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Customer Profitability Analysis

An analysis of the various activities and expenses incurred in servicing a customer in a given period of time

What is Customer Profitability Analysis?

Customer Profitability Analysis is a tool from managerial accounting that shifts the focus from product line profitability to individual customer profitability. Activity Based Costing looks at the various cost drivers to accurately isolate costs and determine a product’s profitability. In the same way, Customer Profitability Analysis is a method of looking at the various activities and expenses incurred in servicing a particular customer within a given period of time.

 

Customer Profitability Analysis

 

Calculating Customer Profitability

Calculating customer profitability begins by identifying the various costs incurred specifically in relation to servicing a specific customer or segment of customers.

For example, a solar panel company serves two types of customers: Individuals and Small Medium Enterprises (SMEs). For the attainment, servicing, and retention of its customers, the company is required to provide consulting and service visits, as well as process the sale orders. Individuals require only one site visit before placing an order. SMEs require more frequent visits, as they are based in multiple locations and are provided with after-sale service as part of the bulk purchase. The customers’ behavior and profitability are given by the following table:

 

Customer Profitability Analysis Table

Customer Behavior Table

 

Application of Customer Profitability Analysis

From the given example, the customer profitability of the Individual segment exceeds the SME segment. This insight then supports the company in its strategic decisions. It can shift its focus towards attracting and retaining more customers from the more profitable Individual segment. Alternatively, it can look for cost reduction approaches for its SME segment. Potentially, it can work to redesign its purchasing process in order to reduce the frequency of visits or orders. Otherwise, it can look to charge its customers for additional service visits to shift the weight of the cost from the company to the customer.

 

Benefits of Customer Profitability Analysis

This insight might not be attainable from traditional reporting methods. In a company’s income statement, there is no granularity provided in the calculation of its Selling, General, and Administrative Expense line.

One of the most common marketing metrics of sales per segment may also be misleading. If the company reported 120 customers in the Individual segment and 80 customers in the SME segment, managers might believe that SMEs contribute to two-thirds of their annual sales.

 

Sales by Segment Table

Sales by Segment Chart

 

By following the Pareto 80-20 Rule, they conclude that they should focus on this smaller group of customers that contribute to a larger share of annual revenue. However, as we know from the added analytical granularity offered by the above Customer Profitability Analysis, they would then be allocating more resources to a less profitable customer segment.

 

Customer Profitability by Segment Table

Customer Profitability By Segment Chart

 

Replacing Sales with Customer Profitability, the company will gain a more accurate insight into which customer segment is the stronger driver of its overall profitability.

 

Criticism of Customer Profitability Analysis

The biggest criticism regarding Customer Profitability Analysis is the selection of a limited timeframe and segmentation criteria. With the emergence of Big Data, customer profitability can be calculated with new methods that determine a customer’s lifetime value rather than just the sales within a restricted timeframe.

In other words, customer profitability is restrictive in the way it segments the value of a customer within a set period of time rather than their value throughout their total lifetime engagement with the company. Additionally, with respect to segmentation, predictive analytics will be able to estimate the value of individual customers by identifying drivers in behavioral patterns rather than just the value of the average customer in its respective segment.

 

More Resources

CFI is the official provider of the Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Marginal Revenue Formula
  • Absorption Costing
  • Cost of Goods Sold (COGS)
  • Profitability Index

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