What is Customer Profitability and Why Should We Measure It?

By David McNab, President, Exchange Synergism Ltd.

There's no place to start like the beginning, and these questions (what and why) are certainly the right place to begin when you need to decide whether or not your business should be investing in measurement of customers' profitability.

Let's start with the first one: what is customer profitability? The obvious answer is that it is how much a customer contributes to your company's profit. What this really means in practice, however, seems to get complicated as soon as we start to look a little more closely at what we've just said.

What is a customer?

Before spending a dime on customer profitability (or relationship based marketing in general for that matter) it makes a whole lot of sense to figure out who your customers are. And believe it or not, customer likely means different things to different people within your company.

For example: within a Canadian retail bank a customer might mean an account holder; the originator of a transaction, an individual, a household or a family. Depending on who in the organization we ask, we may hear very different views about who or what a customer is.

There may also be complexities in the nature of the relationship between your company and your customers. Joint ownership and multiple beneficiaries of accounts (especially in business to business relationships) add complexity to the question. Intermediaries that play a bridging role between company and end customer, for example the relationship between insurance provider and broker pose challenges to a simple notion of customer.

So it is evident that we had best figure out what we mean by "Customer" before we get started. To offer some guidance on this rather thorny issue we suggest this guideline: a customer should be a purchasing decision unit. What this means in the context of your business may require some careful thought.

Once you have defined who your customers are, the next issue that pops up is whether or not you can actually recognize them in your data. You need the ability to say which transactions and accounts relate to a given customer or you cannot achieve an actionable view of their behaviour and it's implication for profitability of your company. This is usually achieved by establishing a customer hierarchy within your database.

Creating a customer hierarchy is a technical issue, usually resolved by building a Customer Information File (CIF) which cross references customers - however defined - to accounts and transactions. Many companies use Householding algorithms to achieve a similar matching of customers to business activity. Both CIF development and Householding methods are substantial topics that we will leave to a separate discussion. Suffice it to say, it is very difficult to proceed without a reliable customer hierarchy if you want to measure customer profitability.

What is profitability?

Now that the foundation is established we get into the next big question: what is profit anyway? Again there is an obvious answer - it is revenue minus expenses. But which revenues and which expenses to include and when to include them is not at all clear when we take a closer look at your customers' behaviour and your business.

Should revenue be recognized when it is received (cash basis) or when it is earned (accrual basis)? Should your existing customers bear the cost of money spent on soliciting new business from someone else? Which customers should bear the cost of corporate functions like the Lear Jet? Should insurance claim experience or loan losses, or warranty claims or coupons be attributed to individuals (and when)?

These are not trivial or easy questions to answer. The decisions you make concerning the treatment of individual revenue and expense items will have profound impact on the absolute profitability measurement results and the relative profit ranking of your customers. For example one Canadian bank learned that using average cost per account instead of individual transaction costs changed the ranking of many of it's customers by three deciles or more. Their experience highlights how important it is to build a measurement that truly reflects your business.

Once your accounting methods are figured out, are we done? Not really. There are other questions you should think about as well to ensure that the measurement you are going to build will support the decisions you need to make in your business.

In some businesses it is imperative to measure the profitability of customers in relation to the capital resources they consume (e.g. Return on Capital for a lending business). In others it is important to measure profitability over the duration of a cycle that is inherent in the business (e.g. lifetime of a car lease, a growing season for a farmer, a project lifetime for a building contractor, a redemption cycle for a loyalty program customer). There are a wide variety of measurements that may be used to provide insight into the profitability of your customers' business. Choosing what to measure and how to measure will profoundly affect the usefulness of the information you produce.

Customer profitability measurement is not the simplest thing to implement, yet many leading companies have surmounted the challenges that it presents. Why would you want to go through the effort of figuring all this out and building (or buying) a system to do it?

Why should we measure it?

We willingly admit to having a bias towards measuring customer profitability: at a basic level we believe that what gets measured gets managed. Managing value exchanges with your customers as a strategic process is just as relevant now as it was when CRM was first touted as the next great thing. What Customer profitability adds to the mix is an understanding of what pays and what doesn't.

Managing sales

We were once asked to revamp the compensation program for a commissioned sales force. At the time, the 100 or so sales people were generating a substantial negative net present value to the company. The solution we developed was to retarget the sales on which commissions were paid: the rate of commission was built on a sliding scale related to the profitability of the business generated. The result was a turn-around from loss to profit to the tune of several million dollars a year (NPV). At the heart of the analysis was an understanding of customer profitability.

In another example related by a fellow CMA Council member, a retail bank found the discounts demanded by one customer drove their profitability so far into the negative ($40,000 on $10 million in deposits) that they were actually better off letting the customer go elsewhere. Situations like this occur across many different industries where customers negotiate prices.

Sales effectiveness is best monitored through a combination of activity measurements and results measurements. Activity measurements are needed to promote productivity and identify actions that can be taken to improve individual performance. As management guru Tom Peters would say, this is about "doing the thing right."

Results measurement is needed to ensure that our sales people are doing "the right thing." Historically, we have spent lots of time, effort and money acquiring business that provides low or negative value to our companies. The classic statistic first uncovered in retail banking is that 80% of their client base is at or below the zero profit mark. As measurement of customer profitability has spread, we hear similar findings echoed in a number of different industries.

It is quite clear that acquiring profitable customers is a key to managing the margin and the bottom line of your business. Without a disciplined analysis of the profitability of your existing client base it is very difficult to tell which types of customers you should be identifying for acquisition. All of the other target marketing information you presently use remains valid and useful: the difference is you learn which customers you want to acquire.

Having knowledge of customer profitability enables your company to manage and compensate the sales function for delivering value to the organization, rather than revenue or unit sales.

Managing service

To avoid entering into a debate over the difference between sales and service, we will define service as providing fulfillment of the sales promise to your customers. Each industry is different in the way it provides service to customers but it is invariably an activity that provides value to your customers and cost to your organization. One of the key issues in managing service is the allocation of costly resources to customer service rationally.

For example, one Canadian energy services company established a policy of increasing the general level of reserved service "black-out" periods to create capacity. This enabled reallocation of their trucks and technicians to more rapidly service their best customers without increasing overall cost.

Understanding customer profitability offers a myriad of opportunities to you for managing the effectiveness of the resource allocation decisions you make concerning service. In Canada, many industries have a bias towards providing all customers with equality of service levels. While this is one of the cultural attributes that makes us Canadian, it is absurd from a business perspective. Not all customers offer the same value to our companies. Why then must we provide the same service to all customers? The answer may be complex in a regulated industry or one with a high public profile or public purpose, but in many for-profit corporations there is really no good reason that service differentiation cannot or should not be implemented.

Service differentiation opens up the potential to treat your best customers better and to save money by reducing the levels of service provided to customers who contribute less to your company's well being. Remember that there is a numbers game going on here: it is possible to reduce service level 10% on 80% of the customer base and increase it 40% for the remainder for the same cost.

Altering service levels can take many forms. It may involve alterations in reward and recognition program premiums; call wait periods; access to privileged locations, times or content; face time with staff; fast-track processing or just about anything else you can think of that might be valuable to your preferred customers.

The key to affecting service level decisions is knowing two things: who you are affecting and how much change you can afford. Measuring customer profitability can help you to answer both of those questions with facts.

Managing product

Product management is as necessary a discipline in a customer centric organization as it ever has been. Product managers have usually been blessed with access to some form of product profitability measurement which informs their management processes and thinking. Consequently, we rarely see product managers emerging as the proponents of customer profitability in companies. We think this is unfortunate, as there is indeed opportunity lurking in this information for the product manager too.

What the customer view brings to them is a deeper understanding of product interdependencies from a customer perspective. It is no longer appropriate to look at a pricing decision or a product add/drop decision strictly on the basis of the individual product's profitability. Management of customer value demands that we also consider which of our customers are using the products or services we are making these decisions about.

Where are the opportunities to optimize loss leaders for our preferred customers? Where can we create an opportunity for holistic relationship pricing? How much can we afford to give as discounts and to whom? Where can we raise prices without risking our key customers? What are the implications for new product development? These are the kind of questions our product managers need to be considering.

Managing operations

Operations management is largely concerned with optimizing processes to achieve efficiency and effectiveness. This management challenge inevitably results in substantial change as new technologies and practices are adopted. One of the several insights that customer profitability can provide is to highlight which customers are affected by changes and the risk that the organization is taking by implementing operational changes. This is critical when evaluating risk and when communicating to customers about changes the company is implementing.

Another important way that customer profitability can be used in operations is in the evaluation of which processes and procedures are adding value to the company. For example, processes which involve few of the higher end customers have lower value than those that support large numbers of high end customers. Ultimately operations processes can and should be measured in relation to customers and customer value.

Managing finance

In my years as a Financial Controller I was always amused by the budget setting process. It seemed to be a tug-of-war between the conservative projections of management and the Board which always demanded a far higher return. In the end, I always found the resultant plans to be somewhat dissatisfying, sort of like a cease fire called because we ran out of time for the war.

Did we have the kind of information we really needed? What would happen if the Board said the objective was to "close the gap between current value and potential value by 10% and add 5% to revenue from net new business?" With customer profitability measurement, this kind of objectives-based business planning becomes possible. It also gives a much clearer direction to management than traditional planning measures.

In our experience, customer profitability information has not yet taken on this level of strategic use in finance. This may be because the measures are relatively new, and adoption takes time. Nonetheless we foresee that this is where business planning is inevitably going to head, because the customer really is the central measurement basis for your company. Your company's present value is the sum of the present values of your customers. Your company's potential value is the sum of the potential value of your customers plus a factor for net new business. In many business acquisitions these are now taken into account as critical factors in the valuation process. Knowing what these values are is central to understanding the real value of your business franchise.

Conclusion

Customer profitability measurement is challenging to implement; it draws into question our understanding of who our customers are and how we make profit.

It can add powerful insights throughout your business, helping to focus decision making energies on doing what is right for your customers and your shareholders at the same time. In a customer-centric organization, measuring customer profitability has become a business imperative: without it there is no fact basis for managing the value exchange between your company and your customers.

Our sense is that you can not afford to manage without these facts as you make decisions concerning the sales, service, product management, operations and finance functions of your business. especially if your competitors have them.

Tags: Strategy, Analytics