Measuring Customer Profitability

by | Jul 21, 2017 | Business Strategies

Your P&L statement may measure the overall profitability of your business, but it falls short in terms of measuring the profitability of individual customers or services. To continually improve performance, every company should understand the economic building blocks that drive their business and have a deep understanding of their customers. For a company to be valuable to its shareholders it must also be valuable to current and future customers. Knowing how to grow customers into more profitable customers is essential to creating value and remaining competitive.

As companies evolve from a product-centric focus to a customer-centric business model, it’s important to keep in mind that not all customers are profitable. In truth, some high-maintenance customers can even be unprofitable. The true cost to handle one unit or serve one customer is a living barometer of profitability and should, therefore, be examined carefully.

Many companies’ managerial accounting systems are unable to accurately report the information used to rationalize which types of customers to retain, grow or win back and which types of new customers to target.

Accurately translating revenue into profitability requires a costing method that measures the cost to serve each customer or the cost to perform each service. This type of method is an economic or cost model of the business; it differs from an accounting model, which focuses on GAAP standards or financial statements. An economic model should focus on costs (inputs), cost drivers (activities), and how they relate to products or services (outputs). This model may be conceptual in nature or a complex system, depending on the needs of your business.

A costing methodology should provide accurate and relevant cost information, which is not the same as exact or precise cost information. In fact, we believe it can be a mistake to go to great lengths to provide exact information and lose sight of the intent of the analysis. Relevant cost information considers the decision at hand and does not necessarily require an ongoing costing system. It can be a point-in-time analysis that correctly measures customer or product profitability to support a specific decision. Depending on the business situation, direct activity costing information may involve analysis of fully-absorbed costs, incremental costs, historical costs or estimated future costs.

The process of developing a costing model is as important as the methodology itself. Traditional activity-based costing models are often useless for decision support. Every company has unique issues, including their core business model, time and resource limitations and access to data. A successful costing method for most small to mid-sized businesses will rely heavily on the 80/20 rule in applying 20% of the appropriate concepts to realize 80% of the benefits.

Employing a costing model in your company may help you increase your profitability and provide additional guidance in your decision-making processes. The professionals in our firm can assist you in developing these models and analyzing the results. If you would like to discuss how to measure customer or product profitability in your business, please feel free to contact us.