How To Perform a Customer Profitability Analysis in 5 Steps
Updated June 3, 2022
Businesses use many types of metrics to track their growth, understand their profitability and make key business decisions. One important metric is a customer profitability analysis, which indicates how much profit the company earns per customer. In this article, we take a closer look at customer profitability, outline how to calculate it and explain the benefits of using it for your business.
What is customer profitability?
Customer profitability refers to how businesses calculate the profit they generate per customer. It factors in the expenses that businesses produce to gain and serve a particular customer and compares the expenses against the profit the customer brings. When customers generate more profit than businesses spend attracting and serving them, then businesses can consider them profitable. Businesses need to know how much profit they earn per customer so they can determine whether the expense of attracting and maintaining those customers is beneficial to meeting their financial goals.
How do businesses calculate customer profitability?
Businesses calculate customer profitability by determining the annual profit they generate per customer, which comes from determining their total annual revenue produced per customer and subtracting the total expenses incurred to serve customers over a year-long period. To calculate their annual per customer profit, businesses use this formula:
Annual profit = (total annual revenue the customer generates) - (total annual expenses used to serve the customer)
When determining the amount of revenue a customer generates, businesses factor in all sales made to the customer, including any recurring revenue they produce, any upgrades made to their service plan and all cross-purchases of similar or relevant products. To calculate expenses, businesses account for the cost of providing products and services, any expenses related to attracting and retaining customers, such as marketing, the expense of offering customer loyalty advantages and the cost of operations. After calculating their annual profit, businesses can determine the customer profitability analysis using this formula:
Customer profitability analysis = (annual profit) x (number of years the customer remains with the company)
What is a customer profitability analysis?
Customer profitability analysis is a formula that businesses use to understand how much profit an individual customer generates for their organization over time. It helps businesses evaluate whether the cost of providing services and marketing to gain and keep customers generates enough profit for them to continue with their current business strategy. Calculating customer profitability analysis relates to businesses calculating the profitability of their individual products or services in that understanding both measures allows businesses to track the revenue they earn by providing products and services that offer value to their customers.
Benefits of a customer profitability analysis
Performing a customer profitability analysis has several benefits for businesses. The benefits of performing this calculation include:
Minimizing cost factors
One benefit of doing a customer profitability analysis is identifying cost factors related to attracting and retaining profitable customers. A customer profitability analysis can help businesses identify their most profitable and least profitable customers and the expenses incurred for different market segments. By identifying the costs associated with each market segment, businesses can determine strategies for reducing the cost factors for their more expensive markets.
Another option is to stop serving markets that offer less profitability than others. Businesses can restructure their services to optimize their profits by cutting costs associated with less profitable customers and investing more in increasing the revenue generated by more profitable markets. For example, if they find the expenses related to a particular customer group are too high compared to the profit generated by that group, the business may choose to discontinue services to that group or find opportunities to reduce the cost of providing those services.
Targeting the right market segment
Besides reducing the costs associated with less profitable market segments, businesses can use their customer profitability analysis to identify their most profitable customers. Knowing what market segments produce the most profit for your business allows you to analyze that market to identify the key factors that contribute to its profitability. By understanding your most profitable markets, you can either apply similar business strategies to increase the revenue produced by other markets, or you can invest more in expanding and optimizing those markets that generate the most profit.
For example, once you've identified your most profitable markets, your marketing team can generate strategies to reach more potential customers that match your target demographic. Knowing the profit potential of serving a certain demographic can help your business establish a marketing and customer retention budget. When businesses understand their customers and the potential of their customers to produce profit, they can make the most of their opportunities to access and keep the customers that contribute the most to their financial goals.
Improving customer retention strategy
Businesses can use their customer profitability analysis to optimize their customer retention strategy for each market segment they serve. For example, businesses may wish to spend more on providing top-quality services and advantages to retain customers who offer a high rate of profitability. It's important for businesses to earn the loyalty of customers who generate the most profit for their business, even if that means raising the budget and increasing their expenses to retain those customers. For less profitable market segments, businesses may not be willing to incur additional expenses to retain customers who generate less profit.
The customer profitability analysis allows businesses to assess the expenses related to each marketing decision they make and compare that expense to the profit generated per customer earned or retained. Having data to compare expenses with potential profit can help your business make effective marketing decisions. The better you understand the relationship between marketing expenses, customer profitability and customer retention, the more refined you can be in strategizing your marketing budget for each of your market segments.
Increasing the efficiency of operations
Finally, calculating your customer profitability analysis can help you identify any operational reasons that explain why a certain market segment has a lower level of profit than others. For example, you might notice a higher amount of expenses related to a particular market. You may spend more money on marketing to a certain demographic without gaining the expected revenue from that group, indicating that the cost of operations to serve that market is ineffective. Identifying this issue allows you to make adjustments by lowering your marketing costs so they're better aligned with the profit gained.
How to calculate a customer profitability analysis
Here are the steps for calculating a customer profitability analysis:
1. Segment your markets
The first step to calculating customer profitability is segmenting your customers. The process for customer segmentation can vary by your industry. For example, some industries may rely on demographic information like customer age groups, income level and geographic area. Other businesses may rely more heavily on psychographic information, such as customer interests, values, needs and patterns of behavior. Some businesses may collect information in both these areas to gain a thorough understanding of who their customers are and how their customers' purchasing habits affect their business.
2. Attribute revenue to each market
Once you've identified each market segment for your business, determine the profitability for each segment. You can also calculate your total revenue by finding the sum of all segments combined. Factor in any adjustments, such as discounts and service fees, when calculating the revenue for each market.
3. Attribute costs to each market
Next, identify your expenses for each market. This number includes all marketing expenses and costs related to product development, customer retention, distribution and operations. Subtract the cost for each market from its revenue to calculate the profitability for each market segment.
4. Analyze the profitability of each segment
After calculating the customer profitability analysis for each of your market segments, analyze and classify your segments based on profitability. You can categorize your markets by those that promote high profitability, moderate profitability and low profitability to better understand how each segment contributes to your overall goals. Based on your data for each segment, analyze what factors cause each market to meet its level of profitability. Consider whether your current business strategies are working to optimize the profit gained from each of your market segments.
5. Implement strategies to maximize profit and assess
Finally, after analyzing your market segments, develop new strategies for maximizing your profit for each of your target markets. For any market that generates low profitability, consider whether you can improve your marketing strategies, reduce your costs of operations or eliminate services to that group to improve your overall profitability. After identifying your high-profit segments, consider how effective your customer retention strategies are for those groups. Also, determine whether you can invest more in marketing to customers who fit the profile of those in your high-profit market segments to gain more customers.
As part of your plan to implement new strategies, also plan to assess the effectiveness of these strategies. Set specific goals for improving your profitability and define how you plan to measure your progress. For example, you might identify a goal to increase the profitability of a particular market segment by 15% over a six-month period. After setting this goal, create a plan to reduce expenses or increase the revenue generated by the market segment. Assess the effectiveness of your plan throughout the six-month period and make adjustments as needed to reach your goal.
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