Customer Profitability Analysis

Customer Profitability Analysis (CPA) is a financial analysis technique that helps companies to measure the profit earned from each customer or customer segment. It is a tool used by businesses to determine the profitability of their customers. It helps identify and focus on high-profit customers and elements while minimizing the resources spent on low-profit ones.

This analysis enables companies to identify the most profitable customers and customer segments and understand the drivers of profitability. The purpose of customer profitability analysis involves gathering and analyzing data. Especially on the costs incurred to acquire, serve, and retain each customer and the revenues generated from each customer.

• Customer profitability analysis enables businesses to identify their profitable customers.
• It helps them allocate resources more effectively and develop targeted marketing strategies.
• Businesses can now identify the optimal price points for different customer segments and adjust their pricing strategies accordingly.
• It enables businesses to focus on the long-term profitability of their customer base rather than short-term gains.

Customer Profitability Analysis (CPA) is a financial management tool. It helps businesses to understand the profitability of their customers and customer segments. The basic idea is to identify the costs of acquiring and servicing each customer. After that, compare those costs to the revenues generated by each customer.

By understanding the profitability of each customer, companies can allocate their resources more effectively to improve overall profitability. In addition, it benefits businesses with many customers, allowing them to identify which segments are most valuable and which are not worth investing in.

The origins of it can be traced back to the 1970s when companies began to realize the importance of customer retention and loyalty. New technologies and data analysis techniques allowed businesses to gather more detailed information about their customers and behavior in the following years. This led to the development of CPA as a formal management tool.

Companies across various industries use it today, including retail, banking, and telecommunications. In addition, it is typically used with other customer relationship management (CRM) tools to optimize customer value and enhance customer loyalty.

The process of conducting a Customer Profitability Analysis (CPA) involves several steps, which are as follows:

1. Identify the customer base: The first step in conducting a CPA is identifying the customer base. This may involve segmenting customers based on demographics, geography, behavior, or other factors. This segmentation helps businesses to understand the unique needs and preferences of different customer groups and to tailor their products and services accordingly.
2. Collect data: Once the customer base comes to light, the next step is to collect customer profitability analysis data. This may include data on sales, costs, marketing expenses, and customer service costs. The data can be collected from various sources, including sales reports, financial statements, and customer surveys.
3. Analyze data: The collected data is then analyzed to determine each customer's or segment's profitability. This analysis may involve calculating the customer's revenue, the cost of acquiring and servicing the customer, and the profit generated by the customer. The study helps businesses understand which customers or segments are most profitable and which are not.
4. Identify drivers of profitability: Once the profitability analysis is complete, the next step is to identify the drivers of profitability. This may involve analyzing customer retention rates, product margins, and marketing effectiveness. By understanding the key drivers of profitability, businesses can develop strategies to optimize customer value and enhance customer loyalty.
5. Develop strategies: Based on the insights gained from the CPA, businesses can develop strategies to improve customer profitability. These strategies may include targeting high-value customers with special promotions, reducing costs associated with low-value customers, or improving customer service to increase retention rates.
6. Implement and monitor strategies: The final step in the CPA process is to implement the identified strategies and monitor their effectiveness. This may involve tracking customer behavior, analyzing sales data, and measuring customer satisfaction. The monitoring process helps businesses evaluate their strategies' effectiveness and adjust as needed to improve customer profitability.

The formula for customer profitability analysis calculation involves several steps, as follows:

1. Determine the revenue generated by the customer: Multiplying the price of the product or service by the quantity purchased.

Revenue = Price x Quantity

2. Determine the cost of goods sold: This includes all direct costs of producing the product or service, such as materials, labor, and overhead.

COGS = Direct Costs + Indirect Costs

3. Calculate the gross margin: The revenue minus the COGS represents the profit earned on each sale.

Gross Margin = Revenue - COGS

4. Determine the cost of servicing the customer: This includes all costs associated with marketing, sales, and customer service, such as salaries, commissions, and advertising.

Cost of Servicing = Marketing Costs + Sales Costs + Customer Service Costs

5. Calculate the net profit: This is the gross margin minus the cost of servicing the customer and represents the profit earned after all expenses have been considered.

Net Profit = Gross Margin - Cost of Servicing

6. Determine the customer lifetime value (CLV): This is the total net profit a customer earns during their relationship with the business.

CLV = Net Profit x Customer Lifetime

The formula for calculating customer profitability is further refined by segmenting customers as per their value to the business. For example, high-value customers may be assigned a higher profit margin, while low-value customers may be given a lower profit margin.

In addition, the formula can identify areas where costs can be reduced or revenue can be increased to improve profitability. For example, suppose the cost of servicing a particular customer is too high. In that case, the business may consider reducing the level of service provided or increasing the price of the product or service.

Let us understand it in the following ways.

Example #1

Suppose a business that sells fitness equipment wants to calculate the profitability of one of its customers, John. John has purchased ten pieces of equipment from the company over the past year, including five weights and 5 exercise machines.

Using the customer profitability formula, the business can calculate the following:

1. Revenue: John spent a total of $5,000 on fitness equipment over the past year, so his revenue can be calculated as follows:

Revenue = Price x Quantity

    = $500 x 10

    = $5,000

2. COGS: The business's cost of goods sold for each item sold to John was $250, so the total COGS for John's purchases was $2,500.

COGS = Direct Costs + Indirect Costs

= $250 x 10

= $2,500

3. Gross Margin: The business's gross margin for John's purchases can be calculated by subtracting the COGS from the revenue.

Gross Margin = Revenue - COGS

            = $5,000 - $2,500

             = $2,500

4. Cost of Servicing: The business spent $1,000 on marketing, sales, and customer service for John over the past year.

Cost of Servicing = Marketing Costs + Sales Costs + Customer Service Costs

     = $500 + $300 + $200

      = $1,000

5. Net Profit: The business's net profit for John's purchases can be calculated by subtracting the cost of servicing from the gross margin.

Net Profit = Gross Margin - Cost of Servicing

      = $2,500 - $1,000

      = $1,500

6. Customer Lifetime Value: The business estimates that John will continue to purchase fitness equipment from them for the next two years. Therefore, John's customer lifetime value can be calculated as follows:

CLV = Net Profit x Customer Lifetime

         = $1,500 x 2

         = $3,000

Based on this analysis, the business can conclude that John is a profitable customer with a lifetime value of $3,000. Accordingly, the business may develop strategies to retain John as a customer and increase his importance to the company, such as offering him loyalty discounts or cross-selling additional products.

Example #2

One real-world example of direct customer profitability analysis in the news is the Delta Airlines case. In 2022, Delta announced that it would reduce the number of flights to smaller regional airports to focus on more profitable routes.

Delta used customer profitability analysis to identify which routes and customers generated the most revenue and profit. Delta could determine which courses were the most profitable and which customers were the most valuable by analyzing ticket prices, flight frequency, and customer loyalty.

Based on this analysis, Delta decided to reduce the number of flights to smaller regional airports that needed to generate more revenue or profit. Instead, the airline focused on expanding its service on more profitable routes and increasing its business travel market share, which is typically better than leisure travel.

CPA is a valuable tool for businesses that want to improve their profitability by better understanding the value of their customer base. Some of the advantages and disadvantages of it are -

Advantages of Customer Profitability Analysis:

1. It helps businesses identify and focus on their most profitable customers, increasing revenue and profitability.
2. To create more successful marketing campaigns, it offers insights into the behavior and preferences of consumers.
3. It allows businesses to allocate their resources more effectively, ensuring they invest in activities that generate the highest return on investment.
4. It helps businesses to identify and manage unprofitable customers, reducing the resources and costs associated with servicing them.
5. It enables businesses to optimize pricing strategies by identifying the optimal price points for customer segments.

Disadvantages of Customer Profitability Analysis:

1. Implementing it can be time-consuming and expensive, requiring significant investment in data collection, analysis, and software tools.
2. This may lead to more attention to customers who are not currently profitable but can potentially become profitable.
3. It may not account for intangible benefits a customer may bring to the business, such as word-of-mouth referrals or brand loyalty.
4. This may lead to a focus on short-term profitability over long-term customer relationships, which can damage the reputation and trust of the business.
5. The precision and dependability of the data used to produce customer profitability indicators may have a limit on it.

This article has been a guide to what is Customer Profitability Analysis (CPA). Here, we explain it with its examples, advantages, disadvantages, steps, and formula. You may also find some useful articles here -

• Customer Churn
• Customer Acquisition
• Customer Retention