Profit sits at the heart of any business model, but there are multiple approaches to increase it. If your business deals with customers, you may assign a customer lifetime value to each client. Another option is to examine the revenue that each customer generates using a customer profitability analysis. There are multiple benefits to understanding customer profitability, which we’ll explore below.
Understanding customer profitability analysis
A customer profitability analysis (CPA) looks at the revenue (or profit) that each individual customer generates. While activity-based costing examines individual cost drivers to determine the profitability of a product, a customer profitability analysis applies this same approach to customers. Typical costs for customer retention include things like marketing, customer service, fulfillment, and other operations expenses.
In other words, you can look at the cost of providing service to a customer. With CPA, a profitable customer would be one that generates revenue greater than the cost of these expenses. It’s often a useful approach for service providers or SaaS companies, which focus more on customer acquisition rather than product sales. This type of profitability analysis can often yield surprising results. It’s not always the biggest customers who generate the highest revenues. Customer benefits can come from smaller clients with brand loyalty.
How do you calculate customer profitability?
The first step in calculating CPA is to figure out the annual profit per customer. You’ll also need to know the duration a customer has stayed with your business.
Annual Profit = (Total annual revenue generated by the customer) – (Total annual costs of serving the customer)
To find revenue, simply add up all the sales of products or services. This might include recurring revenue, upgrades to existing plans, and cross-purchases of similar products.
To find expenses, you should consider the money spent on customer service, operational costs, and customer benefits.
Once you’ve determined annual profit, you can plug this into the profitability formula:
CPA = (Annual Profit) x (Time spent with company)
Why should you calculate customer profitability?
Once you’ve calculated profitability using the formula above, what can you do with it? There are several benefits.
CPA enables cost-based customer segmentation. You can group customers into segments based on the value they generate. While it’s still important to focus business efforts on groups that generate lower profits, there may be some that actually cost more than the revenue generated. In these cases, it might be more financially viable to cut these customers loose.
You can market services more effectively. In addition to eliminating clients that don’t generate any profit, you can focus your marketing efforts on those customers that generate the highest profits. Spend more time analyzing this group to attract similar high-revenue customers through marketing.
Boost your customer retention strategy by tailoring your efforts to each segment. Higher-profit customers should be given the highest-quality services. With a profitability analysis, you’ll have a better understanding of the costs involved in building customer loyalty.
How to perform a customer profitability analysis
Using the customer profitability formula is just one step in performing a profitability analysis. In addition to defining customer costs, the next step is segmentation. Your business might already have clearly defined customer segments based on geographic location or other physical attributes, but this type of analysis lets you go deeper. Use tools such as market research, user data, and poll data to explore why certain customers generate more profit than others.
A data-driven approach gives clear insight into things like product returns, customer service contacts and marketing spend. You’ll be able to break down average cost per customer-related activity, including:
Average customer service contact per order
Average return rates
Average shipping costs
Marketing costs per order
Examining all these costs and plugging the data into the formula above can reveal fresh insights into which customers generate the highest profits and why.
Ultimately you can use these figures to develop new strategies to increase customer loyalty and retention rates, while creating higher-value relationships.
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