What Makes a Customer Profitable? – Valutrics

A profitable customer is a person, household, or company that over time yields a revenue stream that exceeds by an acceptable amount the company’s cost stream of attracting, selling, and servicing that customer. Note that the emphasis
is on the lifetime stream of revenue and cost, not on the profit from a particular transaction.
Customer profitability can be assessed individually, by market segment, or by channel.
Although many companies measure customer satisfaction, most companies fail to measure individual customer profitability. Banks claim that this is a difficult task because a customer uses different banking services and the transactions are logged in different departments. However, banks that have succeeded in linking customer transactions have been
appalled by the number of unprofitable customers in their customer base. Some banks
report losing money on over 45 percent of their retail customers. There are only two solutions to handling unprofitable customers: Raise fees or reduce service support.

PROFITABILITY ANALYSIS A useful type of profitability analysis is shown in the
Figure  Customers are arrayed along the columns and products along the rows. Each
cell contains a symbol for the profitability of selling that product to that customer. Customer
1 is very profitable; he buys three profit-making products (PI, P2, and P4). Customer 2 yields
a picture of mixed profitability; he buys one profitable product and one unprofitable prod-
uct. Customer 3 is a losing customer because he buys one profitable product and two
unprofitable products.
What can the company do about customers 2 and 3? (1) It can raise the price of its less
profitable products or eliminate them, or (2) it can try to sell them its profit-making prod-
ucts. Unprofitable customers who defect should not concern the company. In fact, the com-
pany should encourage these customers to switch to competitors.
Customer profitability analysis (CPA) is best conducted with the tools of an accounting
technique called Activity-Based Costing (ABC). The company estimates all revenue coming
from the customer, less all costs. The costs should include not only the cost of making and
distributing the products and services, but also such costs as taking phone calls from the
customer, traveling to visit the customer, entertainment and gifts—all the company’s
resources that went into serving that customer. When this is done for each customer, it is
possible to classify customers into different profit tiers: platinum customers (most prof-
itable), gold customers (profitable), iron customers (low profitability but desirable), and lead
customers (unprofitable and undesirable).
The company’s job is to move iron customers into the gold tier and gold customers into
the platinum tier, while dropping the lead customers or making them profitable by raising
their prices or lowering the cost of serving them. More generally, marketers must segment
customers into those worth pursuing versus those potentially less lucrative customers that
should receive less attention, if any at all.
Some researchers make an interesting analogy between the individuals that make up the
firm’s customer portfolio for a firm and the stocks that make up an investment portfolio.
Just as with the latter, it is important to calculate the beta, or risk-reward value, for each
customer and diversify the customer portfolio accordingly. From their perspective, firms should assemble portfolios of negatively correlated individuals so that the financial contributions of one offset the deficits of another to maximize the portfolio’s risk-adjusted
lifetime value.

The case for maximizing long-term customer profitability is captured in the concept of customer lifetime value. Customer lifetime value (CLV) describes the net present value of the
stream of future profits expected over the customer’s lifetime purchases. The company must
subtract from the expected revenues the expected costs of attracting, selling, and servicing
that customer, applying the appropriate discount rate (e.g., 10%-20%, depending on cost of
capital and risk attitudes). Various CLV estimates have been made for different products and
services.

CLV calculations provide a formal quantitative framework for planning customer investment and help marketers to adopt a long-term perspective. One challenge in applying CLV
concepts, however, is to arrive at reliable cost and revenue estimates. Marketers who use
C L V concepts must also be careful to not forget the importance of short-term, brand-building
marketing activities that will help to increase customer loyalty.