Customer Profitability Analysis Essay

Activity Based Costing (ABC) is best known for its appilcation in computing product costs, but firms also find it useful in determining the cost of serving customers and as a basis for evaluating the profitabilty of a specific customer or group of customers. Why is this important? Most managers agree that 80% of their profits come from the top 20% of their customers and most important, the bottom 20% of their customers are unprofitable. For example, to compete with Walmart,Best Buy works hard to attract profitable customers and equally hard to discourage the unprofitable customers which those that are price shopping and looking for discounts and promotions and comparing prices to Walmart. Best Buy studies demographic and sales data for each store location to identify profitable and unprofitable customers. Customer profitabilty analysis idetifies customer service activities and cost drivers and determines the profitability of each customer or customer group. Here, customer service include all activities to complete the sale and satisfy the customer including advertising, sales calls, delivery, billing, collection, service calls, inquiries and other forms of customer service. Customer profitability analysis allow managers to: Identify most profitable customers Manage each customer’s cost-to-serve Introduce profitable new products and services Discontinue unprofitable products, services or customers Shift a costomer’s purchase mix toward higher-margin products and service lines Offer discounts to gain more volume with low costs-to-serve customers Choose types of after-sale services to provide How to calculate Customer Profitability Analysis The first step of CPA is to create a simple model of revenue by customer on the one hand, and total business unit costs and overheads on the other. Second, subtract the direct product and service costs from each customer (costs of good sold/cost of sales) to arrive at a gross margin per customer. Third, it should be possible to identify other costs specific to the customer such as a particular sales campaign or servicing and retention  costs. Orders of magnitude will do rather than getting hung up on 100% accuracy. Be consistent if applying any proxy. Fourth, sort customers by net profit and draw a cumulative profitability curve staring with the most profitable to the least. This is an effective way to visualize the relative profitability of customers and it soon becomes apparent which customers are critical to the business. Fifth, before taking any decision on non-profitable customers, make sure that you have strong retention activities in place to secure your most valuable customers. Sixth, get behind the real reasons why some customers are unprofitable and determine the appropriate strategies and tactics to enhance the profitability of your customer portfolio. Thought about sacking customers, should be put to one side until you have gained a clear understanding of the reasons. As we’ve seen there are lots of reasons for being unprofitable, and it is important to think ahead to potential value over time, not just recent history. (Six step to Customer Profitability Analysis, 2007) A good understanding of the profitabilty of a firm’s current and potential customers can help firms improve overall profits and become more competitive. This begins with an analysis of the cost to serve the customer. Customer Cost Analysis Not all customers require similar activities either before or after sales. Examples of customer-specific activities include: Order processing costs Billing, collection and payment processing costs Account receivable and carrying costs Customer service costs Selling and marketing costs Customer cost analysis is the process of identifying the activities and cost drivers related to servicing customers. Traditionally these costs are hidden in the customer support, marketing and sales function. Activity based costing can help managers to understand their costs to serve costomers. Different activities often have different cost drivers. Based on the activities and cost drivers involved in services performed to acquire and compelete a transaction, customer costs can be classified into the following  categories: Customer unit-level cost – resources consumed for each unit sold to a customer. Examples include sales commission based on the number of units sold or sales dollars, shipping cost when the freight charge is based on the number of units shipped and cost of restocking each returned unit. Customer batch-level cost – resources consumed for each sales transaction. Examples include order-processing costs, invoicing costs and recording of sales returns or allowances every time a return or allowance is granted. Customer-sustaining cost – resources consumed to service a customer regardless of the number of units or batches sold. Examples are salespersons’ travel costs to visit customers, monthly statement processing costs and collecti on costs for late payments. Distribution-channel cost – resources consumed in each distribution channel the firm uses to service customers. Examples are operating costs of regional warehouses that serve major customers and centralized distribution centers that serve small retail outlets. Sales-sustaining cost – resources consumed to sustain sales and service activities that cannot be traced to an individual unit, batch, customer or distribution channel. Examples are general corporate expenditures for sales activity and the salary, fringe benefits and onus of the general sales manager. Customers profitability analysis provides valuable information to the assessment of customer value. In addition, firm must weigh other relevant factors before determining the action appropriate for each customers. The folllowing are among these relevant factors: Growth potential of the customer, the customer’s industry and its cross selling potential Possible reactions of the customers to changes in sales terms or sevices Importance of having the firm as a customer for future sales references especially when the customer could play a vital role in bringing in additional business. Customer Lifetime Value Many companies now see the impotance of looking at the long term value of the customers, the expected contribution to profit during the full period the company retains the customers. This concept is called customer lifetime value ( CLV), and it is calculated as the net present value of estimated future profits from the customer for a specified time, which may be three or five years. Present value is used because the profits from the customer are expected to occur over a number of years. To provide a more comprehensive  and strategically relevant measure of the value of the customer, CLV takes into account the company’s expectations about the future potential growth in profits for a customer. CLV can be used to measure the value of a customer or group of customers and to determine how marketing and support services should be allocated to these customers to improve the firm’s overall profitability. Since there is a significant level of judgment involved in estimating th e variables in the calculation. It is also important to compare different calculations of CLV made with different assumptions about profit forecasts and discount rates. It have three types of potentially unprofitable customer who might be retained: New and growing customers, who promise profitable business in the future and may provide a stepping stone for penetratig lucrative new markets Customers providing qualitative rather than financial benefits including customers at the edge in the development of new markets who provide valuable insights into likely trend movements in consumer demand Customers providing increased capability because of their status as recognised leaders in their markets or field of expertise. Thus, where customer profitability analysis reveals that a particular customer is unprofitable, it does not necessarily follow that this customer should be eliminated. Nor does it follow that the customer must be persuaded to accept terms and cindition will rwduce the customer’s level of satisfaction. Negotiations with customers might well reveals that less frequent deliveris would actually benefit the customers without causing cos tky stockpiles. Clearly, there is scope for negotiating with customers to influence their behaviour without compromising the customer’s level of satisfaction. Some aspects of improved negotiation might include: Non-cash incentives from sunk-cost investments for example sponsoring a season of a major cultural events primarily yields advertising benefits however seats in the accompanying corporate boxes might also yield enticing customer incentives. Similarly, a company’s accumulated frequent-flyer points may perhaps be spent on customers new or existing Restructure of delivery runs to create a more timely but less frequent service for the customer Capacity maximization on delivery runs that are required for profitable customers by offering a more frequent service for the potentially unprofitable customers with unpredictable demands Purchase of equipment on behalf of customers which they can use rent-free, in lieu of discounts or agent’s commissions. The  cash saved on reduced discounts potentially should exceed the cost of the assets. Additionally, ownership is retained and a stronger bond is forged with the customer thereby generating greater negotiating power in future Free short-term financial advice which will create efficiencies for the customer leading to reduced internal workload and consumption of resources New products at no cost in return for reduced discounts to serve a dual purpose, improving customer profitability while providing a useful vehicle for the promotion of new products A trade-off between quantity discounts and settlement discounts that minimizes the costs of cash overdraft and maixmizes long-run production scheduling The overriding consideration with a customer profitabilty analysis is that management will at least be armed with information about unprofitable customers and can focus attention on developing those innovations or strategoes that might reduce the lack of profits of a particular customer wi thout reducing that customer’s satisfaction. Alternatively provided a shift of thinking is possible, management can restructure the manufacturing process that will ultimately lead to a shift in the rsults of a customer’s profitability. The role of mechanics of activity based costing in developing a customer profitabilty analysis should not be underestimated with activity based costing, a general ledger amounts are dissected, making the assignment of costs to customer easier. In particular, the associated on costs of employing sales staff and motor vehicles would be analysed in detail and be readily available. This would embrace vehicle operating costs as well as fringe benefits and payroll tax, holiday and long service leave entitlements, worker’s compensation insurance, mobile telephone and training costs. Several of these items might conveniently be omitted from non avtivity based costing customer profitability analysis because of the complex analysis required to divide the general ledger amounts between the activities of different salesperson. Why Calculate Customer Profitability? The reasons why we calculate customer profitability is to help the company to improve its cost performance and also for manager to make decision about which customer or market channel to focus on. Besides, to improve the profitability by eliminating non-profitable customers and maximizing sales or services to profitable customers. Also act as an understanding of the  true costs of each segments including taking into account non-production costs when determine profitability. Definition and concept Customer profitability analysis based on the recognition that each customer is different. Therefore each dollar of revenue or each dollar of cost generated by the customers does not contribute equally to a company’s profitability. The general approach to customer profitability is based on the segmenting that customer base to determine the revenues and costs contribute to each segment. This is often combined with an Activity Based Costing (ABC) approach. ABC is a costing methodology that identifies activities in an organization and assigns the cost of each activities with resources to all products and services according to the actual consumption by each. Traditional cost accounting often supports a 20-80 rule that 20% of the largest customers, who purchase the most products, contribute 80% of the profits. Using ABC, analysis have often found that 20% of the customers generated 300% of the profits. The remaining 80% of the customers are actually unprofitable and can result in loss of 200% of the profits (Good Practice Guideline 2002, pg 21). Once the profitability and non-profitability segments are identified, profitability segments are maximized while non-profitability segment are reduced or eliminate. Based on the diagram above, basically there are two basic approaches to customer segmentation, for example demographic which could be categories into geographic area, customer age, gender, and income level. Second approach is psychographic which include customer values, attitude and customer interest, Once customer segmentation have been identified, the annual revenue is being calculated per segment. How this is done will depend on the product or service offered by the company, Discount, service fee should be included to determine the true amount of the revenue generated, Next, annual cost is calculated per segment. This will involve directly attributable product or services cost including overhead cost and ABC approach is the most effective way to allocate the cost. Profitable customer is equal to annual revenue exceed annual cost. And non-profitable customer is equal to annual cost exceed annual revenue. However, this will involve more accurate analysis to determine this. As for pr ofitable customer, it  need more detail planning to develop long term customer relationship to increase the revenue. Therefore, customer retention and loyalty program are needed The ability to determine customer profitability on an individual basis can add value to the company customer relationship. The customer can be helped to reduce its costs and the company can become more profitable. (Good Practice Guideline 2002, pg 22). However, for least profitable or non-profitable customer, there are two options of action: Eliminate – ceasing to supply these customer. This can be done by no longer marketing or raising the price, or even change the product. Re-engineering – turning the least profitable or non-profitable customer into profitable customer by decreasing the costs and increasing revenue. For example, using differential prices. With a new understanding of which customers were profitable and which were not, Kanthal become dedicated to turning unprofitable customers into profitable ones. The company developed ways to retain the customers and decrease their administrative and selling costs (Kaplan and Cooper 1998:188). In short terms Kanthal tried the following: reduce the size of its product lines, accept orders only for stocked items use external distributors to reduce the cost of small accounts, change compensation to salesmen to emphasis profit rather than only sales volume, and engineer to reduce set-up times and improve operational efficiencies. (Good Proactice Guideline 2002, pg 21) Last step is to implement new strategies, example changes in pricing, cost reduction should be reviewed to determine the impact on customer profitability. Recently, many companies have learn to understand the causal relationsip between employess and customers and the impact on revenue growth and firm profitability (Epstein, 2000). Customer performance measure is measurement used by organization to measure the revenue growth and firm profitability through market share, customer acqui sition, retention, satisfaction and customer profitability. CUSTOMER MEASURE DEFINITION Market share Reflects the proportion of business in a given market (in terms of number of customers, dollars spent, or unit volume sold) that a business unit sells. Customer acquisition Measures in absolute or relative terms, the rate at which a business unit attracts or wins new customers or business. Customer retention Tracks in absolute or relative terms the rate at which a business unit retains or maintains ongoing relationship with its customers. Customer satisfaction Assesses the satisfaction level of customers along specific performance criteria within te value proposition. Customer profitability Measures the net profit of a customer, or a segment, after allowing for the unique expenses required to support that customer (Epstein, 2000) Market share can be defined as the percentage of all sales within a market that is held by one brand / product or company. Market share can be measured in several ways. However, the two most important measures are by sales revenue and sales volume (the number of units sold). These are to analyze the impact of their own actions on market shares, as well as their profit implications. Lacking such knowledge, one might be tempted to oversimplify the cause-and-effect relationships between market shares and marketing variables, or to equate market shares to profitability (a not unusual tendency even among seasoned businessmen). Many individuals in business indeed keep a close watch over day-by-day changes in market shares, so much so that market-share movement to them is almost synonymous to market information (Cooper, 2010). By comparing the profit obtained from various market share the organization may identify which market share gives more profit and should be focus on those customer desire and wich customer gives less profit and the organization may choose either to improve their product/ service or lowering te product/ service on that market share. Characteristics of new, loyal and lost customers are particularly important for companies to understand. Marketing analysts group customers into segments of recent new purchasers, high-volume purchasers and non-purchasers using customer transaction data, and analyze the resulting segments to identify their common characteristics. Attributes of new customers provide a good appearance of a company’s likely acquisition target market. Similarly, characteristics of lost customers may define less desirable market segments, or may reveal problems in customer service or product satisfaction. Improvements in retention programs are saving companies significant time and money – keeping existing customers buying is much less expensive than  acquiring new customers (Customer Acquisition, Retention and Attrition Analysis, 2014) Measurement that will show the situation of business are : The number of new customers per quarter of year Total sales to new customers per quarter of year Sales to new customer as a proportion of total sales When business is good marketers can afford to take an evolutionary approach to customer acquisition and retention by continually optimizing branding, creative, advertising mix, and offer strategy. But during challenging business situations, an evolutionary approach is bound to yield underwhelming results (Customer Acquisition & Retention, 2014). The difference in sales in a market share from year to year, will act as indicator to the organization regarding percentage of new customers obtained or lost customers. Customer retention is the ongoing customer relationship that yields revenues from the sale of additional products or services. The revenues become more profitable as the customer becomes easier to serve. Since the customer is buying again it is assumed that less sales effort is required, customer service costs decrease, and the costs of acquiring customers decline. Customer loyalty encompass customer retention but also includes the customers’ recommendation of the produ ct or service to other potential customer. As for example, word of mouth recommendation is important to Southwest Airlines, whose reservation system has never been accessible to travel agents. It has relied on advertising and customer loyalty to spread its message to potential customers. The airlines which began flying in 1971, has consistently been profitable. Convinced that customer loyalty is a important factor in increasing profitability than is market share, Southwest Airlines strives to build customer loyalty by providing at low fares dependable, frequent service over relatively short routes, delivered by friendly employees (Epstein, 2000). Measures of customer loyalty were selected because they reflected both length (retention) and depth (cross sell) of the bank-customer relationship. Length of relationship is reported by both division-reported customer retention rates (percentage of customers who remained customers during 1993) and mean customer-reported relationship tenure. Relationship depth is measured by division cross-sell rates, which record the percentage of customer  households with multiple accounts (account cross sell) or multiple services (service cros s sell) (Hallowell, 1996). Companies are very aware that acquiring a new customer is more expensive than retaining an existing one, so companies cannot afford to lose customers due to poor service at the contact center level. The contact center must be viewed as an essential extension of the company, and an important part of the brand experience. Therefore, ensuring that the experience is pleasant, efficient, and satisfies the customer’s need is crucial to success. The most common method for measuring customer satisfaction is through surveys, either during or after the call. While this method provides some intelligence around the customer experience, it doesn’t offer the most accurate view of customer satisfaction. This is due to the small sample size and the fact that the only questions asked are those deemed important by the enterprise. Surveys also lack detail, such as which of a customer’s experience with your company caused the review, which agent handled the interaction and what was the root cause of a dissatisfied call. Lacking this critical information, enacting meaningful change is extremely challenging. Without the use of speech analytics, contact center operators are left w ith an incomplete view of customer satisfaction and a disconnect between the scores they receive and the actions that caused the scores. Speech analytics uncovers the reality of what happened during a call, enabling companies to improve the business processes and agent behaviors most affecting the customer’s experience. Nexidia’s Managed Analytic Services team uses speech analytics technology to locate the agent behaviors and business process that have the greatest impact on the customer. As example, the team first begins by identifying the calls which contain sentiments of dissatisfaction. By building searches that contain words such as â€Å"unhappy,† â€Å"speak to a manager† or â€Å"frustrating,† the team creates a category of calls in which the customer seemed upset, or the call escalated. More refined searches such as â€Å"this is the xth time I’ve called,† or â€Å"my hold time was excessive† will yield further insight. The team drills into this category of calls to create sub-categories. These sub-categories show which types of calls most often contain frustration, such as billing calls or calls for technical assistance. The team also identifies which agents have the most dissatisfied calls and compares the percentage of these calls to total volume. The second step in evaluating  customer satisfaction begins by identifying behaviors and processes that typically cause customers to become upset. These include excessive transfers, requests for call backs, and long non-talk times. The team creates call categories which contain these issues, providing a foundation for performing root cause analysis. Studying the root cause arms companies with the information needed to understand why these â€Å"trigger† events occur, and what steps can be taken to prevent them. As behaviors and processes are modified, monitoring customer satisfaction becomes a continuous cycle, thus ensuring maximum return on investment. (Nexidia Managed Analytic Services, 2010) The relationship of customer loyalty and customer satisfaction can be seen in the following categorization of customers; it is important to understand fully the environment which the customer is working, as extrinsic factors may drive them from one category to another: Apostles. Customer who are loyal and satisfied and recommend the service to others. Mercenaries. Customers who may switch service suppliers to obtain lower price, but are highly satisfied. Hostages. Customer who are highly dissatisfied but have few or no alternative. Terrorists. Customers who have alternatives and use them, and also try to convert other customers by expressing their dissatisfaction (Epstein, 2000). Customer profitability of a various group of customer may be identify by measuring the profit gain by a group of customer from year to year. Profitability measures were determined based on their hypothesized relationship to customer satisfaction and loyalty. Both of the measures used, ROA and NIE/Rev (non-interest expense as a percentage of total revenue), reflect profit at the individual division. See Roth (1993) for an analysis of similar performance measures in service firms. Given the intent of this study, NIE/Rev is preferred to ROA as a more appropriate measure of profitability. Retail bank profit can be separated into, first, the results of operations (revenue-enhancing as well as cost-incurring) which influence expenses and revenues that are not sensitive to interest rates, and second, treasury activities, which influence interest-sensitive costs and revenues. This paper addresses primarily non-interest-sensitive components of profitability, hypothesized to relate to customer loyalty. ROA contains both interest-sensitive and non-interest-sensitive components, while NIE/Rev is generated only from non-interest-sensitive costs (the revenue portion of NIE/Rev may be somewhat  related to customer-relevant interest rates). Appendix 1 discusses ROA, NIE/Rev and the other measures used in more detail (Hallowell, 1996). By comparing the profit of different group of customer, the difference amount of profit will act as indicator which group of customer that gives high profit and low profit. Other than that, customer profitability may be determined by other tools of measuring customer performance such as market share, customer acquisition, retention,and customer satisfaction. Five reasons why customers can be unprofitable. They are: (Six step to Customer Profitability Analysis, 2007) 1. The sales force is under continual pressure to close deals and offers discounts to secure business within the sales period. 2. Pricing errors due to incorrect estimates of time. 3. A one-size-fits-all approach to serving customers leading to over servicing where the business levels does not justify it. 4. Loss leaders are offered to customers who always shop around for a deal, in the expectation that profit will be recovered over the lifetime of the customer. 5. The connection between customers and costs is not made and over time some become a greater drain on resources. Conclusion Customer profitability analysis provides a method to help firms see and understand the profitability of their customers. It takes effort and management sponsorship to make it feasible and worthwhile. It is a method and not an end in itself, but without it that investment in slick technology might not be such a good idea, if it only speeds up your ability to attract the wrong customers. Your allocation of resources to customers may also be based on erroneous information. If you have this understanding it uncovers new options for profitable growth and can help you work out which customers to attract, which to really hang on to at maybe greater cost. To help decide which to grow, CPA must be augmented with an understanding of potential lifetime value. It is recommended that Customer Profitability Analysis (CPA) be measured through Activity Based Costing. There are various group of customer, therefore it would be better to differentiate them through segmenting b demographic or goegraphic or so on, to make it easier to recognised which group of customer that gives high/low profit, and which of  the customers should be focus on, eliminate or re-engineering. Other than that, CPA may be measured by analyzing the customer performance measure of market share, Customer acquisition, retention, and customer satisfaction. Increase in Customer Profitability might be caused by increase in market share, customer retention which wil lead to increase in customer acquisition and probably increase in customer satisfaction. REFERENCES Cooper, L. G. (2010). Market Share Analysis , 1. Customer Acquisition & Retention. (2014). Retrieved October 23, 2014, from Lenati: http://www.lenati.com/our-expertise/customer-acquisition-retention Customer Acquisition, Retention and Attrition Analysis. (2014). Retrieved October 23, 2104, from Microstrategy: Best in Business Intelligence: http://www2.microstrategy.com/download/files/Solutions/byDepartment/CRM/Customer_Acquisition.pdf Dikoli, M. S. (1995). Customer Profitabilit Analysis: An ABC Approach. 5. Epstein, M. J. (2000). Management Accounting Guideline. Customer profitability analysis , 8. Faculty of Finance and Management. (2002). Customer Profitability Analysis , 36. Nexidia Managed Analytic Services. (2010). Customer Satisfaction Analysis , 2. Six step to Customer Profitability Analysis. (2007, May 7). Retrieved October 23, 2014, from Accounting Web: http://www.accountingweb.com/topic/six-steps-customer-profitability-analysis