Customer Profitability: In this article, we are covering the third part of Customer Relationship Management Complete Notes which is important for different competitive exams like Business and Marketing Exams, Management and Leadership Exams, Information Technology Exams, Sales and Customer Service Certification Exams, MBA Entrance Exams, Industry-Specific Exams etc.
Table of Contents
Notes on Customer Profitability
This is the third part of CRM Notes – Customer Profitability where we are going to cover Introduction of Customer Profitability, Customer Profitability Management, Measure and Evaluate Customer Profitability Management, Customer Life Time Value, Selection of Profitable Customer Profitability, Customer Profitability Analysis, Customer Retention and Customer Defection.
Introduction of Customer Profitability
Organizations use customer profitability analysis to identify the most valuable customers or customer segments to prioritize marketing, sales and service investments. By studying profitability metrics such as lifetime value, repeat purchase rate, and churn rate, analysts can identify profitable segments, uncover defining characteristics of those segments and target similar populations for acquisition.
Similarly, retention programs may be created for particularly profitable customers. Business intelligence provides the statistical and data mining capabilities to calculate lifetime value, identify product affinities for cross-sell campaigns, and perform predictive analysis of profits resulting from additional marketing investment.
Customer segments or individual customers may be further investigated through ad hoc analysis, lists of customer segments may be automatically generated, or alerting rules may be applied to customer segments to automatically notify relationship managers when profitable customers have executed a transaction.
Within any given customer base, there will be differences in the revenue’s customers generate for the firm and in the costs the firm has to incur to secure those revenues. While most firms will know the customer revenues, many firms are unaware of all costs associated with customer relationships.
In general, product costs will be known for each customer, but sales and marketing, service, and support costs are mostly treated as overhead. Customer profitability analysis (CPA) refers to the allocation of revenues and costs to customer segments or individual customers, such that the profitability of those segments and/or individual customers can be calculated.
The impetus for the increasing attention for CPA is twofold. Firstly, the rise of activity-based costing (ABC) in the 1990s led to an increased understanding of the varying extent to which the manufacturing of different products used a firm’s resources (Cooper & Kaplan, 1991; Foster & Gupta, 1994). When using ABC, firms first identify cost pools: categories of activities performed within the organization (e.g., procurement).
For all cost pools, cost drivers are identified: units in which the resource consumption of the cost pool can be expressed (e.g., number of purchase orders). Costs are then allocated to cost objects (e.g., products) based on the extent to which these objects require certain activities (measured in cost driver units). Once it became accepted that not every product requires the same types and same levels of activities, it was a small step to see that customers, too, differ in their consumption of resources.
The size and number of orders, the number of sales visits, the use of helpdesks, and various other services can be very different for each customer. Consequently, some customers incur more relationship costs than others, leading to different levels of customer profitability. Although this has long been recognized, it fits better in the logic of ABC than in the traditional costing systems. Secondly, information technology makes it possible to record and analyze more customer data—both in type and in amount.
As data such as number of orders, number of sales visits, number of service calls, etc. is stored at the level of the individual customer; it becomes possible to actually calculate customer profitability. It is considered good industrial marketing practice to build and nurture profitable relationships with customers. To be able to do this, a firm should know how current customer relationships differ in profitability, as well as what customer segments offer higher potential for future profitable customer relationships.
CPA can deliver such knowledge. While many publications extol the virtues of knowing which customers are profitable and which are not (Cooper & Kaplan, 1991; Jacobs, Johnston, & Kotchetova, 2001; Shapiro, Rangan, Moriarty, & Ross, 1987; Storbacka, 1997), most publications provide no more than a cursory description of the actual implementation process of CPA. One notable exception is the case description by Noone and Griffin (1999) set in the hotel market. Firms operating in industrial markets face specific implementation issues however.
These issues are related to characteristics such as the use of account management and personal selling, indirect selling via distributors, maintenance and repair services, demonstrations of equipment at customer sites, and extensive discounting and bonus structures for customers and distribution partners. The objectives of this article are to develop a general approach for the implementation of CPA in industrial firms and to share what was learned from the actual implementation of such a process in one national subsidiary of a multinational industrial firm.
Customer Profitability Management (CPM)
Managing profitability requires not only a customer-centric focus but also a thorough understanding and effective management of customer profitability. Customer profitability management is a strategy-linked approach to identifying the relative profitability of different customers or customer segments in order to devise strategies that add value to most profitable customers, make less-profitable customers more profitable, stop or reduce the erosion of profit by unprofitable customers, or otherwise focus on long-term customer profitability.
Managers are often surprised to find out that a small percentage of customers generate substantially more than 100% of profits, and the remaining customers are either breakeven or unprofitable. Using a customer profitability management system replaces intuitive impressions of customer profitability with fact-based information and supporting analysis.
The backbone of a CPM system is a costing system that is focused on tracing and causally assigning costs to each customer or customer segment without arbitrary broadly averaged cost allocations. Assigning revenues to customers or customer segments can present a few issues, but the major challenge in implementing a CPM system is the selection and implementation of an accurate and informative costing system. A costing system should not only accurately assign product costs and gross margin to customers or customer segments, but it should also assign the costs to serve.
Cost accuracy and visibility are important in CPM. Using Time-driven Activity-based Costing (TDABC) provides costs that identify resource consumption by customers or customer segments.
The signals provided by the CPM system, based on full costing of traceable costs to customers and making visible business-sustaining costs, will lead management to consider strategies to increase profits. The signals do not provide answers in themselves, but they could lead to generating alternative courses of action. Decisions related to customer profitability strategies require tailor-made analysis.
There are system issues that must be considered in the design and implementation of a CPM system. Awareness of the commitment of time, financial, and personnel resources required by a CPM system is critical to its success.
Investments in customers should be considered in view of an estimate of customer life value. That is, in addition to current customer profits, the potential of generating future profits from a customer should also be considered. Managing customer life value is a means to enhancing long-term profitability.
Essential to the success of CPM is the buy-in by employees and managers who will be affected by its implementation. Resistance to change is a phenomenon that applies equally to CPM as it does any other organizational change. To develop the CPM system and then seek the support of employees and managers is not likely to result in developing a sense of ownership, nor will it guarantee an effective CPM system. To get employees and managers to buy in at the outset, they should be involved in its development and their ideas must be sought. Only with a sense of ownership will the organization be able to navigate the troubled waters of change.
Customer Profitability Management focuses upon an organisation’s most profitable customers and products with the aim of improving “bottom line” performance. According to Marko Seppanen and Jouni Lyly-Yrjanainen (2002) of the Cost Management Centre at the Tampere University of Technology, over the past decade the focus of management accounting has shifted from product-based costing towards customer profitability management. The authors cite a Connolly and Ashworth (1994) statement that profitability analysis in its development has moved through three distinct phases i.e.:
- Product or brand profitability analysis
- Market sector, or customer account, profitability analysis
- Customer profitability analysis
Measure and Evaluate Customer Profitability Management
The following provides an indication of how Customer Profitability Management processes may be assessed:
- Customer Lifetime Value (CLV), e.g., customer lifetime revenue potential-lifetime costs = customer lifetime value. CLV is a measure of customer profitability over the lifetime of the organization/customer relationship.
- Customer Loyalty, seeks to measure overall customer loyalty. This may be presented as an index and used in conjunction with other leading measures such as customer satisfaction to predict market trends and assess current organizational performance. Customer loyalty can be quantified using an aggregation of loyalty measures such as repeat purchases, no. of different products purchased, relationship duration, and loyal customers.
- Customers – Loyal, e.g. (a) number of current customers not purchasing, or intending not to purchase, new competitor products as a % of total current customers, or (b) % of customers of particular duration or longer. This measure provides an indication of customer retention/loyalty. The first formula could be used where repeat purchases are not measurable due to the nature of the product or service offered. Typically, this can be measured by survey.
- Customer Relationship – Duration, is the average duration of relationships of an organization with its customers or, the duration of relationships with key/individual customers
- Customer – Projected Retention, is commonly measured via surveys and is expressed as the ‘number of customers over the past year who intend to repurchase as a % of total number of customers. This measure provides an indication of projected customer retention/loyalty and may be effective in the measurement of current customer satisfaction as opposed to measurements relating to customers already lost.
- Customers – Value of Key Customers, e.g. (a) value of total sales or contracts to key customers as a % of total value of gross sales or contracts, per period, or, (b) value of sales or contracts gained through referrals from key customer as a % of total sales or contracts. This is a measure of the performance of identified key customers, allowing the effectiveness of special relationship strategies to be assessed and refocused as necessary.
- Customer – Repeat Purchasers, e.g. (a) number of repeat purchase customers over the past year as a % of total number of customers or, (b) Value of repeat sales as a % of total sales or, (c) % of purchases by current customers. This measure provides an indication of customer retention/loyalty.
- Customer Account Profitability, e.g., profit from customer account/sales turnover of customer account. This is a measure of the value of specific customer accounts.
- Customer Acquisition Cost, e.g., average cost of attracting new customers. This is a measure of the cost involved in attracting or retaining customers.
- Return on Investment (ROI), e.g., net profit before taxes/total assets. This measure provides an indication of how well profits are being generated from use of the organization’s resources. A measure commonly used to compare performance between organizations; ROI is useful for assessing an organization’s competitive advantage. In this context it can be used to track the success of a CPM initiative.
- Market Share Projection, e.g., projected % total market sales accounted for by company’s products. This is a measure of projected market share, commonly used in setting goals or targets in new product promotions or when penetrating new markets with existing products.
Customer Life Time Value
- Customer lifetime value (CLV), lifetime customer value (LCV), or lifetime value (LTV) is the net present value of the cash flows attributed to the relationship with a customer.
- The use of customer lifetime value as a marketing metric tends to place greater emphasis on customer service and long-term customer satisfaction, rather than on maximizing short-term sales.
- Building Profitable Customer-Centric Strategies: Maximizing Profit Potential
- Our high-impact processes for becoming more customer-centric and creating innovative strategies will be valuable only if we can effectively deliver on these profitably.
Selection of Profitable Customer Profitability
- We first understand the key factors that will drive profitability for customer insight initiatives.
- During the innovation stage, the objective was to creatively generate new sources for capturing intelligence from customers and creating insight that could enhance the way we communicate and sell to customers.
- As you learn more from customers about their needs and preferences, you have the opportunity to better target your marketing messages, offers and channels, which ultimately leads to reduced marketing expenses and increased conversion rates.
- Customer life time value
The key factors that will drive the profitability of customer insight initiatives include these:
- Reaching high-value customers and prospects
- Capturing intelligence on a critical mass of customers to justify the fixed costs of setting up and managing the program
- Generating incremental profits from increased sales to new customers, higher customer retention, selling more to existing customers or winning back lost customers
- Reducing costs of delivering solutions and servicing customers
- Capturing intelligence cost-effectively
- Building the ability to influence customer profitability over time
Customer Profitability Analysis
Typically, traditional cost accounting is not able to identify product and service costs or distribution and delivery costs for individual customers. ABC can help identify customer activities and track those costs that are allocated to specific customers. This can provide management with unique information about customers and customer segments. The benefits include:
- protecting existing highly profitable customers;
- repricing expensive services, based on cost to serve;
- discounting to gain business with low cost to serve customers;
- negotiating win-win relationships that lower service costs to co-operative customers;
- conceding permanent loss customers to competitors; and
- attempting to capture high-profit customers from competitors
Medical science teaches us the “life is in the blood”. When blood stops flowing, life stops very quickly. It is the same with our businesses; customers are the life blood of our business. When we stop having a “flow” of customers, our business will die very soon. So, it is very important to acquire and keep customers. Our business is not about ourselves; it is about our customers. The focus of your business shouldn’t be on yourself; rather it should focus on your customers. They are not really interested in how long you have been in business or how much education you have.
Customers are interested in what your business can do or provide for them. We call these “customer benefits”. The dynamics of the business ecosystem have changed the way in which companies do business both in relationship management and the streamlining of their operations. Relationship marketing is emerging as the core marketing activity for businesses operating in fiercely competitive environments. On an average, businesses spend six times more to acquire new customers than to keep them.
Therefore, many firms are now paying more attention to their relationships with existing customers to retain them and increase their share of customer’s purchases. The practice of relationship marketing also has the potential to improve marketing productivity through improved marketing efficiencies and effectiveness.
Customer retention is the key to any organization’s effectiveness. Customer centric approach to marketing programme helps retain customers and win back lost customers. An organization needs to study the needs of the various market segments and design the marketing programmes tailor made to suit the segments. Customer anticipates several things from the company in addition to the product; which the firm has to study well to bridge the gaps between customer expectations and firm’s delivery.
Customer retention is the activity that a selling organization undertakes in order to reduce customer defections. Successful customer retention starts with the first contact an organization has with a customer and continues throughout the entire lifetime of a relationship.
A company’s ability to attract and retain new customers, is not only related to its product or services, but strongly related to the way it services its existing customers and the reputation it creates within and across the marketplace.
STRATEGIES FOR CUSTOMER RETENTIONS
- SETTING SATISFACTORY SERVICE STANDARDS
- CONCENTRATION ON COMPETITORS
- CUSTOMER ANALYSIS
- COST ANALYSIS
- CONCENTRATION ON THE PAYING ABILITY OF CUSTOMERS
- KNOWLEDGE ON PURCHASE BEHAVIOUR PATTERN
- DIFFERENCIATION IN PRICES AND QUALITY STANDARDS
- FOCUS ON REDUCING DISSATISFACTION
- ATTENTION ON CHANGING REQUIREMENT OF CUSTOMERS
- CONCENTRATION ON PERFORMANCE
- TRAINING TO SUPPLY CHAIN EMPLOYEES
- EMPOWERMENT TO SERVICE PROVIDERS
- INCENTIVIZING SERVICE PROVIDERS
- AUGMENTING INTANGIBLE BENEFITS
- VISIT TO THE POINT OF USAGE OF THE PRODUCT
- DEVELOP PARTNERSHIP WITH CUSTOMERS
- ORGANIZING CUSTOMER CLUBS
- RELATIONSHIP BASED PRICING SCHEMES
- EFFECTIVE CUSTOMER COMMUNICATION SYSTEM
- CUSTOMER COMPLIANT MONITORING CELL
- DEVELOPING CUSTOMER SATISFACTION INDEX
- FOCUS ON PREVENTIVE ACTIONS
- CONCENTRATION ON CUSTOMER SATISFACTION RESEARCH
- FOCUS ON FOCUS GROUP
- BUILDING SWITCHING BARRIERS
Customer defection is the rate at which customers defect or stop the usage of products of a company. business with high defection rate, would be losing their existing customers.
In order to overcome this, they use another term of customer retention, in simple words it’s to retain or prevent the existing customers to defect the product.
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Types of Defection
- Price Defectors
- Product Defectors
- Service Defectors
- Market Defectors
- Technological Defectors
- Organizational Defectors
Strategies for Prevention of Defection
Every customer that you keep represents at least three that you don’t have to attract. Numerous research studies indicate that the cost of acquiring a new customer usually runs from two to four times the annual cost of keeping an existing customer. Obviously, an effective customer retention strategy translates into profits.
It has been estimated that most companies spend about 98 percent of their time reacting to problems and less than 2 percent preventing them. The first, most important, way to prevent customer defections is to identify and define each problem from the customer’s vantage point.
Superior service and database management provide your best defense against customer defections. Service provides the opportunity to solve customer problems and build partnerships; the database serves as a vehicle to personalize customer communication and enhance your relationships.
FAQs on Customer Profitability
What is meant by customer profitability?
Customer profitability can also provide an estimate of firm value, thus providing a link between marketing investment and shareholder return. The premise of customer-based valuation is simple. If the customers are the key profit generators of a firm and we can estimate the lifetime value of each customer, the current and future customer base of a company should provide a good proxy for its market value.
What is meant by customer acquisition?
Customer acquisition management is a term used to describe the methodologies and systems to manage customer prospects and inquiries, generally generated by a variety of marketing techniques. It can be considered the connectivity between advertising and customer relationship management. This critical connectivity facilitates the acquisition of targeted customers in an effective fashion.
What is meant by customer defection?
Customers often take their business to competitors when they feel that their needs or wants are not met or if they encounter breakdown in customer service or poor-quality products.
What is meant by sales force automation?
The company’s sales department is constantly looking for sales opportunities with existing and new customers. The sales force automation functionality of CRM software allows the sales teams to record each contact with customers, the details of the contact and if follow up is required. This can provide a sales force with greater efficiencies as there is little chance for duplication of effort.
What is meant by campaign management?
The approach taken by the sales team is often focused in a campaign, where a group of specific customers are targeted based on a set of criteria. These customers will receive targeted marketing materials and often special pricing or terms are offered as an inducement. CRM software is used to record the campaign details, customer responses and analysis performed as part of the campaign.