Measuring Customer Profitability

Every year, manufacturers and distributors invest millions of dollars in software designed to track detailed information about individual customer needs and purchasing behaviors.

Lost in all the excitement and debate about CRM is whether manufacturers and distributors are actually making more money as a result of their investment in CRM software and data analysis.

Customer Relationship Management (CRM) is based on the assumption that if you learn more about your customers you can provide them with better service, cross-sell products more effectively, and simplify your sales and marketing process. The overall goal of CRM is to increase customer loyalty which in turn – it is assumed – will lead to additional sales.

However, lost in all the excitement and debate about CRM is whether manufacturers and distributors are actually making more money as a result of their investment in CRM software and data analysis.

Companies who use CRM typically customize and extend their product and support offering in an attempt to increase customer loyalty through higher service levels. For example: smaller more frequent deliveries; rebate and pricing schemes; stocking a greater variety of products; and providing customers access to more information.

While the measures of customer satisfaction and loyalty often increase as a result, most companies also report that these increases are accompanied by a decline in profitability, especially if these new product and support offerings do not lead to higher prices and increased sales volume.

In reality, only a minority of the customers you serve are truly profitable.

In reality, only a minority of the customers you serve are truly profitable. A recent study of customer profitability conducted by IBM indicates that, on average, most of your profits come from 20% of the customers you serve. Seventy percent of your customers are at a break-even point. And the remaining 10% of your customers actually have a negative impact on your profitability.

No matter how good the concept behind Customer Relationship Management sounds, you need to understand who your profitable customers are, and more importantly who your unprofitable customers are. Unless you recognize the differences between customers you will more than likely make one or more of the following common mistakes. You will lose profitable customers through overpricing, your will gain unprofitable customers by underpricing, and/or you will continue to subsidize unprofitable customers at the expense of your bottom line.

Our experience indicates that manufacturers and distributors generally understand product costs but not customer costs. It is remarkable given today's economic environment how many manufacturers and distributors don't know which of their customers are profitable and which are not.

You need to understand who your profitable customers are, and more importantly who your unprofitable customers are.

The reason for this huge informational void is that the General Accepted Accounting Principles (GAAP) followed by the vast majority of organizations, are ill equipped to address the issue of customer profitability. These rules essentially disavow the relevance of customers by excluding, with a few exceptions, all information about them from financial statements despite the fact that customers are a company's primary asset. Not to mention that customers are responsible for every penny of a company's revenue. Another limitation of the GAAP is that these accounting principles are designed to collect and distribute information at the product/service level, not at the customer level. An interesting approach when you consider that profits come from customers not products.

To succeed in today's market place you absolutely must know which of your customers are profitable and which are not.

To bridge the knowledge gap that exists in most organizations you need to focus your efforts on making the connection between customers and costs. In other words, you need to start thinking about and managing your customers in terms of profitability.

There are three components that determine the profitability of a customer.

First is the cost of acquiring a new customer. Most companies do not know how much it costs to acquire a new customer because they lump these costs into fixed categories like SG&A that yield little in the way of understanding how these costs vary from customer to customer. Start by identifying the sales and marketing activities and the associated costs that can be traced directly to the acquisition of a specific customer. If you can't get specific cost information, it is OK to use best guess estimates as you begin this process. Of course they will be off, but as you gain experience you can replace them with researched-based numbers.

The second component of customer profitability has to do with how long you keep customers. It costs 5 times as much to acquire a new customer as it does to increase sales with an existing customer. Despite this fact, the national average for customer migration is 10% each year. This means that every 5 years manufacturers and distributors need to replace half of their customer base. This is a very expensive proposition given today's economic conditions. The goal is to identify what type of customers are migrating and why. If you discover that it's your unprofitable customers that are migrating, you can breathe a sigh of relief. However, if you discover that it's your profitable customers that are migrating you need to quickly determine what you can do to keep them longer.

The third component of customer profitability has to do with the costs of serving a customer after the sale has been made. These costs can be the difference between profitability and losing money. Many companies take pride in the fact that they go above and beyond when it comes to customer service. In fact some go so far as to proudly expound that their goal is to exceed their customer's expectations. This is great if customers are willing to pay more for this level of service. However, if you are providing a high level of service to customers who buy primarily on price your bottom line will suffer. Some manufacturers and distributors have addressed this issue by moving to Activity Based Pricing where customers pay for the services they utilize. The goal is to match the level of service to the customer's contribution to profitability.

The goal is to match the level of service to the customer's contribution to profitability.

As you proceed keep in mind that measuring customer profitability is not a science. Rather it is a quest that will lead to better decision-making regarding which products and services to offer to which customers. It is a quest that will ultimately lead to improved profitability for those who make the journey.

For Additional Information On Managing Customers For Maximum Profitability call 800.867.2778 or e-mail info@indusperfgrp.com.

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