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Exploring Different Approaches to Profitability Measurement
A large number of companies already carry out some form of profitability measurement but according to David Roscoe, managing director of IT consultancy Prophit Share, much of it is wildly off target. Too often it is based on board level assumptions about customer behavior or what aspects of the business result in profit. However, as businesses increasingly grapple with the globalization of markets, shortened product lifecycles and market fragmentation, the realization is dawning that existing customers must be placed at the center of the operation.
Posted Feb 5, 2001
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A version of this article first appeared in Customer strategy, a magazine published 10 times a year in London by TBC Research. Through its comprehensive portfolio of magazines, events and research, TBC Research is dedicated to helping senior business professionals make more informed technology decisions.

Following a detailed measurement of customer profitability, a large insurance company was astonished to learn that its high spending customers were not actually its most profitable. Prior to the revelation most of its marketing campaigns had been directed towards these individuals, when in fact it was schoolteachers who were providing the most profitable streams, a market segment which it had previously ignored. Recently, Campbell's Soup admitted that not all of its customers are equal and as a result embarked on a major strategic u-turn. It altered its marketing by targeting its new products and brand image to suit the tastes of customers deemed to be loyal, rather than attempt to cater to the masses.

A large number of companies already carry out some form of profitability measurement but according to David Roscoe, managing director of IT consultancy Prophit Share, much of it is wildly off target. Too often it is based on board level assumptions about customer behavior or what aspects of the business result in profit. However, as businesses increasingly grapple with the globalization of markets, shortened product lifecycles and market fragmentation, the realization is dawning that existing customers must be placed at the center of the operation. Measurement determines which customers are worth investing in and which are not, and lies at the heart of any customer relationship management (CRM) drive. This movement is also reflected on the customer side. Management consultant Wendy Hewson points out that as customers' bargaining power has increased, so have their expectations of higher service and product quality.

Easy as ABC

In one sense, measuring customer profitability is straightforward - you track customer revenue and product revenue, allocate the cost of goods sold and, according to Bob Shaw, visiting professor of marketing at Cranfield School of Management, "it should be fairly easy to come up with customer contribution." This is customer profitability at its most basic, the difference between revenues and cost on a per customer basis.

However, existing CRM systems struggle to provide adequate measures of customer profitability. CRM cannot manage customer interactions or provide detailed information about two customers who both buy the same products but behave in different ways. Customer A may take products in one monthly shipment but customer B may require four weekly shipments. Although the revenues from each customer are the same and the costs of manufacturing and shipping the product are the same, the cost of servicing differs.

Take the case of a supplier to the off license chain Oddbins. Some time ago the chain was receiving most of its wines and spirits on a discounted basis, with the exception of Bacardi products. By ensuring that single cases of Bacardi were delivered to each of its outlets, the company managed to save money on its own delivery system. When the supplier began a customer profitability measurement it discovered the anomaly and the loss of potential revenue in the delivery system.

Oddbins' behavior was in no way an exception and typifies the trader mentality that permeates the retail arena, in which various methods are used to squeeze discounts and save money. A common example is the company that requests that goods be delivered centrally, then once the order has been made rings the call center and asks for local deliveries, saving the cost of making the deliveries itself. Shaw believes this kind of practice across any number of industry segments is endemic and is costing business "many millions" every year. Measuring customer profitability can reveal these practices by highlighting the areas where revenues are leaking away and also provide the information to shape a future strategy, informed by detailed data about customers and costs.

To measure customer profitability an activity-based costing (ABC) system is essential. ABC changes the measurement focus from volume drivers to activity drivers and exposes fundamental differences in the cost of manufacturing products. This allows the identification of profitable market segments and products, helps identify the process costs which can inform strategic decisions and enables the redirection of pricing, creating an appropriate customer segmentation strategy. The downside is that despite the obvious benefits that ABC can provide, its implementation is difficult in practice and consequently projects have in many cases been restricted to pilots.

Segmenting the Market

However, while ABC is necessary to understand true profitability, customer segmentation can be done independently. Unfortunately, Hewson argues that it is often not carried out thoroughly enough. She says that any segmentation process should involve four steps: identify the profits that customers have generated in the past, identify the factors that drive the profitability of different customers, rationalize customer costs and pricing policies to eliminate inefficiencies and model the future profitability based on the rationalized costs and revenues.

She points out that because profitability analysis is driven in many companies by management accounting, the last two steps of rationalizing costs and modeling future profitability are often left out. She also argues that to allocate every cost if it is fixed is a mistake. For example she says: "The costs of senior relationship managers might be seen as fixed, but time spent with one customer could be directed towards another, therefore their costs should be allocated to the customers they deal with." Another common error is to misunderstand the nature of the costs spent on locking in customers: "These costs can be viewed as investments in customer assets which, like investments in other areas, should be spread over the expected life of the asset rather than set against the initial revenue from the customer."

Roscoe speaks for many when he says that the use of traditional profit measures based on products rather than customers is rapidly becoming an outmoded approach, and argues that companies now need to understand how profit can become an integral element of the brand. "The brand is only as good as the product sold, and the product can be strengthened by customer segmentation and a resultant improvement in service."

The imperative to segment customers is compounded as emerging technologies are beginning to provide cheaper ways of reaching customers, most typically via the Internet. As Hewson adds: "The challenge is to develop channel strategies that support the way in which customers buy whilst maximizing the service cost equation." Roscoe points out that this requires a different operational method. He gives the example of a company which had traditionally relied on its telephone-based channel but then moved into the online environment.

It simply transferred its pricing model, incorporating cost of goods, cost of sales, operating costs and marketing costs to its Internet set-up. But it soon learned that the footprints of its Web site customers were entirely different from those of its phone-based customers and the old pricing model was no longer relevant. It realized that it needed to monitor the type of customer that was using the Web site and adjust its prices accordingly, because people were expecting a cheaper deal for shopping via the Web.

Turning Loss into Profit

The opening up of new channels not only affects customer expectations but can influence them to move to online suppliers. Creating segments and targeting efforts to retain profitable customers opens up the possibility of cross selling and what is euphemistically called managing costs. In plain language this often means getting rid of the customers who don't pay. "By creating a profitability modeling strategy, you can figure out what kind of segments you want to attack, look at how they buy from you and ask how you can pull them all the way through the process. Once you understand this you can figure out how much you want to spend on your customers," adds Roscoe.

The German airline Lufthansa has attempted this approach following a sweeping examination of its customer base. A database, which held transactional information, was merged with a database designed to hold economic information on the airline's five million customers. It was an expensive exercise, but one which allowed the airline to see which customers were profitable and which were not. From this information it restructured its customer base, launching a series of marketing initiatives designed to attract high net worth customers who had moved to other airlines. However, rather than dump unprofitable customers it has decided that they can become profitable; it is just the manner in which they are treated that needs to be changed. The airline is setting up new relationship models for these customers by building up their profiles and constructing an appropriate IT system designed to service them.

US company Harrah's Entertainment, which owns 18 casinos in the US and a number of casinos in Europe, took this approach a step further. The company has embraced the concept of measuring customer profitability with such gusto that it now claims to be able to evaluate the profitability of a customer over an 18-month period and after only a handful of visits to a casino. Traditionally casinos treated customers as belonging to the venue they most often visited, but have discovered that those who visited more than one establishment represented a fast growing revenue segment. In a bid to retain these 15 million customers, the company introduced a loyalty system called "total gold". The strategy was based on a data warehouse with a customer database available for all departments to search and query.

Using the database, the company analyses hundreds of customer attributes to assess the likelihood of a visit, predicted spending and opportunities for cross selling, and to determine the value of each customer. Harrah's claims to have achieved a return of over $74m during the first few years of using the technology and initiating CRM processes, merely by taking the view that a customer represents potential to all of its locations. John Boushy, chief information officer of Harrah's, claimed in a speech at a CRM conference earlier this year: "This is one of the best investments that we have ever made and will prove vital in forging new business strategies and opportunities in the future."

Harrah's is a shining example of successful customer profitability measurement to the extent that its customer reorientation has helped to bolster its future prospects. "Those who use their customer base as assets are more in tune with what drives profit level. It safeguards the position for the future and will show any changing trends much more quickly," says Roscoe.

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