Chapter 2
Customer profitability score
- Why: To better understand customer profitability
- What: To measure the levels of profits that different customers are generating
- When: When profitability of customers is vital and when different customer groups are generating different levels of profits
- The question this indicator helps you to answer: to what extent are we generating profits from our customers?
Why does this KPI matter?
Satisfying or, more likely, ‘delighting’ customers has, in recent times, become nothing less than a corporate mantra, the belief being that it is by satisfying the needs of customers that organisations can make a profit and therefore grow and prosper.
Although the basic argument is fundamentally sound (organisations can only make money if their customers buy the supplying organisation’s products or services), there is a caveat: not all customers are equal. Some customers contribute substantially to an organisation’s profit line, while others actually lead to the supplying organisation losing money – that is, the cost of delivering the product or service is more than the revenue generated from that transaction.
In their zeal to ‘delight’ customers, organisations run the serious risk of moving into a loss-making situation. Organisations offer, but do not recover the costs of delivering, additional product features and services to their customers.
This customer profitability ‘inequality’ has been known for several decades and verified by numerous studies. As one powerful example, a customer analysis of a US-based insurance company found that 15–20% of customers generate 100% (or more) of profits. Further analysis found that the most profitable customers generate 130% of annual profits, the middle 55% of customers break even and the least profitable 5% of customers incur losses equal to 30% of annual profits (see the practical example on page 16).
Simply put, a measure of customer profitability ensures that an organisation does not lose sight of its ultimate objective: to make a profit from selling products or services.
How do I measure it?
How do I collect the data?
Data are collected through the analysis of marketing and accounting data as well as the output from activity-based costing exercises.
What formula do I use?
Customer profitability is the difference between the revenues earned from and the costs associated with the customer relationship in a specified period. Put another way, customer profitability is the net contribution made by individual customers to an organisation.
As customer profitability covers several time-frames, it is not in itself a single measure. There are four primary measurements of customer value:
- Historical value of a customer, which looks at the value earned from a customer relationship over an extended period of time, such as prior fiscal quarter, prior year or since the start of the relationship. It can be measured as a simple average of previous periods or can be time weighted, placing higher emphasis on recent periods. Averaging in this manner has the effect of smoothing reported results for a customer, lending consistency to the reported values.
- Current value of a customer, which looks to a shorter time-frame, often a month (in order to coincide with reporting cycles). Current value is often volatile, since cyclical factors in the relationship are often not reflected within a single month. Current value has the advantage of highlighting the effects of changes in the customer relationship when compared to previous period current values. It is most useful for quantifying the benefit of campaigns, new offers and pricing changes on customer value.
- Present value of a customer, which is a future-oriented measurement that typically considers the future revenue and cost streams of the customer’s existing business. This measure is usually only extended to include the contractual lifetime of ongoing products or services. Present value is useful for ranking customers according to value and determining sales compensation rates, and is frequently used as a basis for modelling the impact of decisions concerning price and service before they are implemented.
- Customer lifetime value, which is another future-oriented measurement. What distinguishes it from present value is a modelling component: lifetime value takes into account projected revenue and cost streams not only from the existing relationship but also from business that is expected to be done with the customer in the future.
As part of their assessment of customer profitability, organisations will often also use time-based, activity-based costing, which essentially measures the present total cost of providing services or products to a customer. This requires obtaining information on only two parameters: the cost per hour of each group of resources performing work, such as a customer support department, and the unit times spent on these resources by specific activities for products, services and customers. For example, if a customer support department has a cost of $70 per hour, and a particular transaction for a customer takes 24 minutes (0.4 hours), the cost of this transaction for this customer is $28. This can be readily scaled up to companies with hundreds of thousands of products and services and thousands of customers.
How often do I measure it?
When customer profitability is measured depends on the metric being assessed (see the What formula do I use? section). Remember that there is no single measure of customer profitability as they relate to different time periods.
Where do I find the data?
These data can be extracted from the accounting and marketing data, but also from time-based, activity-based costing analyses.
How difficult or costly is it to measure?
Measuring customer profitability is certainly important but it can be expensive, especially when an organisation is analysing the profitability of many customers. Many companies will use time-based activity-based costing to allocate appropriate costing. This requires training, resourcing and management, and requires the costing staff to spend some time in the business.
How do I set targets for this KPI?
Companies should look to move loss-making or break-even customers up the profitability categories.
Practical example
Here is an example of calculating customer profitability in a bank.
- Establish the costs per customer: Using activity-based costing models, the bank has established costs for different customer services or customer interactions. For example, mailing of statement = $1.00, calling the bank’s contact centre = $2.00, visiting the branch = $3.00. It then estimates the behaviours of customers and might even be able to put them into different categories (e.g. customers over 50 who are more likely to visit the branch). However, to keep this example simple we say that on average a customer receives a statement once a month, visits the branch once a month and phones the contact centre once every two months. This now means that it costs the bank on average (12 × $1.00) + (12 × $3.00) + (6 × $2.00) = $12 + $36 + $12 = $60 per year to do business with an average customer.
- Establish profit per customer. In this example, the bank knows that on average it is able to generate a 3.5% profit on each dollar it can invest. So if customer A has a deposit of $1,500 and customer B has a deposit of $15,000, the customer profitability looks like this:
Customer A:
- generates a profit of $1,500 × 0.035 = $52.50
- but overall is not profitable when subtracting the average costs per customer from the profits. In this case the customer profitability score is $52.50 − £60 = −$7.50 (a loss of $7.50).
Customer B:
- generates a profit of $15,000 × 0.035 = $525.00
- and therefore a healthy profit. In this case the customer profitability score is $525.00 − $60.00 = $465 (a profit of $465).
Some tips and traps to consider
Organisations need to ensure that they look holistically at the information generated from customer profitability metrics. For example, customers who are presently unprofitable can have high customer lifetime values (and vice versa). Therefore, organisations should not be in a rush to cease trading with unprofitable customers.
A further warning is that, in acquisitions, organisations often focus heavily on the lifetime value profitability metric, without taking into account that there is usually high volatility in the purchasing behaviour of ‘new’ customers.
Further reading and references
Robert S. Kaplan, A balanced scorecard approach to measure customer profitability, 8 August 2005, Working Knowledge, Harvard Business School, http://hbswk.hbs.edu/item/4938.html