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Customer Profitability Analysis

Introduction
Customer profitability analysis (CPA) helps companies to better understand
customer service activities and cost drivers, and to determine the
profitability of each customer or customer category. Customer service
encompasses all activities related to completing a sale and satisfying the
customer, including advertising, promotion, delivery, billing, collections,
service calls, inquiries, and other customer services. CPA helps managers to:
present profitable new products and services;
analyse profitable customers;
administer each customers costs-to-serve;
suspend unprofitable products, services, or customers;
change a customers purchase mix, typically aiming to sell higher
margin products and service lines;
deal with discounts to achieve more sales with lower operating costs;
and
select the types of after-sales services to provide for customers.

Sufficient analysis of the companys current and potential customers profit


potential can help companies to increase profits and enhance their
competitiveness. This process begins with an analysis of the customer costs.

Definition and concept


Customer Profitability Analysis (CPA) is the: Analysis of the revenue streams
and service costs associated with specific customers or customer groups. A
customer profitability analysis is an evaluation process that focuses on
assigning costs and revenues to segments of the customer base, instead of
assigning revenues and costs to the actual products, or the units or
departments that compose the corporate structure of the producer.
Kotler (1997) defines a profitable customer as:
A person, household or company that, over time, yields a revenue stream
that exceeds by an acceptable amount the companys cost stream of
attracting, selling and servicing that customer.
Good practice suggests that this analysis is undertaken over the lifetime of
customers, so that a Customer Lifetime Value (CLV) can be obtained. This is
calculated on the basis that the profitability of customers can vary
significantly over the life of their relationship to a company.
CPA is an important management accounting tool based on the recognition
that each customer is different. Therefore each dollar of revenue or each

dollar of cost generated by the customer does not contribute equally to a


companys profitability. CPAs value lies in its ability to improve strategic
decision making.

CPA can be used to work out which customers comprise the top 20% (and
the bottom 2%).
It can also be used to help companies to understand:
how dependent they are on the most profitable customers
what proportion of resources are used for different customers
the full cost of servicing a customer including advertising, service and
returns
which customers are targeted by competitors.

Five things you can learn from customer


profitability analysis
Customers purchasing behavior is fairly homogeneous, anyone can get
reliable and actionable results by grouping them by size or channel, leaving
only the key accounts that enjoy special discounts, or require non-standard
fulfillment, to be treated individually.
Not all customers are equal. But somewhat counter-intuitively, it is frequently
not the ones that account for the lions share of the revenue that generate
most of the profit. All too often, these large accounts have such bargaining
power that they already enjoy large discounts and generous payment terms.
But once indirect expenses such as selling and support costs are factored in,
they frequently turn out to be loss-making. At the other extreme are the
plethora of occasional customers that never purchase enough to cover the
cost of setting up and administering their account. As a result, when net
margins are plotted against customers according to their revenue, you get a
graph like the one below.

Now, while many customers may not be generating a positive net margin,
most will be making some contribution to overheads. So it is detrimental to
overall profitability to fire customers unless you have first identified whole
tranches of indirect expense that can be successfully eradicated as a result.
A better alternative is to implement a raft of incremental improvements to
increase gross margins, and make it cheaper to do business with the
customers you already have, rather than going out and winning new ones. So
here is my list of the five key things you can learn from your
customer profitability analysis that you can put into action:
1. Focus your acquisition spend: Now you know exactly who your most
profitable customers are, make sure the marketing strategy is based on
winning more of them. Dont waste big budget dollars retaining unprofitable
customers or making it difficult for profitable customers to do business with
you. That is not to say that every customer needs to be profitable. Having a
few unprofitable key accounts that make a significant contribution to
overheads may make sound commercial sense.
2. Target your retention activity: Likewise, make sure retention activity is
not wasted hanging on to loss-making customers. Also ensure that your
customer contact teams are aware of which group of customers are the most
valuable to the business. Its key to then in turn empower reps to quickly
ameliorate any occasional service failures with credits and free product to
keep these customers happy.
3. Rework your discounting policy: Knowing how net profitability varies
with customer size gives you important insights that once paired with data
about product profitability will help you formulate a commercially driven

discounting policy. At the same time, you are likely to uncover instances
where unprofitable customers enjoy special discounts that were based on
projected volumes that were never achieved. In addition, business to
business customers will be enjoying volume related discounts, retrospective
rebates and early settlement discounts, all of which need analyzing in
considerable detail.
4. Revisit your channel strategy: One of the key reasons customers are
unprofitable is because the costs of doing business with them is out of step
with their potential for profit. This can be anything from sales people calling
too frequently on customers with limited potential or even telephone selling
to customers who should really be ordering online. Moving such customers to
self-service sales and service channels results in cost savings. That savings
can be used as introductory discounts to smooth the transition to this new
service model, and reinforce the behavior.
5. Plug the holes in your terms of business: Many customers fail to
generate any profit because they only place small orders where the
contribution fails to meet the cost of order processing and fulfillment.
Reviewing minimum order quantities can do a lot to keep the costs of doing
business with a customer better aligned with the amount of business they
give us. But, Ive always been an advocate of subtly incentivizing customers
either to change their behavior. This can include encouraging the use of
lower cost, self-service channels, or incentivizing them to buy more product
by making attractive bundles or by having a minimum shipping charge or
free delivery over a certain order value.

3 Benefits of an Analysis of Customer Profitability


Over time weeds grow in any garden. In the same way, unprofitable
customers work their way into your company. To avoid the high costs of low
profit customers, you should perform an annual analysis of customer
profitability, thereby weeding your garden of customers who are sapping
your profits and cash flow.
There are many ways to look at your customer base. Some of the factors to
consider are sales volume, gross margin, profitability, number of
transactions, and average sale per transaction. Looking at this information
will not only shed light on those customers who are a drain on company
resources, but highlight opportunities to sell more to higher margin
customers who have low activity.

1. The elimination of customers that are costing you money.


Sometimes the costs may be indirect. Firing the customers with low gross
margins is straightforward, but what about the customers that pay a good
gross margin but require a lot of effort from operations? Not only do you
need to address gross margin but you need to consider the costs to service
that customer.
2. Focus!
If you get rid of the clients that are high maintenance then it frees your
organization up to focus on the more profitable customers. A successful
strategy might be to cross sell additional products or services to those clients
who value the relationship. Another strategy would be to target new
customers with the same characteristics as the good clients you have today.
3. Increased Productivity across the Organization
The benefits of weeding out high-maintenance, low profit customers will
reach across the organization. The sales department benefits by focusing
their prospecting on the right clients who value and will pay for the
companys products and services. Operations and finance will realize
improved productivity in servicing only those customers who are reasonable
in their demands for service. No more getting beaten up on margins,
special payment terms, or Friday afternoon rush jobs!
The bottom line is the advantage of customer profitability analysis is
improved profitability and cash flow! The two ingredients necessary to grow
a company faster.

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 distribution by the customers will in

general be notice to the firm. These will also creating new opportunities for
the firm in these three areas below.

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a r k e t i n
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Customer profitability analysis - approach


The general approach to CPA is based on segmenting the customer base to
determine the revenues and costs attributable to each segment. This is often

combined with an activity-based costing (ABC) approach. Once the profitable


and non-profitable segments are identified, profitable segments are
maximized while non-profitable segments are reduced or eliminated. Each of
the key steps in this process is outlined below.
Figure below shows a six-step approach to implementing CPA. Figure below,
will provide a direction to a marketer and a management accountant.

1.Customer
segmentation

3. Use ABC to
2. Revenue
attributable to
each segment

determine the cost


attributable to each
segment

4. Analyze the
Analysis
Implementation

6. Review the impact of

5. Develop strategies

the new strategies on


the performance of the
customer segments

to maximize profits
from profitable
customers and reduce
or eliminate less
profitable or nonprofitable customers

profitable versus the


less profitable or
unprofitable customer
segments

The implementation of CPA


The goal wanted by the firm with the implementation of CPA:

A n im p r o v e d u n d e rs ta n d in g o f th e firm s s o u rc e s o f p ro fita b ility

A n im p ro v e d u n d e rs ta n d in g o f th e re la tio n s h ip b e tw e e n (c h a ra c te ris tic s o f) c u s to m e rs a n d c o s ts ;

A n im p ro v e d u n d e rs ta n d in g o f th e re la tio n s h ip b e tw e e n th e b e h a v io u rs o f e m p lo y e e s a n d

c o s ts ;

B e tte r in fo rm e d d e c is io n s a b o u t th e a llo c a tio n o f re s o u rc e s to c u s to m e rs a n d m a rk e t s e c to rs .

Step 1 Customer segmentation


The basis for customer segmentation will differ across companies and across
industries. Currently, there are two basic approaches to customer
segmentation:
1. Demographic segmentation based on observable characteristics such as
geographic area, customer age, sex and income level.
2. Psychographic segmentation based on customer needs and behaviour
such as customer values, attitudes and interests.
Step 2 Revenue attributable to each segment
Once segments have been identified, the annual revenue is calculated per
segment, how this is done will depend on the products or services offered by
the company. Adjustments to the price paid by the customer for a product or
service, such as discounts, service fees or product enhancement fees, must
be included to determine the true amount of revenue generated by each
customer and the aggregated amount calculated for the customer segment.

Step 3 Use ABC to determine the cost attributable to each


segment
The annual cost is calculated per segment. This will involve both directly
attributable product or service costs and also customer costs, including
allocation of overheads, marketing, sales and distribution costs. It is these
customer costs which are often hidden, such as quality control and
inspection costs, order picking, order fulfillment and customer ordering costs.
ABC is an effective way to assign both types of costs to customers.
Step 4 Analyze the profitable versus the less profitable or
unprofitable customer segments
The profitable customer segments will be those whose annual revenues
exceed annual costs. As the profitability of customer segments is likely to
vary from year to year, a more accurate analysis could involve calculating
profitability over the lifetime of each customer segment, as noted below.
Step 5 Develop strategies to maximize profits from profitable
customers and reduce or eliminate less profitable or non-profitable
customers
For profitable customer segments, this step involves detailed planning
around the development of long term customer relationships for increased
revenues, and hence profitability such as customer retention and loyalty
programmers. To address the least profitable or non-profitable customer
groups, two main actions are used
1. Elimination ceasing to supply these customers. This can be done by no
longer marketing to these customers, changing the product or service so that
it is no longer suitable, or raising prices.
2. Re-engineering turning the least profitable or non-profitable customer
groups into profitable ones by either increasing revenue or decreasing costs
attributable to these groups, or both. Examples include charging additional
fees for services or using differential prices, according to customer segment.
Step 6 Review the impact of the
performance of the customer segments

new

strategies

on

the

The implementation of any new strategy, for example, changes in pricing,


cost reduction or customer service, should be reviewed after an appropriate
period to determine the impact on customer profitability.

Customer Lifetime Value (CLV) This is the value generated by a customer


over the lifetime of a customers relationship to a company. This concept
recognizes that the annual profitability of a customer group will vary from
year to year. To calculate the CLV, companies need to make judgements
about the duration of the companys relationship with the customer. This
includes the likelihood, frequency and amount of expected purchases over
the lifetime of the customer. To determine the present value of these future
income streams, a discount rate (usually the companys cost of capital) is
used. CLV estimates are particularly useful to:
Companies with large variations in purchasing patterns by customers
Companies with high customer acquisition costs
Companies with high customer retention costs.

DETERMINING CUSTOMER PROFITABILITY


The following major categories should be included in the determination of
customer profitability:Customer Revenue
Revenue is generally the most straightforward category to determine.
Companies usually have information that captures sales/revenue associated
with specific customers. Other information needed may include customer
discounts, rebates and other deductions.
Customer Product Cost
Product cost is typically the largest cost category and is usually calculated or
estimated by every company. Sometimes companies calculate product costs
for analytical purposes which differ from those used by accountants to value
inventory. We generally find that many companies have a product costing
system in which there is a varying degree of management confidence. Our
approach assumes that product costs are accepted by management and are
appropriately calculated for use in determining customer profitability. If not,
the effort to determine customer profitability must be expanded to include a
potential revision to product costing methods. This review is necessary
because there may be some cost types that have been included in product
costs that are related more to the customer than to a product. These costs
may include, for example, engineering or design costs, special
manufacturing equipment and practices, or even invoicing and collection. If

significant, some or all of these costs may have to be removed from product
cost and, instead, be directed or assigned on a customer basis

Customer-specific Costs
Customer-specific costs are those costs that are driven primarily by the
needs or demands of a particular customer. Besides the costs identified
above which may have been incorrectly classified as product costs, they
include many of the costs which are usually referred to as Selling, General &
Administrative costs. However, they are viewed from the customers
perspective and the way in which they add value to the customer. These
would include sales, marketing, distribution, advertising, legal and executive
expenses.
Asset Opportunity Costs
Asset opportunity costs are those costs that can be assigned to customers
based on the assets of the company that a particular customer consumes.
They could include working capital such as inventory and accounts
receivable as well as fixed assets such as machinery &equipment.

Advantages of CPA
Improved profitability by eliminating non-profitable customers and
maximising sales or services to profitable customers.
An understanding of the true costs of each customer segment, including
taking into account non-production costs when determining profitability. Nonproduction costs can sometimes be more significant than production costs.
It provides a method of identifying customer groups who are of lifetime
value to the company, and who are worth retaining or protecting.
Improved strategic decision making by providing useful information for
customer related decisions, including pricing, discounting and marketing
decisions.

Disadvantages of CPA
Companies may not have the data capture systems to produce an accurate
estimation of customer segmental revenues and costs.
There may be practical difficulties in calculating costs attributable to each
segment. Implementing ABC is often challenging for many companies.
CPA may overlook the combinations of products or services purchased by
customers. Customer profitability depends on the mix of products or services
bought. The danger is that the analysis will be used on specific
underperforming products or services, and will overlook the impact of sales
of other products to the customer.
Annual profitability may not be representative of lifetime value. The costs
of attracting and retaining a customer should be compared with the lifetime
earnings and not just with the customers annual earnings. For example, Taco
Bell sells tacos at less than $1 each. However, the firm has estimated that a
loyal repeat customer generates up to $11,000 over their lifetime [Kotler,
1997].

Many of these disadvantages


developments in this area.

have

been

overcome

due

to

recent

Key developments
1. Advances in information technology:
This has allowed companies to improve the quality and quantity of
information concerning customer profitability, including information on
revenue, costs, retention and lifetime value. Many companies have
sophisticated customer profitability models and customer databases. These
can be designed for any type of business and to accommodate different
customer characteristics. Data can be aggregated by size of customer, size
of order, service complexity, post sale service requirements, location or other
factors. Information technology can provide detailed information and analysis
on individual customers or groups of customers.
2. Managing customer value
Analyzing customer profitability has evolved into managing the overall value
of customers. CPA now includes analyzing customer lifetime value and
impact, as well as managing profitability through analysis of customer
segments and margins. Customer lifetime value looks at the profitability of
the customer over their lifetime. Customers have an impact on other
customers, company employees and other groups through their transactions
and communications. For example, they can refer other customers to
company offerings.

Case studies
An insurance company, A-Insure Limited, decided to use CPA to identify
profitable and non-profitable customers after it grew concerned about the
poor financial performance of one of its policy options. A-Insure collected
customer data through original policy proposal forms which were stored
electronically in a customer database. It was able to conduct a complex cross
correlation between known cost drivers and the demographic and other
characteristics of policy holders. The cost drivers were:
commission payments to financial advisers who sold the policy
early surrender of the policy by the policy holder

changing of bank details and consequent chasing of missed premiums


responding to customer queries.
The analysis identified that the policy was unprofitable when sold to recently
retired clients but was profitable when sold to other client segments.
Recently retired customers had more time to review and consider changes to
their insurance policies and to make queries. In response, the company
reduced agents commissions on the policies according to the age of the
policyholder to discourage them from selling to the non-profitable client
segment.
Most companies have a customer database that can be mined for
information to identify customer segments. If companies do not have the
software to perform detailed CPA, specialist software can be purchased from
many business software vendors.

Improving customer profitability


Improving the measurement and management of customer profitability ABC
and customer profitability analysis provide the basis for managerial decision
making and actions. The information available from these analyses can be
utilised to further corporate goals and strategies and maintain profitability.
An important outcome of customer profitability analysis is the understanding
of how to better manage customer profitability. The success of profitability
systems can be measured as much by the awareness they raise as by the
decisions they directly impact. Thus, in addition to the substantial benefit of
directly increasing customer and corporate profitability, the process of
analysis, discussion, and understanding of the drivers of customer-related
costs can motivate employees to improve their own performance and their
customer relationships.
An ABC analysis of the unprofitable customers is just as important as that of
the profitable ones. The fixed costs of unprofitable and fired customers
often remain after the customers have departed. The contribution margin will
thus need to be allocated and absorbed by the remaining customers.
Companies must then analyse the change in projected operating expenses
as customers are added and deleted (see Figure 15, left). The analysis of
continuing fixed customer-related costs often influences decisions regarding
investments in customer relationships and attempts to convert unprofitable
relationships into ones that are healthy and profitable for both the customers
and the company. Before an unprofitable customer is permitted to depart, all

avenues should be explored to turn the customer into a profitable one,


including an assessment of the word of mouth consequences. In addition,
management should consider the lifetime value of a customer, cross-selling
opportunities, and both the short-term and long-term profitability. Finally
good judgment by management and other qualitative information should be
included in any decision to fire unprofitable customers.
Customer profitability measures often reveal that some newly acquired
customers, are unprofitable due to large customer acquisition costs. In early
periods, this cost has not yet been covered by the margins earned through
selling products and services to the customers. In these cases lifetime
profitability analysis becomes the basis for retaining these customers.
Customers that are unprofitable in the short-run often become very
profitable as their purchases increase and their cost to service decreases.
Likewise, customers that are unprofitable in the long-term may require
immediate action to turn them towards profitability. This may include
promoting more cross-selling opportunities to broaden the product range of
customer purchases. Finally, other customers may be prestigious to retain,
even if they are unprofitable, since they may add reputation and credibility
to the company and improve the ability to sell to others.
Much of the customer profitability analysis has focused primarily on one type
of product or service for an individual or group of customers. ABC customer
profitability analysis is increasingly flexible and forward looking, and can
incorporate a wide amount of variability. ABC analysis proposes to:
cut across the entire value chain;
focus on multiple rather than single transactions of a customer;
focus on multiple products bought by a single customer;
accumulate costs related to a customer rather than to a specific product or
service; and
structure the analysis to be narrow in focus or broad to include all
customers
It is the variability and adaptability of ABC implementations that makes them
very attractive to companies. The use of ABC will rapidly increase as
information technology continues to make vast amounts of data and
information readily available to management.

Information technology
Developing customer databases has improved decision-making regarding the
cost of keeping existing customers. Customer profitability models can be
designed for any type of business and for different customer characteristics.
Data can be aggregated by size of customer, size of order, complexity of
service, post-sale requirements, delivery distance, etc. The information
technology is currently available to provide detailed information and analysis
on individual customers or groups of customers. First Union and many of the
other banks discussed here have developed profitability models from their
large databases. Customer service representatives can then obtain instant
customer profitability rankings from the computer.
Barriers to implementation
People often feel threatened by change, do not understand it, and are
opposed to it within a company. Commission salespersons will try to protect
customers even though they may not be profitable to the company.
Customer profitability analysis can be a large undertaking for an organisation
in terms of the resources used and the costs to complete the initiative.
Barriers to implementation can include:
convincing management that potential organisational improvements justify
the resource allocation;
obtaining the significant required resources that include information
technology, equipment, and staff for analysis and preparation;
changing the sales incentive system to reward customer profitability rather
than sales volume;
obtaining buy-in from employees within the company who are often
reluctant to change; and
training employees in the use of customer profitability analysis and its
measurement and rewards.
However, management must be sensitive to required change within the
organisation and be sure that employees are included in the decision and
change processes. Sears did an excellent job of change implementation.
While the new Sears vision began with top management, the implementation
of the changes began with changing employee attitudes, obtaining employee
buy-in, and increasing training costs for new and existing employees. The

success of customer profitability analysis depends on the information


reaching those who make and influence decisions.

Conclusion
Customer profitability analysis deals with sales revenues and costs
generated by customers. Managers are interested in forward-looking
analyses of customer profitability. Prospective CPA calculates the net present
value of future expected revenues and the costs associated with serving
customers over the entire future customer lives. To estimate future costs and
revenues, a retrospective analysis of customer profitability is valuable and
essential. Managers must constantly make decisions that involve trade-offs.
They need to determine how much to invest in human resources and in
customers. To make these decisions they need to analyze the returns that
are likely from those investments, the costs of those investments, and the
managerial incentives in place to make those investments. This guideline
offers an improved understanding of the analysis of customer profitability in
order to assist managers in the allocation of corporate resources.

Bibliography
This term paper is prepare by the participation of all group members and the
important class lecture of our honorable course teacher and also have some
books and websites which are given below for further query.
W. Bigg :cost accounting
Philip kotler: Principle of marketing
Cooper, Robin, and Robert S. Kaplan. 1991. Profit priorities from
activity-based costing.
The Design of Cost Management Systems. Upper Saddle River, NJ:
Prentice Hall, Inc.
Foster, George, and Mahendra Gupta. 1994. Marketing, cost
management and management accounting. Journal of Management
Accounting Research (Fall).
Fornell, Claes, Michael J. Ryan, and Robert A. Westbrook. 1990.
Customer satisfaction: The key to customer retention. MOBIUS
(Summer): 14-17.
GOOD PRACTICE GUIDELINE MARCH 2002 (FACULTY OF FINANCE AND
MANAGEMENT)
Customer Profitability Analysis in Accounting (Relevant to PBE Paper II
Management Accounting and Finance) Dr. Fong Chun Cheong, Steve,
School of Business, Macao Polytechnic Institute

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