How to Determine and Drive Customer Profitability
As you enter the budgeting and planning season for the upcoming year, certain factors will always be considered to ensure your new financial plans are aligned with business objectives. Analyzing past performance, current market trends, your sales pipeline, and expected changes in the competitive landscape all form a foundation for setting realistic financial goals. In addition to those considerations, we are suggesting that you review one more item in the process: a customer profitability analysis.
What might not be apparent as you make revenue projections is the degree to which high-cost, low-value customers are draining your resources and cutting into your profits. Let’s say you’re working close to production capacity and you’re wondering whether you have the resources to bring more customers on board. One option for increasing your capacity would be to invest in more equipment and hire more workers, which could require a significant investment. The better option may be to make room in your portfolio by replacing unprofitable customers with profitable ones.
From frequent corrupt files and document changes to customized stock, some customers are often more trouble than they’re worth. A customer profitability analysis provides visibility into every touchpoint on the customer’s journey and uncovers specific costs related to which and how many resources each customer is using.
A brief overview to get started
This example is very simplistic due to space, but you will get the idea. To get a customer profitability analysis started, the first step is to collect data on how much each customer or customer segment contributes in terms of sales. Then identify costs, which generally fall into two categories—variable and fixed. From here, you can construct an analysis starting with the cost of goods sold (COGS)—the direct costs associated with the products or services they purchased. This includes manufacturing or purchase costs, shipping, and any other direct expenses tied to fulfilling a customer’s orders. Next allocate indirect/fixed costs, such as such as rent, utilities, indirect labor and more. Choose an appropriate method for allocating these overheads—this could be based on customer usage of resources, order frequency, or transaction complexity. For example, customers who require more frequent support or customized solutions may incur higher costs in these areas.
Subtract the total costs (direct and indirect) from the revenue generated by each customer to calculate their profitability. This can be done on an absolute basis or as a percentage of revenue.
Red flags will appear
As you conduct the profitability analysis, you’ll start to notice some trends. If any of these red flags sound familiar, you may be dealing with an unprofitable customer:
- You receive a high volume of change requests. If your customer is calling every other day with a new request, they’re probably taking up more time than they’re worth
- The customer offers a low volume of work
- The customer uses non-standard or customized stock
- Your work for the customer only involves print and mailing. These jobs are a red flag because the high-value data services are excluded
Once you’ve identified an unprofitable customer, there are choices to consider: You can change your customer’s behavior in terms of how they do business with your company. You can increase your pricing or implement minimums. Your final option is to terminate the relationship.
Unprofitable customers consume a lot of resources, but unless you perform a profitability analysis, you might not realize it. Performing a customer profitability analysis—or hiring someone to do it for you—is a step every business should take to maximize the value of their customer portfolio. If you can get a handle on which customers cost more than they bring in, you will no doubt begin to see big differences in the profitability of your business in the upcoming year.
For a deeper dive into how to perform a Customer Profitability Analysis read our article “A Customer Profitability Should Be On Your To-do List” here.
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