Calculating Customer Profitability
This article shows calculation options for customer profitability. We’ll look at how to calculate both periodic and lifetime customer profitability.
Periodic Customer Profitability
The calculation of periodic customer profitability often follows the format of a company’s income statement. The general format for a company that sells goods is:
Revenue
– Cost of Goods Sold
– Other Income
– Other Expenses
= Contribution to Profit
I’ll now go into more detail about each line item of this simple income statement.
Revenue
Assigning a customer’s revenue to them is easy for many businesses, especially those with a B2B model. B2C companies may not be able to do this. One way they identify a specific customer is via a loyalty ID number or phone number for the customer. This is one reason companies promoted loyalty programs so heavily. A company might also be able to identify customers via common payment data, such as the same credit or debit card being used for multiple purchases.
I listed only one line for revenue in my simple income statement, but it’s often beneficial to have a line for each major source of revenue from a customer. In banking, this might be the interest income from each loan or type of loan. Some companies may break it down by product line.
Cost of Goods Sold
When we consider costs, we must make the decisions discussed in the last lesson. Some companies will only include direct costs in the cost of goods. Others will include manufacturing overhead or other allocated costs. Like revenues, costs of goods may be broken out by major service or product line.
Service companies don’t have the same costs of goods and income statement structure as a products company. What they often have is a large salary expense, parts of which may be directly associated with customers. A consulting company may know the hours each employee spent on each client. They may allocate the salaries and potential other costs from support departments (e.g., human resources, information technology) based on those direct service-hours of customer service employees. Those allocated costs may be put directly under the client revenue or put lower in the income statement to highlight that they are allocated costs.
Other Income
The other income line can include add-on revenue, fees, or incidental revenues. In a banking customer profitability analysis system, there might be lines for loan fees, deposit fees, and investment advisor fees.
These are important for customer profitability because these services come with costs. The company must decide if customers are willing to cover all or part of those costs.
In banking, these fees can also lead to ethical questions. Some of the customers with above-average profitability were those with high overdraft fees. This is not the revenue a financial institution wants for the health of the customer or the company.
Thinking more broadly, a customer may be driving costs and/or revenue in ways that the company doesn’t want. The company must find ways to encourage customers to act in ways beneficial to the company and the customer. For example, frequent orders may cause costs for both the customer and the company. The company could educate the customer about these costs and find ways for more efficient order practices. Custom or rush orders may drive up costs. The company could pass along these costs as other income or might allow them only for the customers with the highest profitability to absorb those costs.
Other Expenses
This is where costs other than direct product or service delivery are captured. Costs can be driven or applicable to a customer across a spectrum of plausibility. The company may group those costs in this section into two categories: indirect costs with a high degree of plausibility for application at the customer level and indirect costs with a low degree of reasonable allocation basis at the customer level. As noted in the last lesson, some companies don’t allocate one or both of those categories to customers. For those that do, it’s best to list them in this section. This allows decision-makers to calibrate their decisions to the reliability of the information at the customer level.
The customer profitability analysis system may allow a high degree of granularity for these costs. Companies may want to drill into the transaction counts across a high number of transaction types to identify the drivers of costs and profitability of a customer. In a bit of irony, tracking costs in detail may cause additional costs. A company has to calculate whether the value of that information (i.e., the expected value of improved profitability) is worth the cost.
Companies must also decide whether to include taxes in other expenses or as a line below other expenses. Most companies only calculate pre-tax customer profitability. A company may want to consider taxes if different customer actions or characteristics drive different tax outcomes. Some bank transactions have tax advantages. Banks tend to adjust revenues on a “fully tax equivalent” basis in those cases.
Two other types of costs are probabilistic costs and actual costs. This is relevant for potential bad debts in receivables. In banking, there are reserves for losses on loans. In both cases, the company books an accrual expense for the probability of expected future losses. Another option is to not allocate the reserve expense at the customer level and only deduct actual charge-offs.
What Time Period to Measure?
The system I created calculated the customer profitability for each of the past twelve months. A summary report showed the total for each customer for the past quarter and the past year.
Each time frame has its benefits. Looking at monthly profitability helps sales staff see trends up or down in customer activity and profitability. A single quarterly or yearly number is much easier to scan for multiple customers or to list in a summary report of all customers.
Monthly profitability is very volatile. Customers ranked by profitability would greatly change each month. Annual profitability provides a longer-term and more stable assessment.
The calculations I’ve discussed so far in this lesson are for historical profitability. These are based on historical amounts for the volumes in the past. I explore modeling future profitability using marginal profitability in a later lesson.
Customer Lifetime Value (CLV)
Calculating customer lifetime value (CLV) is a type of net present value (NPV) analysis. You project the revenue and expense cash flows and then divide each of them by a discount rate to arrive at a single NPV number. Note that CLV is a cash-based profitability analysis, while periodic customer profitability is usually done on an accrual basis. To learn more about NPV analysis, check out my course on modeling profitability in Excel.
Let’s dig a little deeper into the components of this analysis:
Customers
For which customers do we calculate CLV? A question to ask first is, “What decision are we making with this CLV information?” One of the most common uses of customer CLV is to calculate whether a new customer’s lifetime value covers the acquisition costs (i.e., marketing and sales). In this case, you would calculate CLV excluding any acquisition costs and then subtract acquisition costs to see if they are positive.
CLV may be more useful for modeling the future profitability of customer segments and not individual customers. It might be used to see if discounts given today to attract a new customer are justified over the projected long-run net cash flows from that customer.
Revenues and Expenses
When projecting future amounts for a decision, I favor using marginal revenue and expenses. Looking at segments of customers, rather than individual customers, means that increases in production capacity may be relevant marginal costs. I like to say that costs cause costs. If targeting a new customer segment will increase direct costs, challenge whether that will force increases in other costs in the company. All these costs, whether “direct” or “indirect” from some cost methodologies, are marginal if they are new costs that are more than likely to occur due to the decision contemplated.
Time Periods
One option for the number of periods is the expected life of a standard customer that’s part of the customer segment being analyzed. Some would say that the future is very uncertain and likely to change. In this case, you would only project cash flows for something like three years.
Discount Rate
A good starting point for a discount rate in NPV analysis is the weighted average cost of capital of the company. Ideally, that rate would be adjusted up or down for the riskiness of the customer being analyzed. At a more granular level, it may be adjusted for the different products within a customer relationship. For example, a bank may use a higher discount rate for a customer with a lower credit rating. This higher discount rate may only be applied to the loans or to the full relationship. Not using a higher discount rate makes higher revenues from riskier customers drive higher projected NPVs, which may lead companies to take on too much risk.
Customer Profitability Metrics
If I told you that a customer had a profit of $100 over a year, would you know whether that’s good or bad? For a customer with $10 million in sales, it’s a pathetic return. A ratio may convey more information in a single number.
Companies sometimes try to apply entity-level metrics at the customer level. Some banks would calculate a return on capital or return on equity amount for a customer. The great trick to that metric is figuring out how much capital to apply to an individual customer. Long story short, there is no easy (i.e., highly justifiable) way to do this.
Another option is to calculate the working capital driven by a customer or customer segment. This would be considered the “investment” in a return on investment calculation. The customer’s profit would then be divided by this investment to get a metric.
A simpler metric is to use the contribution as a percentage of sales. While simple, it may ignore differences in amounts of working capital caused by customer segments unless those are all allocated as a cost of capital in expenses.
There is no single ratio metric that’s widely used in customer profitability for periodic profitability. Still, these metrics may be useful. The best use of a ratio metric may be to set a baseline at some point and then to set strategies to improve that ratio. Those actions will increase the contribution toward profit from customers to increase overall company profitability.
A customer profitability ratio mentioned in marketing literature is the customer lifetime profitability divided by the customer acquisition cost. The higher this number is above one, the more likely that a customer or customer segment will be accretive to the company’s profit. The weakness of this ratio is that it uses the CLV formula we explored earlier. There are components of that formula that are determined very subjectively, such as the number of periods to use, which costs are marginal costs, and the discount rate.
When is a Customer Unprofitable?
After all this analysis, we are ready to tackle an important question: When is a customer unprofitable? Below are the answers to that question from a survey of companies. Note that companies could choose more than one answer.
- Net Profit < Zero: 46%
- Net Profit < Company Guideline: 28%
- Future Profitability: 24%
- A lot of Judgement: 30%
I love that last response. Almost a third of the respondents say judgment is a significant part of the decision. I’ll discuss this more in a later lesson.
The other three responses are similar to what we’ve seen earlier. A company that uses fully loaded historical costs may decide to define unprofitable as a negative profit. That definition lacks any reference to a return on capital unless it includes the cost of capital as an expense.
Customers may need to have a profitability above zero to justify them. This is especially true when customer profitability includes only direct costs. How much does profit need to be above zero? Each company must set a guideline. It may be calibrated off capital costs or may be set by a hurdle amount above a level seen at a certain decile of their current customers.
Future profitability is a much better measure for decisions about what to do with the customer in the future. As noted earlier, a customer with poor past profits may improve in the future, and vice versa. Future profitability may be easier to calculate than past profitability if one only includes projected marginal revenue and costs. How does a company determine those projected amounts? To quote the final option of the survey, it takes a lot of judgment.
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