Measuring the profitability of a group of customers / products / contracts / suppliers can provide valuable insights into a business. It is often the case that a large proportion of profit is earned from a relatively small group, whilst other contribute very little or even destroy profit.
Challenges: In most cases it is straight forward to measure the revenue earned, however it is more difficult to measure the costs associated with the customer relationship, especially some of the less direct costs to serve. Activity Based Costing (ABC) can help with assigning indirect costs to a customer.
It is often irrelevant in practice to attempt to assign all indirect costs to a group of customers / products / contracts / suppliers. Instead a decision must be made as to where to draw the line between costs applied to a group and unallocated overheads. By doing this the profitability analysis is instead a measure of the contribution to overheads / profit. This approach generally provides much more relevant and useful information for decision making as there are no questionable assumptions involved.
In addition to customer profitability it is important to measure the overall value of the customer relationship; how long a customer takes to pay has a major impact on cash flow, some customer relationships may be unprofitable but essential to retain other more profitable customers, other customers may be unprofitable now but have the potential to be hugely profitable in the future. For each business the drivers of value may differ, this must be taken into account when assessing the value of a customer relationship.
The analysis provided has proven invaluable to many clients in a number of areas; customer negotiations, marketing strategy, pricing strategy, product offering, targeting new customers and in some cases terminating a customer relationship.
Profitability analysis should never just be about the one profit number. The analysis is infinitely more valuable when it shows the reasons why a customer is profitable or not; it may be that 90% of the products purchased by the customer yield a high return which is wiped out by the other 10%. By understanding the value of a customer relationship as well as the drivers of value behind it, you are well placed to make decisions to increase the overall value of the company.