How Customer Profitability Affects Your Business
As a business owner, you are likely familiar with the concept of the 80/20 Rule of Customer Profitability.
This general rule will often apply in determining the profitability a business realizes. For example, 80% of the profits come from just 20% of the customers.
Of course, the numbers vary from one business to another, but the key points to focus on are these:
- Do you know the profit contribution for each of your customers?
- Have you undertaken a customer profitability analysis for your business recently to assess what changes you may wish to consider in marketing and selling to your customer base?
Preparing this analysis could be very enlightening but how do you go about figuring out the value to your business of individual customers or customer groups?
This step is crucial in identifying and maybe encouraging, those who are contributing the most.
Basically, there are four ways of analyzing your sales information to assess customer profitability including:
- Revenue by Customer
- Gross Profits Realized from Each Customer’s Purchases
- Number of Purchases Made by Each Customer
- Costs of Serving Each Customer
Each method has its own merits, but some ways do it much better than others. Let’s take a look at these in a little more depth.
Revenue by Customer
This method is by far the most common one that business people generally apply.
Assume Customer A generates $500,000 per year in sales for your business and Customer B only generates $300,000 per year, it’s likely you’ll see Customer A as the bigger and perhaps better customer.
A simple sales revenue review is straightforward but does not address how profitable your sales are to each customer. Determining revenue by customer is simply the starting point of assessing customer profitability. You need to do a deeper review.
Gross Profits Realized from Each Customer’s Purchases
Let’s assume Customer A’s $500,000 is based on 250 items sold at an average of $2000 each and your current gross profit margin per unit is $400. Their gross profit contribution to your business is then $100,000.
Customer B’s $300,000 sales volume is for higher-priced items you sell, and they buy 50 items at an average $6,000 each.
Your gross profit margin for each of these items is $1,800. Their gross profit contribution to your business is $90,000.
Interesting to note that although Customer A spends $200,000 more than Customer B in a year, their contribution to your gross profit margins is only $10,000 greater.
To better understand the customer profitability of each, we need to look deeper and compare the number of purchases made by each customer.
Number of Purchases Made by Each Customer
As noted, Customer A purchases 250 units a year whereas Customer B makes only 50 purchases per year.
The gross profit contribution generated by Customer A is an average $400 per unit, while Customer B provides a gross profit contribution of an average $1,800 per purchase.
When comparing customer sales under this method, each unit sale made to Customer B is nearly 4.5 times more profitable than a unit sale to Customer A.
Costs of Servicing Each Customer
We all know that the costs of servicing each customer are based on several cost factors including the time and cost of labor of your team to service your customer needs.
When taking everything into account from direct selling costs to fixed overheads, it’s very likely that a customer making fewer more profitable unit purchases per year is going to cost less to service than one with higher unit sales volume but with lower profitability per unit.
As you will no doubt appreciate, this depth of analysis reveals some interesting facts important to managing your customer profitability and how you may wish to target your marketing and sales approaches to your customer base.
Although in our example Customer B is the ‘smaller’ sales volume customer by $200,000, this customer generates almost the same gross profit contribution to your business as Customer A.
On the surface, you would be better off getting customer B to purchase just one more unit than trying to get Customer A to make a lot of extra purchases, or to get more customers like B than A.
Please note this is not to simply say that Customer A or B is more important than the other to your business. Rather, it is about having an understanding of what each of them contributes.
I would encourage you to take a more in-depth analytical review of your customers and their purchases.
Quantifying each customer’s contribution to your net profit rather than just their gross sales volume will likely cause you to assess them differently.
This in turn will allow you to structure your marketing and sales planning to create a more targeted approach that will increase the overall customer profitability and the profitability of your business going forward.
If you are thinking about or currently working on developing your business sales strategy plan and are in need of assistance, please contact Rick Gendemann, one of our business advisory leaders. We look forward to the opportunity to connect with you to discuss your business and address how we may able to work with you on developing and implementing your business sales strategy action plan.
Rick Gendemann, CPA, CA, is a Business Advisory Leader with Manning Elliott LLP. Rick can be reached at (604) 557-5760 or rickg@manningelliott.com