The Customer Profitability Analysis

Industries are shifting from being product-centric to customer-centric. Customer relationship management is aimed to understand customer behavior and profitability and leverage this info to more effectively manage customers in a one-to-one relationship. The goal of CRM is to attract new customers, retain, up-sell, or cross-sell to existing customers.

Customer profitability analysis (CPA) is a new management accounting practice that has evolved in the increasingly competitive business environment. In this environment, the traditional cost and margin analysis is insufficient and does not give the complete picture for the cost-profitability relationship. It allows the businesses to disaggregate revenues and costs to levels of individual products and customers to reveal previously hidden costs.

Activity-based costing (ABC) and the related activity-based management (ABM) are the foundation of CPA. ABC is a costing analysis system to identify an organization’s activities and cost drivers followed by assigning the costs to these activities. ABC and ABM are utilized as strategic tools for management to achieve the following goals:

Better understanding of customer and product profitability by uncovering hidden financial info which leads to identification and reduction of non-value-added activities and streamlining processes

Provide cost-effect info to link the costing to products and customers and evaluate product and customer return on investment

produce useful info to provide management with direction for costing and marketing strategies

Better informed decision making than traditional gross margin analysis

Provide info for company to develop strategies to transform unprofitable customers into profitable customers

Assist future customer selection: target more profitable industry channels and customer types

An increase in overall profitability in many organizations has been demonstrated through the use of ABC.

Here we analyze three approaches of applying ABC to carry out CPA, namely 1) customer lifetime value (CLV), 2) channel/customer profitability analysis, and 3) product line and customer return on investment (PROI/CROI) analysis. We will first go over the individual scenario and answer the questions assigned to the topic analysis. After that a comprehensive comparison of the three scenarios will be provided.

Customer Lifetime Value

Definition: CLV is a comprehensive, fact-based measure of customer worth (value contribution) over the lifetime of a business’ relationship with their customers. A performance measure of long-term customer worth.

Industry and customer types: CLV can be applied to both manufacturing and service companies. Industries mentioned in the article include internet based retailers, retail-banking industry, telecommunication companies, power generation companies. Based on their values, CLV divides customers into four segments: champions, demanders, acquaintances, and losers.

Customer service costs and revenues: CLV measures four costs: 1) Cost to acquire; 2) Cost to provide; 3) Cost to serve; 4) Cost to maintain. The revenues are sales generated in manufacturing or service industry.

Role of technology: Technology plays a critical role to enable CLV. The utilization of sophisticated information collection systems allows the collection of data from multiple customer touch point allows the evolvement of single CRM applications into integrated CRM. Other technologies include the automation of CRM process and technologies to facilitate collection of financial and statistical info. As a result, the data collected for CLV analysis is highly enriched.

Limitations: The article discusses several challenges that reflect the limitation of this analysis method:

It is difficult to define a “customer” being an individual, an account, a household or business address.

It is difficult to link customer information into a single customer record since a customer may leave or return multiple times during its lifetime.

It is difficult to measure cost, not revenue to the customer level

The costs of acquisition and service may be considered fix but are indeed variable

Product pricing does not distinguish between the value of product and service. Menu pricing can mitigate this issue.

ABM requires great commitment of resources and management buy-in than traditional cost accounting

Developing strategies: CLV enables the ability to understand and segment customers based on value and allow companies to develop differentiated customer management strategies. Specifically, “champion” customers must be retained and valued, “demander” and “acquaintances” should be up-sold while reducing the costs, “losers” must be converted into profitable customers or defected. Executing these strategies should result in better and longer relationships with the best customers and increased profitability for the company.

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The specific ABM-based customer management strategies include: 1) Educate the customers to better understand the value they receive; 2) Establish two-tiered pricing structure and service activities to differentiate high- versus low-value customers; 3) Reduce the “drivers” of cost and complexity associated with customer behaviors; 4) Focus marketing/sales on high-value customers; 5) Enhance loyalty programs to retain high-value customers.

In addition, understanding the characteristics of profitable and unprofitable customers, CLV provides a prediction tool to forecast the behavior of future customers and better target company’s business development activities.

Channel/customer profitability

Definition: This is a financial analysis method that uses ABC to analyze the company’s profitability picture at customer channel and individual customer level. The process of this analysis consists of the following steps: 1) Develop an activity dictionary; 2) Determine spending on each activity; 3) Identify products, services, and customers; 4) Select activity cost drivers; 5) Calculate activity rates. The information derived from these steps is then used to analyze customer channel profitability, profitability of different classes of customers in one channel, and profitability of individual customers for the four largest customers.

Industry and customer types: The industry described in the article is a service company. Their customers can be categorized into two channels based on the type of service they receive. The customers in one channel can be classified into high, average, and low based on the rates of sources of revenues (worker compensations). The customers are also analyzed at individual levels for the four largest customers based on sales volumes.

Customer service costs and revenues: The revenues are earnings based on the service provided. The three costing activities identified and analyzed are 1) filling work orders; 2) Hiring temporary employees; 3) Processing payroll/billing.

Role of technologies: This is not specifically mentioned in the article.

Strategies development: The channel/customer profitability analysis for the company has revealed the following key information:

The company’s sales composition is very different from what has been assumed (assumed 60/40 industry/clerical vs. actual 85/15).

It leads to the identification of the channel, the class of customers, and the individual customers that are generating losses.

It leads to the identification of profitable industry channel and customers

Provided with the above information, the analysis enables the following strategic planning:

Develop strategies to maintain these customers such as maintaining the current pricing arrangements.

Propose decreasing overhead as key mitigation strategy to turn non-profitable customers into profitable customer.

The overall strategic value of the channel/customer profitability analysis is two-fold: to convert unprofitable customers into profitable customers and assist in future bidding for contracts.

Limitations:

Activity-based costing does not reduce cost. Reducing overhead for unprofitable customers does not automatically lead to cost reduction.

Unique situations are revealed by deep analysis and may not be captured by ABC

Data may not be readily available for certain parts of analysis (e.g. no easily accessible procedure for determining if an applicant applied for clerical or industrial employment)

Product line and customer ROI

Definition and analysis process: Product return on investment (PROI) and customer return on investment (CROI) are financial analysis by assigning assets to activities and ultimately to products and customers to allow manager to analyze customers and products similar to ROI analysis. Extend analysis of product lines and customers beyond what provided by traditional cost and margin analysis to the determination of customer and product-line ROI. It is most useful to analyze customers and products that have significant asset utilization.

The process of PROI/CROI starts with the development of two matrices: 1) listing all products and major activities associated with production and distribution; 2) assigning activities to customers’ demands. The second step is to conduct preliminary assessment where activities are rated first. Product or customer is then associated with each activity with consumption ranking. The third step is to identify areas of high or average capital intensiveness with significantly different demands from different products or customers. Finally, management uses the analysis results to develop strategies to target identified areas in order to improve PROI and CROI.

Customer and industry types: The exemplary company described in the case study is an automobile parts manufacturer with two primary customers, an automobile manufacturer and after-market suppliers of auto parts (retailer).

Types of customer service costs and revenues: PROI/CROI analyzes the utilization and consumption of company assets by various products and customers such as equipment and machinery, tooling, inventories, and receivables. Variation of asset utilization is resulted from customized demands such as specialized tools and equipment and store inventories for special customers. In the case study, the revenues are generated by selling the manufactured auto parts directly to customers.

Strategy development: When used to analyze the right situations, PROI/CRPI analysis is advantageous over the traditional margin analysis and return on sales analysis by demonstrating that the customers and products that use assets more intensely may be subsidized by those that use assets less intensely. It can provide management with more complete picture of benefits derived from customers or project lines, assessing impact of product or process redesign and product or component sourcing decisions, and leverage in negotiating prices or other business terms, including payment polices, reduced inventory levels, or investment in tooling with customers. Specific examples where PROI/CROI can impact decisions include: 1) Utilize outsourcing; 2) Better utilize the existing asset/investment base; 3) Simplify existing product lines; 4) Negotiate pricing and/or concessions with customers.

Role of technologies: This is not specifically mentioned in article.

Limitations: PROI/CROI is not practical for all organizations. It must be built upon an existing ABC system or in conjunction with implementation of an ABC system. It is most beneficial when an organization has significant asset utilization/consumption differences between customers or production lines.

Comparison of the three ABC-based CPA methods

The three CPA methods share many similarities. Specifically the following similarities can be generalized across the three methods:

All three methods are based on ABC. The fundamental principal of analysis is conducted by assigning resources (costs or assets) to activities based on the realization that revenue alone is an inadequate measure of value and customer profitability is more relevant.

All three methods are ways to break down general costing info to individual product and customer levels in order to uncover hidden financial info that is not readily revealed via traditional financial analysis methods.

All three methods are utilized to analyze service activities, which are either a component of a non-service industry (such as manufacturing), or a service industry (such as placement company).

All three approaches result in similar benefits to a company’s management, where they provide necessary costing info to help management better understand the current status of the costing in order to re-design and optimize product process, identify and retain the most profitable customers, convert non-profitable customers into profitable customers, and forecast new customer behaviors.

There are some differences among the three methods:

PROI/CROI focuses the assignment of assets to activity (asset allocation) with the goal of evaluating product return on investment PROI/CROI. It is an extension of ABC, utilizing the same activities and cost drives from the ABC system to assign assets instead of costs to products and customers.

Channel/customer profitability and PROI/CROI focus on “snapshot” analysis of the current data, while CLV focuses on “life-time” long-term customer data.

CLV evaluates customer profitability at an enterprise level, which is less of a requirement for the other two analysis methods.