Customer Profitability Analysis

Customer Profitability Analysis

Should a firm focus primarily on the customers who are ready to pay a higher price? Are those customers the most profitable to the firm?
Is that always the case? If not, how can firms overcome this bias?

WHAT IS CUSTOMER PROFITABILITY ANALYSIS? INTRODUCTION
Firms typically employ a Cost-plus Approach or a Perceived Value Approach to pricing their products and services. Usually it seems only logical that the customers (or 'accounts') who are willing to pay the highest price should be the firm's topmost priority.
However one should keep in mind that the costs to serve each customer type often differ considerably, and hence their profitability also differs.
So forms should not simply focus on the highest revenue yielding customers, but are better off understanding customer profitability before choosing target audiences.
Customer Profitability Analysis (CPA) is a marketing and management accounting method, allowing businesses to determine the profitability of each customer or segments of customers, by attributing profits and costs to each customer or segment separately. CPA can be applied at the level of customer aggregates / groups / segments or even at individual customer level (most time consuming, but providing a very precise understanding of a business situation).

There are three essential aspects to customer profitability:

THE COST TO SERVE CUSTOMERS: Cost-plus pricing could provide a uniform profitability across customers, with a good correlation between the prices and the costs. However, Shapiro et al. (1987) have observed that there is hardly a correlation between the price and the cost to serve. The profitability across customers shows a wide dispersion, mainly due to the variations in the four components of the cost to serve:
- Presale costs: These costs vary depending on the distance to reach the customer and on the time and efforts required to close the sale (for example the level of involvement required from management, marketers or sales reps).
- Production costs: Costs are influenced by order size, level of customization, the timing of the order, delivery speed, setup time, inventory holding period, and the firm's accounting policies.
- Distribution costs: These typically vary based on the geographical location of the customer. Specific preferences in the mode of transportation may also affect this cost.
- Post-sale costs: The costs for installation, post-sale customer training, technical support, and maintenance also add up to the cost to serve. For products like capital equipment, these costs are typically high.
One can use Activity Based Costing to accurately determine the cost to serve certain customers or customer segments.
CUSTOMER (CONSUMER) BEHAVIOUR: Shapiro et al. (1987) devised a Customer Classification matrix to divide the customers into four categories based on the cost to serve and the revenue.The firm's primary objective should be to move the unprofitable customers to the profit-making side of this matrix.
- Bargain Basement: These customers are price sensitive and don't require a high level of service and quality. Firms should attempt to transition these customers into Passive accounts to increase the revenues from them.
- Passive: These accounts are very profitable, with a higher willingness to pay and low costs. Firms should try to focus more resources to enhance the loyalty and satisfaction of these customers.
- Aggressive: These customers demand the best service but are willing to pay a low price. These customers are usually powerful ones (national accounts). The firm should try to negotiate the terms for pricing, delivery, and service. The firm should attempt to increase the prices for the services offered to these customers.
- Carriage Trade: These customers have a high cost to serve, but are willing to pay a higher price. Firms should try to reduce the costs by looking into the cost drivers to streamlining internal processes.
MANAGING CUSTOMERS: How do you deal with the differences described above under 1 and 2? The profitability dispersion observed across various customers can be managed using a five-step action plan:
- Pinpoint the costs: Maintaining an effective cost accounting system can help record data based on the customers, orders, products. Also, the four different costs – presales, production, delivery, and post-sale costs can easily be recorded and analyzed.
- Know the firm's profitability dispersion: The firm should plot a customer classification matrix by plotting the costs (obtained in the previous step) with the prices. This gives the firm's profitability dispersion. Firms that keep an eye on their costs and set prices via the customer's perceived value tend to have few passive accounts; firms who ignore their costs, and price based on demand tend to have more aggressive accounts.
- Focusing the firm's strategy: Based on the knowledge of the costs, prices, and profitability dispersion, the firm should formulate their strategy. Low-cost, low-service firms typically target the 'Bargain Basement' accounts, while the firms offering differentiated products/services at a higher price, target 'Carriage Trade' accounts. Due to limited resources and capabilities, the firm can't stretch itself over different types of customers; it has to decide where to focus on the diagonal axis, and what should be the range of customers targeted along the axis. Typically, a firm focusing on a particular quadrant caters mainly to customers belonging in that quadrant.
- Providing support systems: A firm following perceived value pricing needs to put systems and processes in place to manage the profitability dispersion. The low revenue yielding accounts (Bargain Basement and Aggressive) have to be screened carefully. The firm should also take care to maintain separation between the firm's strategy, analysis, and negotiation functions. The firm needs proper marketing research, cost-accounting functions, and pricing analysis to plan on its strategies.
- Regular repetition of the analysis: The buying behaviour of customers tends to be dynamic in nature; the customers also tend to migrate from one quadrant of the classification matrix to another. Given this fact, firms should conduct a repeat analysis of the profitability dispersion.

⇒ Please do share any interesting aspect or experience you have with Customer Profitability Analysis…

Sources:
Shapiro, B. P., Rangan, V. K., Moriarty, R. T. & Ross, E. B. (1987) "Manage Customers for Profits (Not Just Sales), 1987, Harvard Business Review
Faculty of Finance and Management (2002) "Customer Profitability Analysis", 2002, The Institute of Chartered Accountants in England & Wales