it is important that the company add to its balance sheet customer data: Customer Value Added,,,,how are we doing versus competition? What are trends 2. Customer Assets, which can be broken down as you advise.
This is a fantastic piece of work that every CxO and GM should read. I agree that customers should be segmented based on profitability and hassle factor but I am uncomfortable with a black and white view of the situation. The core assumption in your work, if I understand it correctly, is that the organization is optimized and well functioning. Most organizations are not and CLV-in action is messy. With profit as the core reason for being, it skews organizations to make decisions that actually hurt profit.
Get off the phone and close the case. The result is — the customer is dissatisfied, needs more help, complains on Twitter, etc. Is this a customer that should be dropped — may not. Had the customer support person been measured differently — say on customer success and satisfaction — the call might have taken longer but the customer would have been happy with the resolution and might have shared their brand happiness with other prospective customers.
The customer is expecting someone who is measured and vested in see them be successful. Profit is king but it needs to be viewed and managed holistically over the lifecycle of the relationship, not at the activity or discrete time block level. Calculating this for all your marketing activity to enable transparent conversations between CMOs and CFOs on marketing budget allocation is another key cultural step forward in the cooperation needed. Leads are scored and qualified, resources are committed, pipeline values are calculated, then filled with opportunities, forecasts are made.
In manufacturing, where I have worked much of my career, Activity Based Costing has been extraordinarily helpful for identifying opportunities for increased operating control, or cost reduction.
But this benefit contributes to its limitation for decision making on projects that have future strategic importance. When considering those opportunities, looking through the lens of ABC might cause them to appear to have low, or no, remunerative value. ABC is also challenging to implement. Should costs be distributed by unit volume? By contribution to revenue?
How would large expense items, such as CXO salaries be parsed? In any event, the decisions around all of these items can create vastly different numerical and decision outcomes.
This can be true. The problem is, most customers are mixed. Everything is going swimmingly for a few quarters, and then they experience a supply chain interruption, or a product-line makeover.
Materials are returned for re-work. Rush orders are shipped. Product engineers fly to remote factories to snuff out major problems. What was a profitable customer quarter-to-quarter has just gone into the tank. Which brings me to my last point. I believe salespeople should be compensated on revenue, not profit. Many companies allow for this by paying different commission rates for different products. In the case of IT, generally, highest rates for services and support fees, and lower rates for lower-margin products like hardware.
Our margins are much higher when we use them, and my commission check depends on it. Would our staff in Bangalore be available if we waited 30 days — I could hold off the purchase order till then. Most companies would be loathe to have this type of game playing going on. Of course, Andy is right. This is because companies have a normal business strategy which every one signs off on.
No customer strategy exists which all departments are part of. We first build a customer strategy with people from all departments including the CFO. Departmental customer tasks and goals 3. The Customer Strategy is used to build the Business strategy. The Customer Strategy has an agreed upon purpose for the company and this is not profits and it forces customer alignment and breaking of silos. This is outlined in my book Total Customer Value Management: Transforming Business Thinking http: Companies and consultants cannot change things without following the right steps.
Otherwise the CFO will remain responsible for profits! I am very impressed that you comprehensively read my ABC-related article. I agree with most of your observations. As a preface, allow me to position what I believe should be the primary purpose of ABC information and management accounting information in general. It should NOT be to directly provide answers and result in some of the knee jerk types of decisions that you described.
But rather the information should generate questions and stimulate discussion that would include many of the non-financial factors that you provided examples of. I can share more about this. When the incentive is a blend e.
For example, price discount to order less frequently with larger order quantities. Yes, in that example, robust cost information would be needed to calculate the maximum price discount before the ordering becomes profit negative.
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.
Customer profitability analysis for better decisions Is your financial institution capable of answering questions related to the profitability of its customer base? For example, is the current service model for a specific customer segment too expensive when compared to its revenue-generating potential?
model is used initially, determining customer profitability requires a clearer understanding of the causes of the revenues and the costs. CUSTOMER PROFITABILITY ANALYSIS). Customer. CUSTOMER PROFITABILITY ANALYSIS GOOD PRACTICE GUIDELINE MARCH FACULTY OF FINANCE AND . Customer profitability analysis is best conducted with a technique known as Activity based costing or ABC analysis. Customer profitability analysis helps the company understand the net profit coming from each customer which can be calculated by revenue less costs. These costs are various type of costs.
Customer profitability analysis The potential Benefits of Customer profitability analysis (CPA) Customer profitability analysis (CPA) providing the uneven distribution of cost and revenue of customer. The information of the cost bear by the customer proves to be priceless. As the revenue. The financial performance of a company is evaluated by two models in the marketing and sale phase of business cycle: tactically oriented customer profitability analysis model (CPA) and strategically oriented customer lifetime value model (CLTV).