The Art of Customer Profitability Analysis
Without a doubt customer-profitability analysis is a hot topic--especially for companies that embrace customer relationship ideas, because without it interpretations of CRM failures or successes are mere speculation. Hence, it is remarkable how seldom this analysis is discussed in the context of existing finance and accounting practices. Maybe this is because anything that has to do with customers falls traditionally under the marketing and sales umbrella. But whatever the reasons, you need to understand why accounting systems, the data sources of traditional profitability analysis, are ill equipped to support customer profitability analysis and how to fix their shortcomings.
GAAP versus CRM
The first limitation of conventional finance systems is their adherence to General Accepted Accounting Principles (GAAP) rules. Essentially, these systems disavow the relevance of customers by excluding, with a few exceptions, all information about them from financial statements. They do so, despite the fact that customers are a company's primary asset, as they are solely responsible for every penny of revenue. The systems' second limitation is that they are designed to collect and distribute information at the product and service level, not the customer level. The three main roadblocks you will run into are:
1. Product/service costs are aggregated in accounts completely separate from customers, such as cost-of-goods-sold for inventory costing, while revenues are collected at the customer level for billing purposes. For customer profitability analysis both are needed at the customer level.
2. Like product costs, sales/marketing/service costs are also collected in accounts separate from customers, even when they result from direct company/customer interactions. This makes it impossible to calculate customer acquisition and service costs, two essential ingredients of every customer profitability analysis.
3. Accounting systems exist in proud isolation from each other due to fragmented corporate operations. This makes it very difficult to create a single, company-wide customer view, as no common customer identification method exists.
Obviously these characteristics inhibit customer-profitability analysis as all cost differences between customers are disregarded. Inevitably, this leads to distortions. Profitable customers are lost through overpricing, unprofitable customers won by underpricing, and unprofitable customers subsidized through profitable ones. In short, customer relationship management becomes a pipe dream, as it is not possible to manage what cannot be measured.
Reuniting Cost and Customer
To remedy this situation companies have to focus on restoring the connection between customers and costs. Methods to do so range in complexity from as broad and simple as using percentages of sales, to developing intricate allocation methods based on actual activities that incurred the costs. The key points to consider are:
o Allocate first costs that are easily identifiable and also directly traceable to specific company/customer interactions, such as customer acquisition, transaction, service, marketing, and delinquency costs. Tackle the more nebulous ones later.
o Initially, estimates are OK. Sure they will be off, but with experience and time you can replace them with research-based numbers.
o Focus on significant activities and costs by applying the 80/20 rule whenever possible. 80 percent of costs are usually created by 20 percent of the activities, 20 percent of products create 80 percent of your sales.
o Use surrogates for costs that can't be traced directly to individual customers or when you haven't collected sufficient data to make specific recommendations.
o Apply costs at the lowest possible activity level to maintain maximum analytical flexibility. That way they can be rolled up in many different ways.
Overall, keep in mind that just like conventional profitability analysis, determining customer profitability is not science but quest; there will never be one correct number for a customer's profitability. Thus, the chief concern is not pursuing the most precise measurement, but consistency in the application of cost assignment methods.
Involve the Whole Company
Contrary to traditional accounting practices that champion the separation of organizational responsibility, CRM encourages teamwork through cooperation and coordination. Therefore, the creation of customer-profitability measurements involves the whole company. Clear-cut definitions of customers, costs, revenues, and profits accepted by all business groups have to be created. This is especially important, as CRM collaboration will undoubtedly result in interdependent revenue and cost flows; the actions of one business group effect the performance of another, and vice versa. Aim to create a consensus that is general enough to be widely accepted, yet specific enough to be useful.
In regards to the difficulty of the implementation, realize that there are many different ways it can be done. Personally, I don't believe that complex solutions are necessarily the best. Complexity usually crushes flexibility, because change becomes difficult. Realize that much of the raw material to trace costs to customers exists in your systems, albeit in forms requiring transformation. For example, customer transaction histories show all orders, returns, and collection efforts. Use that information to create lookup tables in your database that map activity codes to activity costs.
With some luck you will find similar information in service systems that tell you how often customers contacted the company with questions, complains, and requests. Assigning costs to these actions is also not difficult. Next, identify costs incurred by the company for customer acquisition, marketing, and retention efforts. Here creativity and intuition get you a long ways. For instance, if you have a regular contact strategy, assign ongoing marketing costs based on time factors, such as months since first purchase. That way you don't have to worry about every individual contact. The biggest challenge is usually determining acquisition costs. Direct marketing companies are fortunate as they can usually trace them to specific promotions (if you do not have that opportunity use good judgment). But foremost of all, appreciate the fact that consistency is key. Don't get in a situation where two customers are attributed different cost figures for the same activity, because than the whole analysis looses credibility, users loose trust, and all the work you have done is for naught.
About the Author
Tom Richebacher is an information specialist with the EDS Business Intelligence team. His area of expertise is the creation of statistical and financial models based on database services that are used for customer relationship management purposes. He also develops the infrastructure and reporting systems needed for financial, marketing, and operational analysis and information delivery. Contact him at firstname.lastname@example.org