Customer Profitability Analysis: Definition, Formula, Benefits - SmartKarrot

Customer Profitability Analysis: Definition, Formula, Benefits

In this blog, we will discuss the definition of customer profitability analysis (CPA) including its formula, benefits, and more.

Customer Profitability Analysis: Definition, Formula, Benefits
Customer Profitability Analysis: Definition, Formula, Benefits

If you are into the SaaS business, then surely you would have heard of the term customer lifetime value. It gives you the overall revenue an average customer generates during their entire relationship with a business. But wouldn’t it be more beneficial to know what profit (rather than revenue) a customer generates? Customer profitability analysis is intended towards that. And we are going to discuss it in detail in this blog today.

Customer Profitability Analysis Definition

CPA is a managerial accounting method that allows businesses to determine the overall profit a customer generates. A profitable customer is someone who generates a revenue stream greater than the cost of their acquisition, selling, and serving. Companies calculate the CPA on a customer level or for the entire customer group.

When companies are more focused on products, departments, and locations of their offices, they often tend to lose focus on the customers. As a result, the companies have to sometimes bear the cost of maintaining unprofitable customers which is detrimental to their business.

CPA allows companies to evaluate their customers and know how beneficial it is for them to keep the customers. Based on this value they can decide upon the cost of serving them or even to decide whether to continue or let them go.

It has been found in a study that the size of the customer is not directly proportional to their profitability. Sometimes even the large-sized customers can turn out to be unprofitable ones for a business.

Customer Profitability Formula

To calculate CPA, you need the annual profit per customer, and the total duration a customer stays with your business.

Annual profit = (Total revenue generated by the customer in a year) – (Total expenses incurred to serve the customer in a year)

The total revenue can be generated by the following sources that you need to include:

  • Recurring revenue
  • Upgrades to the higher plans
  • Cross-buying relevant products

And, expenses can be incurred from the following sources which also you need to consider:

  • Cost of customer service
  • Maintaining a customer success team
  • Loyalty perks
  • Operational cost

Finally, when you have the annual profit, the customer profitability analysis calculation goes like this:

CPA = (Annual profit) x (no. of years customer stays with company)

Benefits of Customer Profitability Analysis

Benefits of Customer Profitability Analysis

CPA allows you to understand the business from a profitability viewpoint. Methods like activity-based costing help you assign a cost to each activity associated with a product or service. Businesses can leverage customer account profitability analysis in the following areas to benefit from this method.

Trim out the cost factors

One of the most common exercises to analyze customers is customer segmentation. After segmentation, businesses can segregate the group of customers that are costing more than others. It is still viable to do business with a low-profit generating group. But on a deeper analysis, if you find a group of customers that are costing more than the revenue they are generating, then it is advisable to shut your services to them. By letting them go, you are making your customer base more efficient in your growth engine.

Marketing to the right segment

When the customer segmentation according to profit range has been identified, they can be used for further operations. The attributes of the most profit-generating customer group must be recorded and used for further acquisition. Marketing teams can design their campaigns based on those attributes to attract more such customers. Furthermore, based on their profitability range, marketers can decide what deals and discounts they can offer to the prospects.

It takes commonly from five or six months to more than a year to recover the customer acquisition cost. CPA can give the estimated duration for the ROI on marketing by extrapolating on the attributes of customer segmentations with different profit margins. This helps in setting up the overall budget for marketing and advertisements that a company can afford.

Customized retention strategy

After finding the customer group with different profitability, companies can customize their retention strategies for each group. For the customers with the highest profitability, companies can afford to give a service of the highest quality. That means, they can spend more on serving those elite customers.

What engagement model to choose from – high-touch or low-touch? How many CSMs must be employed for a specific group of customers? Questions like these can be easily answered when you know the cost behind each choice and the profit a customer group would generate. To retain high-value customers, through CPA, you get a clear margin of how much you can spend on building their loyalty. Initiatives like customer loyalty programs can be easily designed based on the profit margin for a customer segment.

Enhancing operational efficiency

The main reason for a customer group to generate lower profits is not always the customer. There might be few flaws in the internal operations of the company that is costing them more to serve the customers.

According to a customer profitability analysis example, let’s say the lower profit customer group is consuming a lot of resources to deal with the same issue in a product over and over again. Instead of allocating resources to that recurring issue, it might be beneficial for the company to build a feature in the product itself that resolves the issue. This would not only lower the operational cost but would also make your product better for future customers.

How to do Customer profitability analysis

To do a Customer profitability analysis, you need to follow a certain approach. The key is to segment the customer base, determine revenues, attribute costs and also have an activity-based costing approach. Let us know all the steps in depth here.

Segmenting customers

The base for a profitability analysis is customer segmentation. This will differ across industries and companies. It can be demographic- based on customer age, income, area, etc. It can also be psychographic that is based on customer needs, behaviours, values, interests, and attitude.

Revenue Attribution

Once segmentation is done, you need to calculate revenue for each segment. The annual revenue is a sum of all segments. Adjustments like discounts, fees, service charges must be included and adjusted accordingly.

Cost attribution

Calculate the annual cost per segment. This will be customer costs, service costs, product costs, sales, marketing, and distribution costs. These costs are usually hidden and need to be added to determine the cost attribute.

Analysis – Profit, Less profitable, unprofitable

Profitable customer segmenting also requires analysis of segments. Classifying those segments that have better revenues over costs is necessary. It must include calculating profitability over the lifetime of customers.

Develop strategies to maximise profits based on focus on specific segments

The next step is to create strategies that increase revenues, create long term relationships, and enhance customer retention and loyalty programs. Strategies can include elimination of least profitable aspects, re-engineering customer groups into profitable ones by increasing revenue and decreasing costs.

Review the Impact

Any new strategy or practice needs to be implemented and worked up accordingly. This needs to be reviewed after appropriate periods of time to understand impact on customers.

Mistakes made while performing customer profitability analysis

While performing customer profitability analysis, it is necessary to track some mistakes. If you know these mistakes in advance,you can avoid making them. Customer profitability analysis allows you to spot long-term customers, identify buyer habits, and improve targeting towards customers.

To calculate customer profitability, you need to track customer behavior and activity. The market is, however, subject to changes and different resources. All this makes it necessary to reduce errors in calculating customer profitability as much as possible.

Assuming every product is the same 

Customer profitability analysis requires you to assume every product is different. One mistake often made is not accounting for the difference in products. If you assume that all products are equal, it leads to varied impacts. You must keep all differences in mind to measure the right impact. In multi-product enterprises, it is tougher to ascertain the impact of a specific product. However, calculating customer profitability in the right manner drives improved customer retention.

Not taking into account all the costs involved 

Sometimes while calculating customer profitability, one might forget other costs involved. It is easy to forget all the costs involved in the business. If you don’t track these costs, it will reduce the overall profitability. Costs in any company can include sales costs, marketing, transportation, handling, warehousing, and more. These costs might sometimes be omitted from the equation.

Calculating profitability in terms of the customer instead of product 

Customer profitability analysis can go wrong if profits are calculated against the customer. For example- while calculating customer profitability analysis, one should not see how much profit was generated from one customer. The process needs to be measured as profit generated from the product. The product must be the central focus of the profitability structure. Profitability needs to calculate per product.

Selecting the incorrect time frame 

While conducting the customer profitability analysis, it is necessary to pick the right time frame. The time frame needs to be long to enhance results. This helps since you get the right picture of the customer’s lifetime value. The time frame needs to cover the aspects of product usage. If you include a short time frame, you cannot be sure if the customer underwent product adoption or not.

What should be done to improve customer profitability analysis

Customer profitability analysis helps determine which customers are in the profitable bracket. It helps improve businesses to include customer satisfaction, value, and market share. Customer profitability helps track potential trends so that businesses can be steered that way. You can also decide on better pricing strategies for the business. Customer profitability analysis, if done right, allows matching customers with better-performing customers to draw insights and offer targeted content.

Keeping track of the product performance, customer product-usage time length, product features, and all costs- internal and external will help improve the customer profitability analysis.

Wrapping Up

While client profitability analysis seems like a very beneficial process, there are few flaws too associated with it. Companies most often do not have the right resources to accurately calculate the CPA. The activity-based costing, and hence customer profitability analysis, is not easy to calculate because the cost of resources is often blurry for each activity.

The cost of attracting and retaining the customer must be calculated over the entire lifetime of the customer. Hence, sometimes customer lifetime value gives a more clear picture than CPA. It gives you the entire value a customer would generate in their lifetime rather than the annualized value of a CPA. Nevertheless, the CPA can be a useful tool to re-examine your business strategies and allocate the right resources to serve the right customers.

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