How do you define your best customers? The customers who generate the most revenue for you? The customers who buy the broadest range of products or service? The customers who buy most often?
All good criteria, but they only tell half the story.
Same question from a different perspective: If two of your customers purchased the exact same mix of products and services at the exact same prices, at the exact same time, they would very likely both generate the same revenue for you, right? But would you make the same amount of profit from each?
My experience is that A-most companies struggle with measuring individual customer profitability, so they don’t know; and B-the answer is: Probably not!
Why does it matter?’ Knowing the answer to that question is going to help you become more profitable. Potentially increasing your profit by 50 – 100%, from sales you’re already bringing in. And at virtually no cost.
It’s likely you’ve heard of the 80:20 Rule:
80% of the results come from 20% of the causes; 80% of your revenue comes from 20% of your customers; 80% of the fish are in 20% of the lake.
The 80:20 rule is almost universal; it applies to just about everything. Everything except profits!
When it comes to profits, my 140:20 Rule is more applicable.
You’ve probably not heard of this rule before, so here’s how it works:
In almost every company I’ve worked with, 140 to 200% of net profits come from 20-25% of its customers or customer segments. Another 50-60% of the customers contribute nothing to the bottom line. And the remaining 15-30% of the customers are so unprofitable that they reduce the business’ profits down to the number reported on their financial statements.
With some customers you lose money on every sale, many contribute nothing to your bottom line; while a few customers generate more than 100% of your profits.
The profitable customers subsidize the losers or, from a different perspective, the losers drain away much of the profits that you’ve already earned.
In answer to my first question, the better way to define your best customers are those who generate the most real profit for your company.
Using that definition, your best customers may not be who you think they are.
So, now that you can define your best customers, how do you identify them?
Customer Profitability Analysis
There are many factors that determine how profitable a particular product or service is in general, and how profitable a particular customer is. Two of those factors are:
- The price you charge.
- Your cost of the product or service.
The price you charge is fairly straight forward, it’s the amount on your invoice – your selling price, less any discounts.
Your cost of the product or service includes, for example, the cost to acquire the product, if you’re a reseller. The cost to create the product, if you’re a manufacturer. Or the cost to perform or provide the service, if you’re a service provider: insurance, dentistry, etc.
Tracking and managing selling prices and product and service costs is fairly common. Most business owners do a good job of it.
Some owners take it a step further: They subtract the product and service costs from revenues for each customer to arrive at a gross margin for that customer. Then use gross margin to determine whether a customer is “good” or “bad.” However margin doesn’t tell the whole story either.
In the relationship between you and your customers, the cost of the products or services that you offer are only part of the total costs you incur in the relationship.
All your customer serving activities, such as order management, logistics, sales, marketing, and customer support, all have a big influence on profitability.
The more service and support a customer demands, the higher your costs and the lower your profits.
However tracking and managing how much it costs to serve each customer is much more challenging because the costs-to-serve are dependent on the customer’s behavior and your response to that behavior.
There is rarely a direct cause and effect relationship between sales volume and costs-to-serve.
In many regards, these costs are controlled by the customer—if you let them!
It is these disproportionate costs-to-serve that generate the significant differences in the profitability of individual customer relationships.
However there is something you can do about it.
When you take the time and invest the effort to track your sources of profit and your costs-to-serve each of your customers or customer segments, you’ll be in a much better position to manage and improve the profitability of each of your customer relationships.
I’m not talking about rules-of-thumb or best guesses. I’m talking about getting real data, and using that data to drive your bottom-line.
Identifying all the resources used to serve each particular customer and what drives the costs of these resources. And you need this information so you can identify those customers that actually generate profit, those that contribute nothing and those that drain profits away.
This means looking at individual transactional costs, not just direct product or service acquisition, manufacturing or distribution costs.
This requires allocating all your overhead and indirect costs for things such as obtaining and filling orders and placing orders with vendors. Allocating all your operational expenses such as shipping and delivery, support, invoicing and accounts receivable collection—all the costs-to-serve each customer.
Once you’ve completed your profitability analysis, you’ll see more clearly why certain customers are more or less profitable than others. And I guarantee you costs-to-serve is one of the biggest reasons.
Next, you improve your profitability by acting on what you find.
To increase the profits you generate from existing customers—to improve your bottom-line, focus on P-R-O-F-I-T-S. It’s both your goal and an acronym that describes the key phases in a profit improvement project:
P–Pinpoint those customers that generate profit and those that drain it by analyzing each sales transaction and each customer relationship.
R– Retain the high profit segments of your business by reallocating resources towards protecting your most profitable customers.
O– Obtain more profitable business by focusing your efforts and resources towards high-potential, under-penetrated customers, markets and sales channels.
F– Find ways to reconnect with lost profitable customers (who are already familiar with you) and get them to return.
I– Improve the profitability of your marginal business by altering customer purchasing habits, altering your offerings and increasing prices.
T– Transfer any drainers that remain to another supplier by gracefully disengaging from them.
S – Systematize the process into an on-going analysis.
If you want to make more profit from your existing sales, actively manage your relationship with each of your customers. And avoid falling into the trap of feeding the revenue beast while starving the profit beauty.
Customer profitability analysis requires little time, simple spreadsheet software and no capital, but can greatly boost your profits. It allows you to looks past basic revenue and gross margin measurements to shine a light on customer behaviors.
By identifying the real costs-to-serve every single customer, you can better manage your relationship with each customer and adjust those operational and financial factors that directly impact your profitability.
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