You’ve probably heard of the term customer lifetime value. This term indicates the total revenue that an average customer generates throughout their entire relationship with the company. But wouldn’t it be more beneficial to know the profits (rather than the revenue) a customer generates? Customer profitability analysis can help you with this.
In this article, we will talk about what customer profitability analysis is, its benefits, and more.
What is customer profitability?
Customer profitability is an accounting method that allows companies to determine the overall profit generated by a customer. A profitable customer is one that generates a flow of income greater than the cost of its acquisition, sale and service. Companies calculate customer profitability at the customer level or for the entire customer group.
When companies focus more on products, departments, and office locations, they often tend to lose sight of customers. As a result, companies sometimes have to bear the cost of maintaining unprofitable customers, which causes business deterioration.
Customer profitability allows companies to evaluate their customers and know how beneficial it is for them to keep them. Based on this value, they can decide the cost of caring for them or even decide whether to continue or let them go.
It has been discovered in a study that the size of the client is not directly proportional to its profitability. Sometimes even large clients can be unprofitable for a company.
Formula to measure customer profitability
To calculate customer profitability, you need the annual profit per customer and the total time a customer stays with your company.
Annual profit = (Total revenue generated by the client in a year) – (Total expenses incurred to serve the client in a year)
Total income can be generated by the following sources that you must include:
- Recurring income
- Upgrades to higher plans
- Cross-buy relevant products
And the expenses can come from the following sources, which must also be taken into account
- Cost of customer service
- Maintaining a customer success team
- Loyalty benefits
- Operating cost
Finally, when you have the annual profit, the calculation of the client’s profitability analysis is as follows
Customer profitability = (Annual profit) x (number of years the customer remains with the company)
Customer Profitability Benefits
Customer profitability allows you to understand the business from a profitability point of view. Methods such as activity costing help you assign a cost to each activity associated with a product or service. Companies can leverage customer account profitability analysis in the following areas to benefit from this method.
1. Cost cutting
If you find a group of clients that are costing more than the revenue they are generating, then it is advisable to end the deal. By letting them go, you are making your customer base more efficient as your growth engine.
2. You can target the right segment
Once customer segmentation is identified according to the range of benefits, they can be used for other operations. The attributes of the customer group that generates the most benefits must be recorded and used for subsequent acquisition.
Marketing teams can design their campaigns based on these attributes to attract more such customers. Additionally, based on their profitability range, marketers can decide what deals and discounts they can offer to potential customers.
3. You can create a custom retention strategy
After finding the group of customers with different profitability, companies can customize their retention strategies for each group. For more profitable customers, companies can afford to provide the highest quality service. That means they can spend more serving those customers.
4. Operational efficiency is improved
The main reason why a group of clients generates less profits is not always the client. There may be some flaws in the company’s internal operations that are making it harder for them to serve customers.
Let’s say the group of customers with the lowest profits is consuming a lot of resources to address the same problem in a product over and over again. Instead of allocating resources to that recurring problem, it could be beneficial for the company to create a feature in the product itself that solves the problem. This would not only reduce the operating cost but also make your product better for future customers.
How to do a customer profitability analysis
The key is to segment the customer base, determine revenue, attribute costs, and also have an activity-based cost approach. Let’s know the steps to follow here:
The basis of a profitability analysis is customer segmentation. This will vary according to sectors and companies. It can be demographic, based on the customer’s age, income, area, etc. It can also be psychographic, based on the needs, behaviors, values, interests and attitudes of customers.
Once the segmentation is done, the income of each segment must be calculated. Annual revenue is the sum of all segments. Adjustments such as discounts, rates, and service charges should be included and adjusted accordingly.
Attribution of costs
Calculate the annual cost per segment. These are customer costs, service costs, product costs, sales, marketing and distribution costs. These costs are often hidden and must be added together to determine cost attribution.
The next step is to create strategies that increase revenue, create long-term relationships, and improve customer retention and loyalty programs. Strategies may include eliminating less profitable aspects, converting customer groups into profitable ones by increasing revenue and decreasing costs.
Check the impact
Any new strategy or practice must be applied and worked on accordingly. It is necessary to review it after appropriate periods of time to understand the impact on customers.