Chapter 9
The Good, the Bad, and the Ugly: Understanding Customer Profitability
In This Chapter
Knowing how profits are distributed among customers
Distinguishing household from customer profitability
Understanding customer value over time
Using customer profitability in marketing
Your customers vary widely with respect to how much they contribute to your bottom line. In Chapter 9, I talk about the importance of keeping your loyal customers happy. You generally find that your most valuable customers are among your most loyal ones — but not always. You may find that you have apparently loyal customers who aren’t contributing a great deal of revenue.
In trying to understand customer profitability, it’s not enough to just look at their total spending. You need to take into account costs and discounts. Revenue is not the same as profit. This means that customers who buy a lot of products from you may not always be your most profitable customers.
Revenue Isn’t Profit: Accounting for Costs
There’s an old joke about a businessman who was so focused on generating sales that he kept discounting his products. He finally reached a point where he was selling his products at a loss. When his accountant pointed this out, he replied, “I know, but I’ll make it up on volume.”
When setting up a customer-profitability framework, the revenue side is relatively simple. You know what products you’ve sold and at what price. As long as this information is attached to individual customers, you’re golden. Even in industries like banking, which have a more complicated revenue stream, the revenue side isn’t that hard to get your arms around. Fees and interest paid as well as the balances that drive interest income all appear on the customer’s monthly statement. The harder part is taking costs into account. You have to work closely with your finance and accounting folks to do this in a way that accurately differentiates the costs associated with servicing different types of customers.
Your accounting folks have a pretty good idea of the profit margins on each of your products. But these margins often don’t take customer behavior into account. How the customer bought the product, online versus from a store, can affect the costs related to that particular customer.
To take customer behavior into account, you need to allocate many costs at the individual customer level. Finance professionals can help you determine an approach that fits your particular business model. Often they employ things like activity-based costing (ABC) and economic value added (EVA) techniques to address this issue. ABC involves distributing costs based on the extent to which various resources are used. A checking account puts a larger burden on a teller than a CD, for example. So checking accounts are assigned a larger share of the branch network cost. EVA is a technique for calculating profit that takes into account the cost of capital. In the context of product and customer profitability, capital means infrastructure like office buildings, computer systems, and so forth.
Allocating customer-specific costs
Many costs can be directly associated with particular customers. The cost of a database marketing campaign can be directly linked to the customers who received it. Shipping costs for an item purchased online can be linked to a particular customer. The fees you pay to credit-card companies when a customer puts a purchase on a card can also be tied back to the customer.
I recently had an alarm system installed at my house. The installation was free, as was most of the equipment. The guy who installed it for me was a chatty sort of fellow, and we got to talking about profit margins in his business. He told me that the company wouldn’t break even on my purchase until sometime in the second year of my contract.
Many business face similar setup costs. Phone and cable service providers make an investment in equipment when they initiate service. Many cellphone service providers offer free or steeply discounted phones. All these costs can be tied back to individual customers.
Customers also require different levels of service. Catalog retailers often offer free shipping on returns. Customer A may buy a given product and love it. Customer B may try one or even several products and return them before settling on the same product purchased by customer A at the same price. But the extra shipping costs may make the second purchase unprofitable.
There are also costs related to the failure of customers to pay their bills. People default on credit cards, mortgages, and auto payments. But even outside the financial services industry, payment can sometimes be a problem. People write bad checks. They refuse to pay for services after they have been rendered. These payment (or more accurately nonpayment) related costs are tied to individual customer behavior.
Combined with their spending levels, transaction-related costs are key to understanding customer profitability. Transaction-related behavior varies widely from one customer to the next, as does spending. These two variables help you usefully differentiate profitability among customer segments.
Allocating infrastructure costs based on usage
You know that you gave your customer a free phone to sign up for your company’s cellphone service. But how do you allocate the cost of building and maintaining your cellphone towers to individual customers? And what about the cost of the home office, the call center, and even your own salary?
These questions about infrastructure and other fixed costs, in my experience, are the questions that cause the most headaches in developing a customer-profitability framework. They simply don’t have clear-cut answers. Before you even start these discussions, get explicit agreement from everyone involved about the purpose of your customer-profitability calculation. Knowing in advance what you do and don’t want to do with it makes answering these sticky allocation questions much easier.
When I was doing customer-level profitability analysis in the banking industry, there was a great deal of discussion surrounding how to allocate the cost of brick-and-mortar branches to individual customers. It somehow didn’t seem fair to burden customers who only used online banking and ATM machines with the same costs as customers who went to the branch three times a week. Why should bank teller payroll count against the profitability of customers who never see them?
And it’s not just a matter of fairness. Different channels have different costs. That ATM network and the online banking infrastructure are far less expensive to maintain than the branch network. At that time, a key corporate initiative was to move customers into lower-cost channels. We wanted to reward our profitable customers for being profitable.
The approach we took was to allocate costs based on usage. We did this not at the individual customer level, but by grouping customers together. We defined low-, medium-, and high-volume customers in each channel and then allocated those channel costs differently for each group.
Tying cost back to the product
Sometimes it’s not a matter of how much a customer uses your infrastructure, but whether they use it. It doesn’t make sense to allocate executive salaries in the mortgage company to customers who only have a credit card, for example.
Manufacturing costs for consumer goods belong at the product level. Some products are more expensive to produce than others. In the case of retailers, wholesale costs — the price that the retailer pays for a particular product — also depend on the particular product.
In both cases, it’s relatively straightforward to assign cost to individual products. It’s then a simple matter to subtract this cost from the sales price to get a net profit for each product. These profits can then be assigned to customers based on what products they buy.
Not Rocket Science: Keeping It Simple
Your customer profitability calculations aren’t intended to be used as a basis for your company’s annual report and SEC filings. Those are essentially legal documents and follow very strict accounting standards. The main purpose of customer-level profitability is to differentiate more profitable customers from less profitable ones. Doing so gives you some freedom to make simplifying assumptions. Simplicity yields stability and consistency over time.
One decision you have to make has to do with the time period you include in a profitability calculation. It doesn’t make any sense to try to calculate customer profitability based on short time periods. Daily or weekly calculations would bounce around from negative to positive based on what the customer is doing, or more likely not doing, on any given day.
The time period you settle on depends a great deal on the nature of your business and your data. In the case of banks, a monthly calculation based on information from monthly statements might be the shortest time period that is even practical for a profitability calculation. But even monthly calculations could turn out to bounce around quite a bit.
As I discuss later in this chapter, you want to track customer profitability over time. In order for profitability measures to be meaningful from one time period to the next, they need to be consistent. You want changes in customer profitability over time to reflect changes in customer behavior. You don’t want those changes to be artifacts of changes in cost allocations.
In many cases, the most useful profitability calculation reflects a whole calendar or fiscal year. One advantage of using a whole year is that it you eliminate fluctuations due to seasonal purchase patterns. Another is that it simplifies cost allocations that may fluctuate throughout the year as well. Perhaps the biggest advantage is that you won’t be bouncing customers around from one marketing strategy to another based on short-term changes in profitability. A year lets you be consistent in your messages.
My wife and I typically take an annual vacation to the island where we got married. And we typically spend a lot of money to rent the honeymoon suite where we originally stayed. Suppose that resort were to focus on our quarterly profitability. They’d view us as unprofitable in the quarter before our visit. But that’s just when they need to be marketing to us to plan our annual trip.
Understanding Household-Level Profitability
Back in my banking days, I was involved in analyzing customer profitability. This was a relatively new topic at the time, and certainly new to the bank. The focus had always been around product profitability. Customer profitability started with product profitability. We calculated the value of each individual checking account, savings account, and so on. We then added up the profit from all of the accounts owned by each customer.
Management was already well aware that, at the individual product level, they had a whole lot of unprofitable accounts out there. (See the earlier sidebar on the 80/20 rule.) The vast majority of the bank’s profit was coming from a small number of accounts. And this was true in almost every product category. The same thing was true at the customer level. Most of the profit was tied to a relatively small number of customers. This led to much discussion about raising fees on checking accounts that were unprofitable. Trying to drive unprofitable customers away was discussed.
This discussion was somewhat tempered by the results of an analysis I did on household-level profitability. At first blush, it was more of the same. A small number of households accounted for a large portion of revenue, but they also accounted for a large proportion of the accounts. Unprofitable households averaged one or two accounts with the bank. Profitable households averaged many more. Some had a dozen or more accounts. This wasn’t really a surprise. The more widgets you sell, the more you make, right?
But what we found was that these high-value households contained a substantial number of very unprofitable accounts. They had unused credit cards, accounts with small balances, and high transaction volume.
This example points up the benefit of understanding the whole household. It would be potentially problematic to be raising fees on the husband’s checking account while waving them for his wife. That’s the sort of thing that will drive customers to a competitor.
Retaining Your Profitable Customers
Because your most profitable customers generate a large portion of your revenues, it’s important to keep them happy. By identifying those customers, you can focus some of your marketing investment on retaining them.
I’ve talked about customer reward cards before. Businesses from grocery stores to coffee shops have customer rewards programs. These programs tend to involve issuing a card that accumulates points toward discounts or free products. Often these cards let those businesses to track purchases at the customer level. What would otherwise be an anonymous cash purchase is tracked back to the customer via a swipe of the loyalty card.
You don’t necessarily need to give stuff away or provide discounts. Sometimes pampering your best customers is very effective. Loyalty programs that provide differentiated service to your best customers can be just as effective, if not more so, than financial rewards. Some theme parks offer early entry to season pass holders, for example. Department stores open their doors early to customers in their loyalty programs.
These so called surprise and delight strategies differentiate service and other benefits without discounting. This approach is quickly becoming a popular and effective way for marketers to reward loyal customers without cutting into already narrow profit margins. It’s also an effective customer retention strategy since it gives new customers an incentive to become more loyal.
My wife travels a great deal on business. She goes out of her way to use the same airline every time. She’s trying to accumulate frequent flyer points. The reason has nothing to do with flight discounts. It has to do with getting differentiated service. Early boarding privileges prevent her from having to check her luggage when the overhead bins get full. She frequently gets upgraded to first class which gives her more room to work while in flight.
Using Profitability to Find New Customers
You’re always looking for new customers. More precisely, you’re always looking for new profitable customers. Understanding what makes your current customers tick can help your acquisition and advertising campaigns. The basic idea is to profile your current profitable customers. Using all the data at your disposal, you want to find patterns that are associated with profitable customers. Ask questions like these:
Do they tend to come from a specific age group or set of age groups?
Do they tend to have incomes above a certain level?
Do they tend to have young children?
Are they concentrated in rural, suburban, or urban environments?
Are they mostly single or married?
Do they tend to buy certain products in particular?
Once you have a profile of your most profitable customers, you can target acquisition campaigns at people who fit it. You can use this profile to help your advertising team choose the best media for its messages.
You can also use this profile to buy lists for mail or e-mail campaigns. Many list brokers have a large amount of demographic data at their disposal. If you provide them with a specific customer profile, they can create a list of prospects that closely resemble that profile.
Dealing with Unprofitable Customers
Some businesses talk about “firing” their unprofitable customers. They may choose to raise prices or reduce service levels to drive these customers either into profitable territory or drive them away altogether. This is a somewhat risky strategy. Bad publicity is one potential negative consequence. But another is cutting off a potential future revenue stream. In some businesses, it takes time to move a customer into profitable territory. You may need to get customers in the door and then expand the relationship until it’s profitable.
Actively trying to drive customers away should be an approach of last resort. A more passive strategy is to just not spend a lot of time and effort marketing to unprofitable customers. If a customer isn’t profitable, it doesn’t make much sense to keep sending them discounted offers, for example.
It may also be possible to turn unprofitable customers into profitable ones by expanding the relationship. As discussed earlier in this chapter, the profitability of customers in the banking industry is at least partly related to the number of different products they have purchased. You may find a group of unprofitable customers who only have a checking account. It may be possible to turn them profitable by selling them a credit card and driving some of their transactions from the checking account to the credit card.
In developing a strategy to deal with unprofitable customers, it’s important to understand what’s behind the situation. Is it the product the customer buys? Or is it the way the customer is interacting with you? You might be far more likely to “fire” a customer who returns a large number of purchases than fire one who just doesn’t buy that much.
It Takes a Lifetime: Understanding Changes in Customer Profitability
A customer’s profitability is not a static measurement. People’s means and needs change over the course of their lives. As a consequence, their behaviors and buying habits change as well.
People move in and out of your business footprint. My wife and I have lived in three different states in the last three years. (We’re officially sick of moving.) This means we’ve changed everything from doctors to grocery stores. We’ve gone from profitable to unprofitable as we moved out of each area. The companies that don’t recognize these shifts are at a disadvantage. They waste money continuing to market to us once we’ve left their footprint. Or they miss an opportunity to connect with us at our new location.
Recognizing movements in customer profitability
Your customer base, as a whole, may appear fairly stable when it comes to profitability. Year over year, you may see about the same percentage of your customers in the ranges of high, medium, and low profitability. But upon closer examination, you will see that some customers are moving up and down among those ranges. By examining these migrations from one profitability range to another, you can begin to identify challenges and opportunities in your customer base. You can build profiles that help you identify customers who may be ready to move up the profitability scale.
Of particular concern to you is understanding customer attrition. That is, understanding how many customers are leaving. The percentage of customers you lose in a given time period is frequently referred to as your churn rate. You need to take a two-pronged approach to dealing with this churn:
Reduce your churn rate through customer-retention programs.
Replace the lost business through customer-acquisition programs.
You can approach customer acquisition through a combination of advertising and purchased lists. Acquisition also depends on recognizing people who are shopping for your products, particularly online. (I talk about customer retention in Chapter 10 and address aspects of customer acquisition related to converting shoppers into buyers in Chapter 12.)
Calculating Customer Lifetime Value
It’s quite helpful to understand the contribution your customer base will produce over the lifetime of your relationship. A common calculation in this vein is known as customer lifetime value or CLV. Giving a detailed explanation of the math behind this calculation is far beyond the scope of this book. It involves some degree of advanced knowledge of finance. But the basic idea is worth understanding.
Essentially, CLV takes into account two factors related to time:
The change in the value of money over time: This is done via the finance equivalent of a bird in the hand is worth two in the bush. Because money earns interest if you save it, a dollar in hand today is worth more than the promise of a dollar in the future. If the interest rate were 4.2 percent, I could deposit only 96 cents today and have a dollar a year from now. In that case, you’d discount every dollar of revenue you expect to get next year to 96 cents to make it equivalent to today’s dollar. Understanding the nuts and bolts of this calculation requires some advanced knowledge of finance. In particular, determining the interest rate to use in applying this principle depends heavily on what sort of revenue stream is being analyzed.
The churn rate: This is a measure of how many customers you expect to lose over the course of the year. If your churn rate is 5 percent annually, for example, you would only include 95 percent of next year’s expected revenue in your CLV calculation.
You (or your finance partner) perform these discount and churn calculations for each year going forward. You’ll have to choose a reasonable time period that represents the expected lifetime of your customer relationship. Once you do, you add up all the yearly contributions to get the customer lifetime value.
You can do this calculation at the individual customer level. But it doesn’t really represent what you can expect from an individual customer. The churn rate is what you expect to see across a particular profitability segment. It doesn’t tell you which customers are actually going to leave. CLV calculations should only help draw conclusions about customer segments.
One useful application of CLV is in budgeting. By knowing what you can expect to earn from a given segment over the entire lifetime of the relationship, you can make an informed decision about how much you want to invest in acquiring or servicing that segment.