Customer profitability

Profits earned oncustomers and cus-tomer segments maybe one of the mostimportant measuresand yardsticks oforganization perform-ance. The bottom lineon any customer (orcustomer segment)profit and loss state-ment represents the exchange ofvalue between an organizationand its customer.

Value to the customer isreflected in the selling prices thatcomprise revenues. Value for thesupplier is reflected in the profit(or loss) from the relationship.Add in working capital, property,plant, and equipment investmentsmade on the customer’s behalfand the return on investment(ROI) on the relationship canbegin to be understood.

This article provides anoverview of customer profitabil-ity, including benefits, applica-tion and use, calculation alterna-tives, and best practices.

Customer profitability quan-tifies the “in-the-bank” profitsof the customer/supplier relation-ship and reports what’s alreadybeen earned. More importantto many industries is customer

valuation, the future value of the customer. The distinctionbetween customer profitabilityand customer valuation is con-tained in the definitions below:

• Customer profitability: Theperiodic reporting of theprofits earned on individualcustomers/customer seg-ments. It’s like reporting theprofits of a business basedon actual revenues and costs.

• Customer valuation: The life-time value of individual cus-tomers/customer segments.It’s like valuing a businessbased on projected revenuesand costs (discounted).

A visual relationship of customer profitability and cus-tomer valuation is illustrated inExhibit 1.

Customer profitability andcustomer valuation both require

a definition of the cus-tomer or customer seg-ments. Forward-look-ing customer valuationrequires assumptionsabout future profit,attrition risk, customerloyalty, and economicand market growth (toname just a few). Forcustomer profitability,

these are not assumptions butwhat actually occurred in thereported financial results.

Projections of the future aresignificantly enabled with histor-ical data and information. With-out understanding the historicand current profitability of cus-tomer and customer segments,projections into the future wouldbe difficult, if not futile. Therewould be no verifications orguidelines for future assump-tions. Customer profitability isa prerequisite for customer valu-ation. For that reason, this arti-cle’s focus is on the former.

BENEFITS

The primary benefit of cal-culating customer profitabilityis relevant and useful informa-tion required to develop strategicplans, enable better decision

Customer profitability quantifies the “in-the-bank” profits of the customer/supplier relation-ship and reports what’s already been earned.More important to many industries is customervaluation, the future value of the customer. Thisarticle explains how the two differ—and why itmatters. © 2008 Wiley Periodicals, Inc.

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© 2008 Wiley Periodicals, Inc.Published online in Wiley InterScience (www.interscience.wiley.com).DOI 10.1002/jcaf.20404

Customer Profitability

John A. Miller

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making, and improve organiza-tional performance and focus.Customer profitability quantifiesthe exchange of value thatgoes on between a businessand its customers. For most busi-nesses, the profitability of customers and customer seg-ments varies substantially.

Customer profitability shouldbe the core of the strategic planand driver of operating priorities.Other than providing productsand services to customers at aprofit, what other reason is therefor being in business? Decisionmakers in sales, marketing, andoperations all benefit from cus-tomer profitability information.Examples of the applicationinclude the following:

• Sales. Keeps the sales organi-zation focused on the high-

value customers and identifieshigh-value customer opportu-nities. Customer cost-to-serve,used to eliminate/reduce cus-tomer behaviors that impactcost and for focused customerservice levels (not all cus-tomers are equal).

• Marketing. Used to alignmarketing and promotioncosts to key customer seg-ments, reducing the risk ofspending scarce marketingdollars to retain the least-valuable customers. Targetnew market opportunitiesand align new product/serv-ice development to the mostprofitable customers (bothcurrent and emerging).

• Operations. Basis for devel-oping and executing compet-itively dominant customervalue propositions.

• Pricing. Pricing decisionscan differentiate serviceofferings in a way that iscommensurate with the valueof each customer. Customerprofitability initiativesemphasize expanding serv-ices to existing customersthrough menu-based andservice-level pricing. Increas-ingly, customers are requiringalternative pricing modelsand the unbundling of serv-ices and costs instead of aone-price-fits-all approach.

APPLICATION AND USE

The overall effort andrequirement for calculating cus-tomer profitability varies signifi-cantly between industries andcompanies. Depending on thecompany, sales and revenues

64 The Journal of Corporate Accounting & Finance / May/June 2008

DOI 10.1002/jcaf © 2008 Wiley Periodicals, Inc.

Exhibit 1

Relationship of CP and CV

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come from a handful of cus-tomers buying millions of dollarsof a single product or from mil-lions of customers spending ahundred dollars a week on a bas-ket of groceries. In the first case,the company would know its cus-tomers by first name. The gro-cery store is unlikely to know therevenues of its customers or theproducts/services they purchased.

Some companies have dataand information about each oftheir customers. For frequent flyers, airlines have data onflight frequency, destinations,revenues, and even seating pref-erence. Other companies have noinformation on customers andrely on focus groups and cus-tomer sampling to segment andunderstand the revenues, prod-uct/service mix, and costs.

Companies with mil-lions of customers, likeutilities, telecom, and insur-ance, capture revenue andservices for each individualcustomer in the monthlybilling for electricity,mobile cell phone service,or an insurance policy. Themonthly billing also providesthem with the information on theproducts and services purchased.The availability of reliable cus-tomer data and information issignificant to the overall workand requirement for calculatingcustomer profitably.

One way to illustrate the dif-ferences between companies isby business model.

• B2B. Businesses selling toother businesses generallyhave a large amount of dataabout each of their hundredsor thousands of individualcustomers. Customer switch-ing costs are moderate,and the customer/supplierrelationship is often

covered by short-term agree-ments and contracts. B2Bapplications of customerprofitability include contractnegotiation and establishingminimum order quantities,order frequency, and lotsize. In times of tight sup-plies, it provides informationto align capacity with themost profitable customers.

• B2C. Businesses that sellto consumers have millionsof customers. Some of thesebusinesses have a rich data-base of customer information,others very little. The switch-ing costs for the customer(consumer) are low. Wal-Mart(data-poor) and Sprint/Nextel(data-rich) are examples.B2C applications of customer

profitability include targetedmarketing, pricing for prod-uct/service bundle, and service levels. The locationof retail items and the layoutof the floor space can bedesigned to appeal to themost profitable customers.

• B2B2C. Some businesses sellto businesses that, in turn,sell to the consumer. Theircustomers, distributors andlarge retail operations num-ber in the tens of thousands,and consumers in the mil-lions. These businesses typi-cally know a lot about theircustomers and little abouttheir consumers. Customerswitching costs are high, andthe customer relationship is

covered by long-term con-tracts and agreements. Gen-eral Motors and John Deere,who sell to independentbranded distributors, areexamples. Examples ofB2B2C applications includeoptimizing distribution,product/service pricing,and focused marketing andpromotional efforts.

Within a single company,its products and services couldhave elements of all three busi-ness models. The entire telecomindustry is built around providingservice to businesses or individ-ual consumers, or through saleby third-party retail operationslike Best Buy and Radio Shack.

CALCULATION

In making the cus-tomer profitability calcula-tion, start with the end inmind. What will customerprofitability information beused for? What decisionswould be made with theinformation? How accurate

does the calculation need to be?Who will use the information?How often will they need it?What costs are to be included inthe calculation? All these ques-tions should be answered andunderstood before the calcula-tions are made.

The calculation of customerprofitability itself is prettystraightforward. Revenues andcost (product/service cost andoperating expenses) areassigned, traced, or allocated tocustomers or customer seg-ments. For most organizations,the product and service portionof total cost is significant (over75 percent). For these organiza-tions, gross profit (sales minusthe product/service cost) by

The Journal of Corporate Accounting & Finance / May/June 2008 65

© 2008 Wiley Periodicals, Inc. DOI 10.1002/jcaf

The overall effort and requirementfor calculating customer profitabilityvaries significantly between industriesand companies.

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customer may be sufficient tounderstand customer profitabil-ity. Matching customer/cus-tomer segment revenues withthe cost of the products/servicespurchased is all that’s required.For some organizations, it’s theoperating cost, not theproduct/service cost, that makesup 75 percent of the total coststructure.

In most organizations, thecost of products and services hasbeen studied, documented, andmade available in standard costsystems, activity-based costingmodels, or embedded in theorganization’s enterpriseresource planning (ERP)and business intelligence (BI)systems. Operatingexpenses (selling, market-ing, finance, informationtechnology, and generaland administrative) may bemore elusive. Part ofthe operating cost is “busi-ness sustaining,” with nocause-and-effect relation-ship to customers. Thesecosts could be allocated arbitrar-ily (on revenues, for example) orexcluded from the calculationcompletely. There is a cause-and-effect relationship betweenother parts of operating costs(sales, marketing, and parts offinance and administration) andthe customer. With a little workand analysis, these costs can beappropriately assigned to cus-tomers.

More demanding is cus-tomer segmentation. Banks,insurance, telecom, utilities, andother companies can take rev-enues and a significant portionof their overall costs to individ-ual customers and customeraccounts. For decision-makingpurposes, this information is oflittle value. It’s the segment thecustomer falls in that is impor-

tant and necessary for decisionmaking. For example, healthinsurance companies know rev-enues and claims (80–90 percentof all costs) for each insurancepolicy they sell. Some policieswill have more claims than oth-ers. That’s the nature of insur-ance, the sharing of risk over abroad population. What’s impor-tant to the health insurance company is the profitabilityof the customer segment. Theprofitability of an individualcustomer is meaningless.

As one goes from a few cus-tomers you know to millions youdon’t know, the identification ofcustomers and customer segmentgets progressively harder. Retail

operations and other businessesserving the consumer are con-stantly gathering sampling datato segment their customers intoclusters that represent the prod-ucts and services they want, buying habits and behaviors,and requirements.

From a competitive stand-point, the goal is to segment cus-tomers into groups with homog-enous needs so they can beapproached, acquired, and insu-lated from competitive attack.The definition of a customersegment and trade-off is as fol-lows:

• Customer segment: A groupof customers with suffi-ciently homogeneous needsthat the segment memberscan be won with a common

value proposition and com-mon marketing. A lowdegree of homogeneityreduces the likelihood offinding a value propositionthat will satisfy most of thesegment.

• Trade-off: Finer segmenta-tion better focuses on cus-tomer needs that leads tobetter-crafted and more differentiated value proposi-tions and greater acceptance,higher margins, increasedloyalty, and higher economicprofit. Too much segmenta-tion leads to increased complexity, informationoverload, mixed customermessages, and little differen-tiation in the segment valueproposition.

Conventional customersegments of a B2C busi-ness include age, annualhousehold income, averagepurchase size, revenues, ZipCodes, occupation, andmaterial status. Customer

segments for Dell computer’sbusiness customers include smallbusiness, medium and large busi-nesses, state and local govern-ments, federal government, edu-cation, and health care.

In addition to conventionalcustomer segmentation, somepeople get creative. TakeWachovia Bank, for example.They have five different segmen-tation programs, each with a keyfocus (in parentheses).

1. P$ycle or psychographic(market comparison);

2. Behavioral (cross-sell/upsell);3. Book of business or value

(cross-sell/upsell and reten-tion);

4. Good to great or prospectivevalue (market comparison andpositioning); and



There is a cause-and-effect relation-ship between other parts of operatingcosts (sales, marketing, and parts offinance and administration) and thecustomer.

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5. Attitudinal (value propositionand design/development).

The multiple segmentationprograms for Wachovia areenabled by the ability to capturecosts and revenues at the accountlevel. A database of profitability,at the account level, can beaggregated and segmented inmultiple ways.

BEST PRACTICES

A great reference fororganizations that haveachieved success in their cus-tomer profitability initiatives isthe best practice partners iden-tified in the APQC/CAM-Iconsortium best practice stud-ies. In two separate stud-ies conducted in 2005 and2007, eight companieswere selected as bestpractice and significantlycontributed to the body ofknowledge aroundthe practice, application,and use of customer prof-itability information:

• FedEx: Created a cus-tomer “desirability”model that considers cus-tomer profitability and otherdimensions that are weightedto derive a relative value ofthe customer

• Marriott: Approximated cus-tomer profitability throughan analysis of relative cus-tomer spending

• North Shore Credit Union:Used needs-based models(propensity) in conjunctionwith member profit scoringto derive a forward-lookingmeasure of potential mem-ber value

• Wachovia: Leveragedaccount-level profit calculation from finance

and aggregated this informa-tion at a relationship level;used a consistent approachand methodology regardlessof line of business or cus-tomer segment

• Zippo: Calculated andreported customer profitabil-ity for each of its 3,500 customers; active proponentand user of activity-basedcosting for both productand customer profitabilitycalculations

• Charles Schwab: Calculatedand reported client segmentprofitability monthly; usedcurrent profitability, as wellas assumptions of futurebehavior, to calculate cus-

tomer value over a three-to-five-year time horizon

• Aon Risk Services: Aon’sclient-facing group trackedtime spent on each of Aon’s10,000 customers and fac-tored in direct costs, supportcosts, back-office costs, andmarketing costs to developcustomer profit and lossstatements and scorecards

• Sprint/Nextel: Used a modelto determine a customer life-time value (CLV) for itsactive customers; updatedCLV data monthly for itssupport analysis and distrib-uted executive-level report-ing on a quarterly basis

Common practices amongthe study partners and deemedbest practice included the use ofmultiple bases of customer seg-mentation, enabled by the abilityto capture revenues and cost esti-mates for each individual cus-tomer account. Customer seg-ments and subsegments areclearly defined and understood(typical were five to nine macrocustomer segments). As with anykind of initiative, buy-in fromthe users, upper-level support forthe customer profitability initia-tive, and holding employeesaccountable for customer prof-itability were identified as pre-requisites for success. Other bestpractices and findings:

• Include the majority ofbut not necessarily all costsin the customer profitabil-ity calculation. Costsincluded in the calculationare reconciled withreported financial results,and excluded costs areknown and understood.• Gear specificprograms/sales efforts tomost valuable customers.Most people are familiar

with the Marriott RewardProgram. FedEx has OneCall for its most valuablebusiness customers,and Zippo sponsors eventsfor consumers and a swapmeet for collectors.

• Convert unprofitable cus-tomers to profitable cus-tomers. None of the bestpractice partners “fire cus-tomers.” When the valueexchange with the customeris unprofitable, they work tofix the problem.

Finance and accounting pro-fessionals should be interestedin one practice consistent across

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© 2008 Wiley Periodicals, Inc. DOI 10.1002/jcaf

A great reference for organizationsthat have achieved success in theircustomer profitability initiatives isthe best practice partners identifiedin the APQC/CAM-I consortium bestpractice studies.

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the partners and identified ascritical to a customer profitabil-ity initiative. That practice wasshared responsibility for owner-ship and customer profitability,bridging a gap between market-ing and finance common inmany organizations.

Customer-facing functionslike sales, marketing, and opera-tions are the primary users ofcustomer profitability informa-tion. In many companies, thisinformation is not avail-able, so these groups makeestimates of customer prof-itability, often based solelyon revenue or proxies ofcustomer behavior (such aspoints in a loyalty scheme).In making decisions toallocate scarce marketing,sales, service, or supportresources, an imperfect estimateis better than nothing.

As official owner of theenterprise’s financial statements,and practical owner of relevantoperational applications likebilling, finance is in the bestposition to understand the cus-tomer’s profitability and toestablish a repeatable and rigor-ous process for updating this

analysis. Finance is also thegroup with the most credibilityto make its estimates acceptableto the rest of the company, byreconciling the company’s prof-itability (reflected in financialstatements) with the total prof-itability of its individual cus-tomers. Although finance cangenerate numbers that reconcile,the assumptions that drive over-head allocation are often subjec-tive and are only vaguely linked

to the behaviors of individualcustomers.

At the best practice compa-nies, marketing and finance arejointly responsible for customerprofitability. Each company hada dedicated group of two to fiveindividuals involved in calculat-ing and reporting customerprofitability. These groupsalso work closely with the IT

team to calculate profitabilityincluding data warehousing,the customer relationship man-agement system, data mining,external databases, and predic-tive analytics.

SUMMARY

Long-term businesssuccess requires sustainableand profitable revenue growth.Customer/customer segment

information provides anorganization with themeans to identify, create,and retain profitable cus-tomers, segments, markets,and channels. Understand-ing the cost of meetingunique requirementsleads to more appropriatepricing decisions and

value propositions for the cus-tomer. In looking at customerprofitability, organizations usethe information to define a pro-file and behavior of the kind ofcustomers that are most prof-itable. With this information,advertising, marketing, andsales resources can be targetedto reach potential customerswho fit the profile.



Customer-facing functions like sales,marketing, and operations are theprimary users of customer profitabil-ity information.

John A. Miller is president of Arkonas, a Texas-based management consulting firm that specializes inperformance management and measurement. He was the subject-matter expert on the APQC/CAM-IConsortium best practice studies on customer profitability and customer valuation.

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