Customer Profitability Analysis

It is a technique for studying consumers and their spending behaviors

Companies would find it more beneficial to know how much profit a customer generates compared to how much revenue a company generates. This is the primary intention of a Customer Profitability Analysis. 

Profit is the fundamental purpose of every firm, and for a firm that does not initially have investors or finance, profit may be the corporation's only capital.

Business collapse is impending if insufficient money or financial resources exist to operate and run a firm. No firm can operate for an extended period of time without producing a profit, but gauging a company's present and future profitability is crucial in evaluating the organization.

Customer Profitability Analysis (CPA) is a technique for studying consumers and their spending behaviors. It may be used to track financial performance as well. 

Some typical consumer spending patterns include 'Impulsive Buying.' It has gotten a lot of attention in consumer research. The phenomenon is intriguing since it is impacted not just by internal psychological elements but also by external, market-related stimuli.

Some consumers like to live a normal lifestyle and prefer buying everyday goods impulsively rather than splurging on luxury brands under the impression that they are spending less and saving more. 

CPA may be used to determine how profitable keeping each consumer is. This allows businesses to make better decisions. Using this indicator may also enhance overall corporate processes.

While analyzing customer profitability takes into account the typical consumer costs, such as the purchase cost, use cost, and post-use cost required to generate that income. 

The objective is to determine which consumers are lucrative for a company. This is a critical business strategy as it enables the company to concentrate on increasing exposure to more important consumers. 

This would help to reduce marketing costs which are usually very expensive because it is at the heart of every firm's ability to make money. Marketing is more than simply a cost; it is the source of revenue for all of the most successful companies.

There are several approaches to understanding your consumer base. This involves determining a customer's lifetime value (CLV). This allows you to decide if marketing to each consumer is a good investment.

In this article, we cover:

  • The purpose of Customer Profitability

  • The steps to conducting CPA

  • The formula to calculate CPA

  • The advantages of Customer Profitability Analysis

  • The criticism faced while conducting analysis

  • Common mistakes faced while analyzing customer profitability

  • Different ways to improve CP

What is the purpose of CPA?

It enables businesses to segment existing customers based on their profit contribution to the brand and thus, optimize their marketing, client service, and operational expenses around the most profitable customer categories.

Organizations that are more focused on their goods, departments, and office locations sometimes lose sight of their consumers. As a result, organizations must sometimes endure the cost of keeping unproductive consumers, which can be damaging to their bottom line.

Customer Profitability

Customer profitability is significantly more than just a transaction's gross or net margin or customer lifetime value.

The profit (customer spend - customer cost) is generated across all customer touch points with the organization's brand, including customer service interactions, refunds, custom fulfillment fees, and more.

How do we determine a profitable customer?

A profitable customer is one that creates a revenue stream that exceeds the cost of acquisition, sale, and service. Companies determine the CPA for each client or for the entire group of customers.

Organizations may use CPA to analyze their consumers and determine how advantageous it is to maintain them. Based on this value, they may determine the cost of servicing them or even whether to continue serving them or let them leave.

How to conduct CPA

There are four key steps that need to be taken into consideration while analyzing customer profitability. 

These include:

  1. Defining customer costs.

  2. Defining customer groups.

  3. Finding the data required.

  4. Putting all the three together to calculate CP.

Step 1 - Defining Customer Costs

Understanding the business expenditures and all the areas where a customer may engage with any section of an organization is the first step in determining customer profitability. 

Other consumer expenses may include (in addition to the actual product or service costs for what they purchase):

  • Marketing expenses (e.g., the Cost Per Acquisition)

  • Costs of customer service contact

  • Costs of social media contact

  • Shipping fees (especially for fund return shipping)

  • Return expenses, such as restocking or refurbishing

Step 2 - Defining Customer Groups

Some organizations have well-defined customer categories that are based on the size of the company or firm unit from whom they buy. 

Creating client personas is an excellent method of customer segmentation. Firms can begin by developing them based on user data (demographic data), poll data, market research, and other sources.

Companies usually segment their customers in 4 different ways:

For enterprises, behavioral segmentation may be the most beneficial. As with psychographics, it takes a small amount of data to be genuinely successful – but most of this may be acquired directly from the firm's website. Consumer groups can be categorized based on:

  • Purchasing habits

  • Shopping habits

  • Online browsing habits

  • Engagement with the brand

  • Brand loyalty

  • Previous customer feedback

Step 3 - Finding the Data Required

Some key data elements include marketing expenditure and cost per transaction-there may be hidden gems in this data when broken down by marketing channel and tied to specific customer groups. 

At the very least, you'll wind up with a series of average expenses per activity, such as:

  • The cost of marketing to create an order (cost per order)

  • The average number of customer support interactions per order 

  • Average price per customer service interaction 

  • Average return rate 

  • Average delivery cost

Step 4 - Putting all the data together

After completing all three steps, the data collected can be used to calculate Customer Profitability.

Customer Profitability Formula

CPA is calculated using the yearly earnings per customer and the overall length of time a client remains with an organization.

Step 1 - Calculating Annual Profit 

Annual profit = (Total revenue generated by the customer in one year) – (Total expenses incurred to provide for the customer in a year)

The entire revenue can be produced by the sources listed below, which must be included:

  • Recurring income

  • Upgrades to more expensive plans

  • Cross-purchase of relevant items

Furthermore, expenditures might be incurred from the following sources, which organizations should also consider:

  • Customer service expenses

  • Keeping a customer success team

  • Benefits for Loyalty

  • Cost of operations

Step 2 - Calculating CPA

Finally, once the yearly profit is calculated, the customer profitability analysis computation is as follows:

CPA = (Annual profit) x (no. of years customer stays or has stayed with the company)

Calculating Customer Profitability Example

Let's look at an example to understand better how to calculate customer profitability.

Assume an organization sells five distinct items. It has customers: X and Y. Customer X purchases all five items. 

Customer Y only purchases four of the same five items. The combined income from both customers is $40,000. The average cost of generating such income is $25,000.

Customer X's total profit = total revenue earned - total expenditures incurred = $40,000 - $25,000 = $15,000.

Customer Y's total profit = total revenue earned - total expenditures spent = $40,000 - $20,000 = $20,000.

Customer Y is the most profitable of the two. This is true even if customer Y purchased fewer items.

Advantages of conducting Customer Profitability Analysis

CPA enables an organization to understand the business from a profit standpoint. Methods such as activity-based costing can assist them in allocating a price to each activity related to a product or service. 

To benefit from this strategy, businesses can use customer account profitability analysis in the following areas:

  • Marketing to the proper demographic - Profit range can be utilized for subsequent operations once the client segmentation based on profit range has been established. The characteristics of the most profitable customer group must be recorded and used for future acquisition.

  • Increasing operational performance - The primary cause of a customer group's reduced earnings is not usually the client. There might be a few problems in the company's internal procedures that are increasing the cost of serving clients.

  • Reduce the cost components - Customer segmentation is a common exercise used to examine customers. Organizations can divide the group of customers who cost more than others after segmentation.

  • Individualized retention approach - Organizations can tailor their retention efforts to each customer category after identifying those with varying profitability. They can afford to provide the highest quality service to their most profitable customers. That implies businesses can devote more resources to serve those affluent customers.

Learn More about Customer Profitability Analysis in detail by reading this article.

Criticism of Customer Profitability Analysis

The most common criticism leveled with Customer Profitability Analysis is the use of a small time frame and classification criteria. This is criticized because sometimes companies do not group the customers accurately, which could lead to inaccurate results.

Companies may also lack the data gathering methods required to get an accurate estimate of client segmentation revenues and expenses.

With the development of big data, however, customer profitability can now be measured using new approaches that determine a customer's lifetime worth rather than just revenues during a specific time window.

Furthermore, analytical tools will be able to evaluate the worth of individual consumers by recognizing variables in behavioral patterns rather than merely the worth of the average customer in each group.

But this is not without its limitations. For instance, some companies may also lack the data collecting methods required to provide an accurate report which would not help them keep proper track of the customer group with the highest generating profit.

This is because analytical tools can be quite expensive, ranging from 2000-7000$ per year. 

Additionally, there may be practical issues in estimating costs attributed to each customer category segment. Many businesses find it difficult to implement ABC. These practical issues can occur because source data isn't always readily available from accounting reports. 

Additionally, ABC data may contradict previously defined managerial performance goals based on traditional pricing procedures.

Sometimes CPA may even ignore product or service combinations acquired by customers. However, to conduct effective customer profitability, the combination of products or services offered is extremely important.

The risk is that the analysis will be applied to specific cases like underperforming products or services and will disregard the effect of sales providing more items to the customer.

Lastly, annual profitability may not be a good indicator of lifetime worth. The expenses of acquiring and maintaining a customer should be weighed against the customer's lifetime profits rather than just the customer's yearly earnings.

Common mistakes while analyzing customer profitability

It is vital to track various errors while doing customer profitability analysis. CPA enables you to find long-term consumers, analyze buying behaviors, and optimize customer targeting.

Customer behavior and activity must be tracked in order to assess customer profitability. All of this necessitates minimizing mistakes in determining customer profitability as much as feasible.

Mistake #1 - Leaving out some of the associated expenses

When measuring customer profitability, it is common to overlook additional costs. It is easy to overlook all the expenditures associated with running a business (since there are many). If an organization does not track these charges, its total profitability will suffer.

Costs in any business might include sales, marketing, shipping, handling, storage, and other expenses. These expenditures are occasionally left out of the calculation.

Mistake #2 - Choosing the wrong time frame

It is critical to select the appropriate time range while doing the customer profitability study. To improve results, the time frame should be extended to monthly or quarterly. This is beneficial since organizations will be able to obtain an accurate view of the customer's lifetime worth. 

The time span must include features of product consumption. If a limited time span is included, it cannot be certain if the customer adopted the product or not.

Mistake #3 - Assuming that all commodities are the same

Customer profitability analysis necessitates the assumption that each product is unique. One common error is failing to account for product differences. When firms presume that all products are equal, they get a variety of results. 

To calculate the correct impact, they must consider all differences. It is more difficult to determine the influence of a given product in multi-product organizations. However, measuring customer profitability correctly leads to increased customer retention.

Mistake #4 - Profitability is calculated in terms of the consumer rather than the product.

If revenues are evaluated against the customer, customer profitability analysis might go awry. 

For example, while conducting customer profitability analysis, one should not look at how much profit one customer makes; rather, the process must be measured in terms of profit created from the product. The commodity must be the focal point of the profit structure. Profitability must be calculated for each product.

How to Improve Customer Profitability

Improving customer profitability is a continuous process. 

Some of the ways to maximize profit include:

  • Enhancing the most profitable customers. Analyze how they can be bigger within the company by analyzing the required resources, budgets, and requirements to increase the profitable customer groups.

  • Organizations can consider developing a premium or reward program to drive increased spending among their most valuable consumers.

Improve understanding of the organization's customers

Previously, accessing customer data was difficult. However, extensive customer profiling is achievable in today's digitally-driven and networked economy. Significant data sets may now be readily acquired, stored, and analyzed using advanced analytics to disclose strategic insights and, to a large extent, forecast future consumer behavior.

All of this is accomplished in real-time. With a better knowledge of consumers, organizations can start delivering products and services that speak directly to different customer segments and deliver on the brand's promise.

Existing Customer Relationship Management (CRM) systems must be evolved.

Many businesses are well on their digital transformation path, and the connected customer is at the center of it. The question is no longer whether a company should adopt digital technology but when. Internet of Things (IoT) and Industry 4.0 technologies are transforming business models for the better, allowing businesses in all sectors to improve company performance and reliably provide unique shopping experiences across different channels.

As businesses implement these emerging innovations, it is vital to promote data integration throughout the organization and guarantee that existing systems can communicate smoothly with other applications. This will improve your ability to gather and analyze data and get strategic consumer insights at a high level.

Customer Profitability Analysis FAQs

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Researched and authored by Shannon Fernandes | LinkedIn

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