Chapter Week

Converting Customer Value -- From Retention to Profit

How to measure individual customer profitability

There are no standard recognised methods for CPA. While the basic concept is simple: to subtract customer costs from customer revenues in order to identify customer profitability, complexity arises because there are many types of costs: direct, indirect, fixed, variable and so on.

Companies often evolve their own approaches in practice, but the fact that different approaches provide very different results should be of concern to anyone trying to measure genuine customer profitability.

The different CPA methods used in practice

CPA methods range from broad and simple methods based on using percentages of sales to allocate costs, through to intricate allocation methods based on those actual activities that incurred the costs. We have encountered a variety of methodologies, including:

  • gross profit contribution;
  • partial overhead allocation (some overheads allocated in proportion to revenue, or even activity);
  • customer-related cost allocation (bringing sales costs and relationship costs, for example);
  • full allocation (even tracing) of customer costs.
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Converting Customer Value: From Retention to Profit
Publisher: Wiley
By: John J. Murphy
ISBN: 0-470-01634-5
410 pages
December 2005
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There are also industry-specific approximation methods, such as Federal Reserve Board functional cost analysis figures as used in the US banking industry.

However, these methods all give very different results, and care should be taken about the appropriateness of each method, especially when the conclusion is to sack some customers. It is important that the more detailed methods are used because, when it comes to migrating unprofitable customers, it is essential to understand the reasons for the lack of profitability. This cannot be done effectively if only the gross margin contribution is known. A key point raised with regard to costs at the basic level is that, for large customers, overhead costs are generally overallocated, and for smaller customers they are generally underallocated.

However, whichever method is used for the analysis, the process and discipline of carrying out CPA will stimulate a customer profitability mindset, which can lead to positive results being achieved. This would suggest that the specific method is less important than the fact of actually carrying it out.

The customer profitability paradigm usually represents a revolution in thinking for most companies and, therefore, it is difficult to accommodate this by simply evolving current systems.

A step-by-step approach to measuring customer profitability

The basic equation for customer profitability analysis is:

Customer profitability = Customer revenue – Customer-related cost

Within the customer-related cost lie several levels of cost, and these will be broken down in the following sections. Before discussing costs, it is actually necessary to begin with a discussion of the measurement of individual customer revenues.

Individual customer revenues

Identifying individual customer revenues is the most straightforward part of customer profitability measurement. Customer transaction data should be readily available in the sales ledger, and need to be combined at the individual customer level. There are some issues commonly encountered here, including the problem of duplicate data, the issue of multiple sites for the same customer, and adjustments to revenue from the use of credit notes, for example. Finally, since CPA can be completed for a company, division or subsidiary, regional business unit, or specific channel, care should be taken to ensure a complete view of the customer, what the customer spent, and its strategic significance for other divisions of the company. What could be an unprofitable customer for one department could be a highly profitable customer for another.

Duplicate data will typically affect a very small percentage of customer records but should not be ignored. Customers can be included more than once into a database for a range of reasons, even due to the name of the person placing the order. Data cleansing to remove duplicates should be carried out in order to minimise the impact of this.

The issue of multiple sites potentially within the control of the same customer can pose a more serious problem. For example, a single customer with small expenditure at multiple sites could represent a significant amount of revenue overall. The best approach is to treat transactions individually to begin with and then to combine them, as appropriate. This is because there are transaction level costs, so it might be important to recognise the number of transactions that each customer has undertaken.

It is also important to reconcile the total customer revenue with any credit notes, discounts or rebates, especially if applied retrospectively, based on volume, for example.

Individual customer gross profit

Having identified the revenues from customers, the next step is to calculate the customer gross profit. The starting point is to determine the direct costs of the different types of products or services the company has purchased. Some of this detail is obtainable from a company's stock purchase orders or invoices. The more complex the company's product or service basket the more time will need to be spent collating the data. Although this may be time-consuming, it is easily done. It might also be necessary to begin the process of CPA with a consideration of the accuracy of product costs. These are the costs of products or services that can be attributed directly to products, and could include materials and packaging, for example.

Customer gross profit = Customer revenue – Cost of goods sold

The starting point for profitability analysis should be to gain a clear understanding of product or service costs; particularly important when a company has a wide range of products. Activity-based costing can be used to assign the costs of activities and resources to those products that incur them. Incorrect cost allocation leads to ineffective pricing, where some products might be being sold at a loss.

Whichever method is used, the aim is to get a value for the gross profit on each customer's revenues.

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This was first published in April 2006

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