What Is Profitability?

Profitability refers to the potential of a venture to be financially successful. This may be assessed before entering into a business or it may be used to analyze a venture that is currently operating. Although it may be found that one set of factors is not likely to be successful or has not been successful, it may not be necessary to abandon the venture. It may instead be feasible to change operational factors such as pricing or costs. There are three basic situations that can describe a business financial situation. It can be profitable, it can break even, or it can operate at a loss. In most cases, an organizations goal is to make a profit. When there is constant or abundant cash flow, it can be difficult to determine profitability. It is easy for a person to make the mistake of linking numerous incoming and outgoing transactions with profit. Spending and receiving money, however, does not mean a business is in a healthy financial state. To determine profitability, it is necessary to access the price of the goods or services being offered. There are several things that need to be considered when prices are established. This includes variable costs such as fuel, labor, and inventory, and it also includes fixed costs such as mortgage, repairs, and taxes. Yield must also be considered. This refers to the amount of products or services produced within a certain time frame or from a certain amount of materials. For example, if a full tank of gas is only sufficient for two deliveries, the price is likely to be higher than it would be if a full tank of gas could accommodate six deliveries. If the price for two deliveries were priced the same as six deliveries, it is likely that profitability would be jeopardized. Tracking profitability may require two things. First, a business will likely need good and accurate records of its expenses. Second, depending on the size and complexity of the venture, a person with good accounting skills may be needed to ensure proper calculations. There may be a number of parties interested in the profitability of a particular venture. For example, sometimes people are owners of businesses but they are not operators, giving them a reason to be interested in the financial health and direction of the venture. Stakeholders who have money invested are also likely to be highly concerned with the profitability of a business. Employees, especially those at the managerial level, should also care because lack of profit can threaten job security and may damage a persons professional reputation.

Customer Profitability What makes a customer profitable? A profitable customer is a person, household, or company that over time yields a revenue stream that exceeds by an acceptable amount the company's cost stream of attracting, selling, and servicing that customer. Note that the emphasis is on the lifetime stream of revenue and cost, not on the profit from a particular transaction. Customer profitability can be assessed individually, by market segment, or by channel.

Although many companies measure customer satisfaction, most companies fail to measure individual customer profitability. Banks claim that this is a difficult task because a customer uses different banking services and the transactions are logged in different departments. However, banks that have succeeded in linking customer transactions have been appalled by the number of unprofitable customers in their customer base. Some banks report losing money on over 45 percent of their retail customers. There are only two solutions to handling unprofitable customers: Raise fees or reduce service support.

What Is Customer Profitability Analysis?

A customer profitability analysis is an evaluation process that focuses on assigning costs and revenues to segments of the customer base, instead of assigning revenues and costs to the actual products, or the units or departments that compose the corporate structure of the producer. Approaching profitability from this angle can sometimes provide valuable insights into how each step of the process of designing, manufacturing, and ultimately selling a good or service incurs cost and generates revenue. Many businesses use a customer profitability analysis as a means of streamlining processes so they provide the highest degree of efficiency and return, while generating the lowest degree of cost. In actual practice, a customer profitability analysis looks at each segment of the process of creating and selling products to customers. The idea is to look closely at the costs that are associated with each of those segments, and compare those costs with the gains that result from the processes and procedures connected with the operation of that segment. Breaking down the task into segments makes it much easier to identify what is actually working to increase profitability with a major client or a group of clients within the customer base, as well as what elements may be inhibiting the potential for earning more revenue from those same clients. Along with aiding in making sure that every aspect of the business operation is functioning in a way that allows for the generation of maximum profits, a customer profitability analysis can also help identify factors that could have a negative impact on the future of the company. For example, most customer profitability analysis templates allow for determining what percentage a given customer or group of customers actually make up of the overall client base, usually in terms of revenue generated. If the analysis makes it clear that the company is depending on two or three large customers to generate half or more of the its business volume, then steps are usually taken to diversify and expand the client base, often by attracting more small to mid-sized customers. As a result, the business is less likely to be crippled in the event that one of those major clients decides to withdraw, since the increased bank of smaller customers who are less likely to wander now accounts for a larger share of the monthly revenue. A proper customer profitability analysis will also look closely at how much of the companys resources are dedicated to producing goods and services for specific clients. The idea is to determine if the maximum benefit is being earned from the current use of those resources, or if there is some way to allocate a portion of those resources to other functions while still

satisfying the customer. Reallocating resources also makes it possible to engage in responsible cost allocation, which in turn strengthens the business over the long term.

Figure 5.3 Customers are arrayed along the columns and products along the rows. Each cell contains a symbol for the profitability of selling that product to that customer. Customer 1 is very profitable; he buys three profit-making products (PI, P2, and P4). Customer 2 yields a picture of mixed profitability; he buys one profitable product and one unprofitable product. Customer 3 is a losing customer because he buys one profitable product and two unprofitable products. What can the company do about customers 2 and 3? (1) It can raise the price of its less profitable products or eliminate them, or (2) it can try to sell them its profit-making products. Unprofitable customers who defect should not concern the company. In fact, the company should encourage these customers to switch to competitors. Customer profitability analysis (CPA) is best conducted with the tools of an accounting technique called Activity-Based Costing (ABC). The company estimates all revenue coming from the customer, less all costs. The costs should include not only the cost of making and distributing the products and services, but also such costs as taking phone calls from the customer, traveling to visit the customer, entertainment and giftsall the company's resources that went into serving that customer. When this is done for each customer, it is possible to classify customers into different profit tiers: platinum customers (most profitable), gold customers (profitable), iron customers (low profitability but desirable), and lead customers (unprofitable and undesirable). The company's job is to move iron customers into the gold tier and gold customers into the platinum tier, while dropping the lead customers or making them profitable by raising their prices or lowering the cost of serving them. More generally, marketers must segment customers into those worth pursuing versus those potentially less lucrative customers that should receive less attention, if any at all. Dhar and Glazer make an interesting analogy between the individuals that make up the firm's customer portfolio for a firm and the stocks that make up an investment portfolio.37 Just as with the latter, it is important to calculate the beta, or risk-reward value, for each customer and diversify the customer portfolio accordingly. From their perspective, firms should assemble portfolios of negatively correlated individuals so that the financial contributions of one offset the deficits of another to maximize the portfolio's risk-adjusted lifetime value.

COMPETITIVE ADVANTAGE Companies must not only be able to create high absolute value, but also high value relative to competitors at a sufficiently low cost. Competitive advantage is a company's ability to perform in one or more ways that competitors cannot or will not match. Michael Porter urged companies to build a sustainable competitive advantage. 38 But few competitive advantages are sustainable. At best, they may be leverageable. A leverageable advantage is one that a company can use as a springboard to new advantages, much as Microsoft has leveraged its operating system to Microsoft Office and then to networking applications. In general, a company that hopes to endure must be in the business of continuously inventing new advantages. Any competitive advantage must be seen by customers as a customer advantage. For example, if a company delivers faster than its competitors, this will not be a customer advantage if customers do not value speed. Companies must focus on building customer advantages. Then they will deliver high customer value and satisfaction, which leads to high repeat purchases and ultimately to high company profitability.

How Do I Do a Customer Profitability Analysis?

A customer profitability analysis compares what was earned from a given customer versus what was spent. Such analyses are important to improving your bottom line and to ensuring that sales efforts are aimed in the right direction. To perform a customer profitability analysis, you will need to select a client to analyze, assemble sales data for that customer for a set period of time and collect data on all expenditures associated with those sales. You will need to include not only hard costs such as materials and product production costs, but also soft costs such as customer service and account management time. You will then compare those numbers to see exactly how profitable the relationship has been. To begin a customer profitability analysis, choose a client and determine a time period to analyze. This might be one or more specific transactions; a calendar period, such as a year; or the life of the relationship. Gather all sales data from the time period you select. This data can most accurately be pulled from past invoices or from your accounting system. The next step is to assemble cost data for the same time period. The stronger your project management process is, the easier this step will be. You'll need to assemble invoices or costs for all physical goods or parts as well as time on machinery. You'll also need to assemble costs for time worked by employees, warehousing costs and cost of carrying capital if you did not receive an advance payment. Some businesses apply a value add formula to labor, which assumes that those costs would have been incurred regardless of whether the work was performed and so charges labor at a lower than actual rate. Complete your customer profitability analysis by subtracting the total costs from the total sales. If this number is negative, you lost money. If it is positive, you made money. To find out the profitability rate, divide the profit number by the total sales number. Compare the

resulting number against the rates of other customers and against your goals for this customer. Keep in mind that you should set the level of acceptable profitability for each customer. In some cases, this might be a set percentage across all customers. In others, it may vary by customer or vary based on your business' situation. For example, you might be willing to take on a new client at a low rate of profit as long as the potential to increase profitability exists. If over time, however, you find the profitability is not increasing, you may wish to let the customer go, or at least stop actively soliciting his business. Similarly, when your business is new, you might be willing to accept low rates of return in order to build a customer base and keep your business afloat. As you become self-sustaining, however, you might find that customers with low profitability rates are better replaced with other clients who are more profitable. A customer profitability analysis can help you make these decisions.

Customer Lifetime Value (CLV)

The case for maximizing long-term customer profitability is captured in the concept of customer lifetime value. Customer lifetime value (CLV) describes the net present value of the stream of future profits expected over the customer's lifetime purchases. The company must subtract from the expected revenues the expected costs of attracting, selling, and servicing that customer, applying the appropriate discount rate (e.g., 10%-20%, depending on cost of capital and risk attitudes). Various CLV estimates have been made for different products and services. Carl Sewell, in Customers for Life (with Paul Brown), estimated that a customer entering his car dealership for the first time represents a potential lifetime value of over $300,000.39 If the satisfied customer brings in other customers, the figure would be higher. Similarly, General Motors estimates its lifetime customers to be worth $276,000 on average. These six-figure values are a graphic illustration of the importance of keeping the customer satisfied for the life of the automobile to better the chances of a repeat purchase.40 Even though tacos may cost less than a dollar each, executives at Taco Bell have determined that a repeat customer is worth as much as $11,000. By sharing such estimates of customer lifetime value with its employees, Taco Bell's managers help employees understand the value of keeping customers satisfied." Mark Grainer, former chairman of the Technical Assistance Research Programs Institute (TARP), estimated that a loyal supermarket customer is worth $3,800 annually.42 We can work out an example of estimating CLV. Suppose a company analyzes its newcustomer acquisition cost: Cost of average sales call (including salary, commission, benefits, and expenses): $300 Average number of sales calls to convert an average prospect into a customer: 4 Cost of attracting a new customer: $1,200

This is an underestimate because we are omitting the cost of advertising and promotion, plus the fact that only a fraction of all pursued prospects end up being converted into customers. Now suppose the company estimates average customer lifetime value as follows: Annual customer revenue: $500 Average number of loyal years: 20 Company profit margin: .10 Customer lifetime value: $1,000 This company is spending more to attract new customers than they are worth. Unless the company can sign up customers with fewer sales calls, spend less per sales call, stimulate higher new-customer annual spending, retain customers longer, or sell them higher-profit products, it is headed for bankruptcy. Of course, in addition to an average customer estimate, a company needs a way of estimating CLV for each individual customer to decide how much to invest in each customer. CLV calculations provide a formal quantitative framework for planning customer investment and help marketers to adopt a long-term perspective. One challenge in applying CLV concepts, however, is to arrive at reliable cost and revenue estimates. Marketers who use CLV concepts must also be careful to not forget the importance of short-term, brand-building marketing activities that will help to increase customer loyalty. Customer Lifetime value (CLV) is a pretty simple, yet important and powerful, concept. Basically, youre asking this: How much profit can I expect to see from my relationship with an average customer?

At the basic level, this is an easy calculation. Lets take the publisher with a single product: Cost to Customer Cost of Product to Publisher = Profit per Sale If I am selling a book for $25, and it cost me $7 to produce that book, then my profit per sale is $18. For the single-product publisher, then, the CLV is $18. But what about the publisher with multiple products? You can measure CLV in a few ways. If you have a complete record of each sale, perhaps because you capture every customer email, then you can simply divide your total profit (revenues costs) by your total number of customers. Most publishers arent that lucky, though, so we get to estimate. Lets use the example of the three-product publisher. Product #1 MSRP: $25.00 COGS: $7.00 Profit: $18.00 Product #2 MSRP: $50.00 COGS: $27.00 Profit: $23.00

Product #3 MSRP: $4.00 COGS: $0.80 Profit: $3.20 Now lets assume that the publisher knows that 75% of customers that buy Product #1 also buy Product #2, and 50% of those same customers also buy Product #3. Calculation of Value for Product #1 $18.00 * 100% = $18.00 Calculation of Value for Product #2 $23.00 * 75% = $17.25 Calculation of Value for Product #3 $3.20 * 50% = $1.60 Total Value: $36.85 In the end, this publisher can reasonably expect that a new customer that purchases Product #1 will mean more than the original $18.00 in profit. In fact, this customer will mean an average of $36.85 in profit. This is a basic look at CLV.