Valuing customers: Part 1 — profitability based on past performance

Editor's note: This article is the first in a two-part series examining customer profitability. It is a look at profitability measured by past performance to be followed in part two by a detailed look at customer lifetime value.

Organisational strategies frequently reflect management's aspirations to improve the profitability of products, services, and customer relationships. The goals set to achieve this need to be SMART (specific, measurable, achievable, realistic, and timely). However, due to the complexities in measuring profitability, some organisations may fall back on measuring revenue alone, which is totally inadequate. When measuring performance, it is often quoted that, "Revenue is vanity, profit is sanity, but cash is king" — however, value is the ultimate measure. The challenge is to be able to generate these more insightful measures.

In this first part of a two-article series, we look at developing a view on profitability, a measure of past performance, while part two will explore customer lifetime value based on the discounted value of predicted future cash flows.

Revenue analysis

Products, services, and customers are often prioritised in relation to revenue streams directly associated with them. The Pareto principle, or "80-20 rule", states that 80% of outcomes are due to 20% of causes. This principle applies to a variety of situations, including natural phenomena, human activities, and even organisational performance. It has been found that sales revenue distribution for multiple line producers will regularly follow a Pareto distribution where 80% of their sales are generated by the top 20% of their products or services by sales value.

Whilst some may find this interesting, it provides very minimal and potentially misleading information to direct product and service strategy. It would not be wise to prioritise effort on these 20% of products or services. Rather than looking at revenue distribution, it is more informative to look at profitability.

Product profitability

Identifying relevant revenues to calculate profitability is often relatively straightforward. However, understanding the direct and indirect costs incurred in providing customers with products and services is far more challenging, as a March 2022 FM article, "Understanding Costs: Part 1 — Costing Concepts", described. Allocating costs to products can be difficult, but the assignment of costs to services is generally even more complex. However, this challenge needs to be mastered in order to generate a sufficiently accurate view on profitability.

The initial important consideration is whether to use actual or standard cost rates. With actual cost rates, volatility is likely to be introduced due to variations in the cost of resources engaged, the efficiency of activity completion, and differing customer demands. Standard cost rates will provide more consistent results but will not highlight the impact of changes in supply-and-demand factors. The most appropriate cost-rate approach should be determined by the intended use of the information and the level of homogeneity of the product or service (see the chart "Best Cost-Rate Approach to Satisfy Intended Use and Level of Homogeneity" below).

Best cost-rate approach to satisfy intended use and level of homogeneity

Very few organisations have products, services, channels, and customers that are homogeneous. Usually, they look to differentiate their offer for different customers in order to gain competitive advantage. However, as the proposition becomes more bespoke, the level of difficulty of accurate allocation of costs increases:

• With homogeneous offerings, straight transaction counts can be adequate.
• As the product becomes more differentiated, it is necessary for the transaction counts to allow for different duration times for the various cost objects.
• When products or services are bespoke, then direct tracing of volume, duration, and counts of other resources is required.

Having allocated costs to products or services, these direct costs are deducted from the product and service revenue to provide a value for gross profit.

The next step is to identify any sustaining costs such as research and development (R&D), design, process set-up, marketing, reporting, and environmental protection or restitution. Having identified these costs, they need to be related to the product, service, customer, or other category identified from the organisation's chosen costing approach. This will derive a net profitability figure.

Pricing

Organisations may price their products and services at a standard markup percentage above the more easily identified direct costs. This markup would be calculated to cover both the total sustaining costs and provide a target net profit margin. If all sustaining costs are allocated to products and services as one consistent markup percentage, then the net profitability distribution will follow the same Pareto distribution, and no benefit is gained compared to just analysing the revenue distribution.

Also, using a standard markup is rarely suitable to cover a fair allocation of sustaining costs, as they are likely to vary with the complexity of the organisation rather than by the volume of sales. Complexity can be driven primarily by the number of different products/services and then additionally by secondary factors such as geographies, languages, regulatory regimes, and customer channels. Therefore, the percentage markup to cover the sustaining costs is likely to be higher for low-volume products and services.

Profitability distribution

With improved allocation of sustaining costs resulting from activity-based costing, an organisation's profitability distribution was regularly found to follow a path that became known as a "whale curve" due to its shape (see the chart "Example Whale Curve Distribution" below). This shows that the top 20% most profitable products can create significantly more than 100% of organisational profits, with the remaining 80% of products either breaking even or losing profit. By adopting the right profit improvement strategies, massive improvements in profitability are achievable, but only if resources are profitably redeployed or the costs eliminated.

Example whale curve distribution

Resultant product and service profit improvement strategies may include process improvement, automation/digitalisation, redesign, policy changes, repricing, substitution, divestments, and, as a last resort, elimination.

Customer profitability

The point of calculating product or customer profitability is to inform better decision-making, which in turn leads to value-adding actions being taken. If the decision-maker has no control over some of the costs that are applied, this can lead to a lack of trust and reliance on the information. However, excluding the costs can misinform if the decision-maker's actions indirectly place demand on the capacity that drives these costs.

The calculation of product or service profitability is probably sufficient information for transactional organisations, such as consumer packaged goods, as the products are homogeneous and the customer relationship is often not known or managed.

For organisations that build their proposition around a customer relationship — such as professional services, banking, insurance, travel, and telecoms businesses — it is more valuable to look at measures of customer profitability. Additionally, the rapid growth in digitalisation and online offerings is creating new relationship-focused organisations in industries that previously may have offered only a transactional proposition: for instance, online shopping (eg, Amazon), taxis (eg, Uber), and takeaway food (eg, Just Eat).

For these customer relationship-focused organisations, a customer's product and service contributions can be aggregated with the direct customer income and sustaining costs to understand customer profitability (see the chart "Derivation of Customer Profitability" below).

Derivation of customer profitability

Historic profitability

Product, service, and customer profitability as measures have their shortcomings as they are backward-looking. As such, they can be of limited use for forward-looking operational and strategic management — the historic profitability is already reflected in sunk costs and realised benefits.

However, it does help to inform the starting assumptions to predict future profitability, cash flows, and value. Customer lifetime value is a forward-looking measure, based on the net present value of future cash flows that may be derived from a customer relationship. This can introduce more ambiguity and complexity into determining profitability, yet the insight gained can be far more useful for decision-making. In the second of this two-part series we will look to the future with customer lifetime profitability and value.

— Paul Ashworth, FCMA, CGMA, is a Jersey, British Isles-based practising management accountant, providing strategic insight and enabling business intelligence systems in financial and business services and public sector organisations. To comment on this article or to suggest an idea for another article, contact Oliver Rowe at Oliver.Rowe@aicpa-cima.com.