Again, however, the answer to this question boils down to the issue of how to define "profitability" itself. Are we talking about the fully allocated profit from a customer? Or should we talk about the marginal financial contribution of a customer? Or, instead of either of these definitions of profitability, should we stick to free cash flow? Each of these economic definitions of "profit" has its advantages and disadvantages. We recommend Appendix 2 of our book Return on Customer (Doubleday, 2005) for a fuller discussion of these issues.
In making the specific decision whether to continue with a customer or not, the most useful accounting treatment for customer profitability is probably the one that deals in a customer's marginal financial contribution. This is the most direct way to calculate the cost to your company if a customer simply disappears from the customer base, while everything else remains constant. If, on the other hand, you are deciding whether to continue serving a group of customers, then previously "unallocated" costs should be bundled into the calculation according to a simple rule: Unallocated expenses are those that would still be incurred even if that customer or group of customers were dropped from the customer base, while everything else remained constant.
Sometimes there are good strategic reasons for serving customer even when you don't actually make money from them. As just one example, this might be appropriate in a B2B firm, when capturing a big "name brand" customer can serve as an important validation of your firm's offering for others. "Hey, if IBM buys our services, then they should be good enough for other business customers, as well…"
Or it may be the case that maintaining a larger scale of operations is critical to your success, and so casting your marketing net wide enough to attract a larger number of customers has resulted in a slice of your customer base that is inherently less profitable. We've seen statistics that in retail banking, for instance, as many as 30% of customers are actually costing the bank money to serve. One bank told us that their top 25% of customers account for 115% of their profit!
This was first published in August 2009