Customer Profitability Analysis

Advanced Management Accounting

Internal Assessment - 1

Name: Nainika jain

USN: 19BMSR084
Class: 5 BMS IF F

What is Customer Profitability Analysis (CPA)?

CPA is a managerial accounting method that allows businesses to determine

the overall profit a customer generates. A profitable customer is someone who
generates a revenue stream greater than the cost of their acquisition, selling,
and serving. Companies calculate the CPA on a customer level or for the
entire customer group. When companies are more focused on products,
departments, and locations of their offices, they often tend to lose focus on the
customers. As a result, the companies have to sometimes bear the cost of
maintaining unprofitable customers which is detrimental to their business.

CPA allows companies to evaluate their customers and know how beneficial it
is for them to keep the customers. Based on this value they can decide upon
the cost of serving them or even to decide whether to continue or let them go.
It has been found in a study that the size of the customer is not directly
proportional to their profitability. Sometimes even the large-sized customers
can turn out to be unprofitable ones for a business

Why Measuring Customer Profitability Is Important

Profitability is every business's goal. Many factors can influence how attainable and
sustainable it is, and the key factor is your customer profitability. Measuring customer
profitability is crucially important, and it can be an enlightening exercise.

Once you build the framework to run a customer profitability analysis, it should be
easier to refresh annually or as often as makes sense for your business. The
significant value you gain through running one is that you will determine if certain
customers are actually costing you money rather than making you money.
In some instances, you may find that the customer group you thought was the most
important (most profitable) is actually of lower value to your company than customer
segments you haven’t identified yet, which suggests a need for a shift in overall
strategy.

If you’re wondering how some customers could be costing you money, it usually
comes down to servicing costs.

Do you have certain customers who call customer service frequently? Are there
certain customers who have special requirements for fulfillment who require higher
labor and fulfillment costs? Or, if you offer customers free shipping and free returns,
are there customers who are using that service too much? You’ll start to uncover
these segments after you run a customer profitability analysis

Calculating Customer Profitability

Calculating customer profitability begins by identifying the various costs incurred
specifically in relation to servicing a specific customer or segment of customers.

For example, a solar panel company serves two types of customers:

Individuals and SMALL MEDIUM ENTERPRISE (SMEs) . For the attainment,
servicing, and retention of its customers, the company is required to
provide consulting and service visits, as well as process sale orders.
Individuals require only one site visit before placing an order.

SMEs require more frequent visits, as they are based in multiple locations
and are provided with after-sale service as part of the bulk purchase. The
customers’ behavior and profitability are given by the following table:
Application of Customer Profitability Analysis
From the given example, the customer profitability of the Individual
segment exceeds the SME segment. This insight then supports the
company in its strategic decisions. It can shift its focus towards attracting
and retaining more customers from the more profitable Individual segment.
Alternatively, it can look for cost reduction approaches for its SME
segment.

Potentially, it can work to redesign its purchasing process in order to

reduce the frequency of visits or orders. Otherwise, it can look to charge its
customers for additional service visits to shift the weight of the cost from
the company to the customer.
Benefits of Customer Profitability Analysis
These insights might not be attainable from traditional reporting methods.
In a company’s income statement, there is no granularity provided in the
calculation of its selling, general and administrative Expense line.

One of the most common marketing metrics of sales per segment may
also be misleading. If the company reported 120 customers in the
Individual segment and 80 customers in the SME segment, managers
might believe that SMEs contribute to two-thirds of their annual sales.
By following the Pareto 80-20 Rule, they conclude that they should focus on
this smaller group of customers that contribute to a larger share of annual
revenue. However, as we know from the added analytical granularity offered
by the above Customer Profitability Analysis, they would then be allocating
more resources to a less profitable customer segment.

By examining Customer Profitability rather than just sales, the company will
gain a more accurate insight into which customer segment is the stronger
driver of its overall profitability.

Criticism of Customer Profitability Analysis

The biggest criticism regarding Customer Profitability Analysis is the
selection of a limited time frame and segmentation criteria. However, with
the emergence of Big Data, customer profitability can be calculated using
new methods that determine a customer’s lifetime value rather than just
the sales within a restricted time frame.

Additionally, with respect to segmentation, predictive analytics will be able

to estimate the value of individual customers by identifying drivers in
behavioral patterns rather than just the value of the average customer in its
respective segment.