Who Are Your Best Customers?

Wednesday Nov 20th 2002 by Melaney Smith

Revenues are the tip of the iceberg. They often don't reveal the true value of your customers. Melaney tells you how to calculate customer profitability.

Do you know who your best customers are?

(Some of you will admit you don't. You probably attribute that to your inability to get reliable customer data. We'll deal with that in another column.)

Those of you who do say you know who your best customers are: Are using revenue as the sole method of calculating customer value?

It's a no-brainer to sort a customer list from highest revenue to lowest each month, then see who's tops, who's increased, who's decreased, who's disappeared. I challenge you to look deeper.

Yes, we are all looking for revenue. Revenue is a means of reaching the end goal: profit. Customers contribute to profit in varying degrees, and not on a strict revenue basis.

When you sort your customer list based on revenue, you ignore the rest of the equation. Product costs, selling costs, support costs... there's a lot more unique to a customer than the amount of revenue she generates.

For example, two customers purchase the same number of items. The customer who chooses items with the highest prices generates the most revenue, right? Well, the same is true for costs, which are not necessarily proportional to revenue. To figure out which customers are really the cream of the crop, you must look beyond the obvious.

It doesn't usually require a complete profit and loss (P&L) statement to evaluate customer profitability. You don't have to be a CPA, and you don't have to be 100 percent accurate. The exercise is enlightening even if you don't get it exactly right.

Customers you thought were your best may not be contributing as much to the bottom line as you thought. Factor in discounts, customer concessions, perks, and higher sales costs. A customer whose revenue is not outstanding but who purchases products with the lowest costs may be more valuable in terms of profitability. Dig a little deeper.

Looking at customer profitability can help you recognize problems in product pricing, sales approach, marketing methods, and more. You may notice certain salespeople tend to bring in greater (or fewer) profitable accounts; you might find similarities between your most profitable customers that help you target more of them. Once you begin to focus on improving customer profitability, you begin to recognize ways to improve overall results. This is especially beneficial if a significant chunk of your company's revenue is generated by a small number of customers.

Consider the following when evaluating customer profitability.

Product Costs

I'll spare you definitions of direct, indirect, variable, and fixed costs. Talk to your finance folks to see if you can easily allocate product costs to specific customers based on their product mix. For some this is easy, while for others it's almost impossible. If you can do it, you probably should.

Think about costs associated with making your products, whether actual materials, royalties, or labor. Products that cost more to make cannot always be sold for higher prices. Imagine two customers generating the same amount of revenue. One buys only Product A, the other only Product B. One of those customers is more profitable than the other, depending on which product costs less to make. If you only compare revenue, you'll view both customers as equal. Your largest accounts might pay prices that are slashed to the bone, thus contribute a surprisingly small amount to cover your expenses. At the same time, a group of middle-of-the-road customers could be stars waiting to be discovered. Find them -- before they jump to a competitor!

Selling Costs

Businesses have so many different sales channels. It's more important than ever to consider selling costs when evaluating customer profitability. Your largest account may have a dedicated sales team outfitted with generous expense accounts. A middle-of-the-road client who found you on the Web might not look so middle-of-the-road when you factor in the selling cost difference. A repeat customer who places many small orders online and pays with a Visa card may be more valuable than one who places sporadic but larger orders through a salesperson who makes an in-person visit. Or vice versa. It'll be different for every business.

Support Costs

Support costs are not always possible to allocate at the account level. I have seen national account programs in which a major account is guaranteed one or more dedicated telephone customer service reps, while another account generating the same amount of revenue has none. It's worth checking to see if your company has special arrangements of this nature that may reduce an account's profitability. With today's varying methods of customer service, this could become more important over time.

Other Costs to Consider

In some cases, particularly when you have a few large customers generating a significant chunk of revenue, you should dig even deeper to understand what costs are associated with top accounts. Product returns, payment history, product customization, and private labeling are a few examples of hidden costs.

As you find customers you thought were valuable but who look a lot different under this new light, develop get-well plans. Perhaps you can identify higher-margin products that are a good fit for some or a lower-cost way of selling to them. As you find customers who are surprisingly high margin, although middle-of-the-road in revenue, start paying attention... before your competitors do.

Reprinted from ClickZ.

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