Determining Customer Profitability

It should be obvious that customers are the main source of revenue for every business. But what’s less obvious is that they are usually responsible for the vast majority of expenses as well. As such, it is essential for companies to accurately measure the true cost of servicing their customers and judiciously manage customer profitability. Determining customer profitability is the best first step in knowing where to place your resources as a company.

In nearly every case, it’s in your company’s best interest to only working with customers who can be profitable over the long run. Of course, taking calculated risk on certain customers or customer segments and investing now to drive higher lifetime value later is an essential part of business strategy. But you can only place bets on potentially better outcomes when you have a clear understanding of your current and future expected net free cash flows from the customers on whom you are wagering. It’s not exactly like betting at the craps table – then again, you know that some of the “bets” you make on resources and on customer investment will pay off better than others. The trick is to figure out which ones, in a changing market, stand the best chance of being profitable.

This is easier said than done, but it is important to put in the effort required to figure it out. This is especially true with your most important, strategic accounts. Every customer relationship should be profitable over time, no matter how big or small. What is amazing to me is how few companies actually measure the profitability of their relationships. Stranger still is that many of the companies that do keep an eye on it, spend more resources looking at the profitability of their normal relationships but fail to dig in and put numbers behind their biggest relationships. The natural tendency seems to be to assume that customers who write big checks are profitable by default but that is not the case. In fact, in more cases than not, the exact opposite is true. Big spend does not equate to large profits.

Evaluating cash flows and ROC (return on customer) and striving to build value creating customer relationships is essential to long-term success in the past. In this post, I will focus on the kinds of questions you need to answer to determine the profitability of your key accounts and better estimate their future cash flows.

What is ROC (Return On Customer)?

Determining Customer ProfitabilityROC (Return on Customer) is a way of determining customer profitability that takes into account the two primary ways customers create value for a business:

  1. by increasing the company’s current period cash flows (upgrades and upsells), and
  2. by increasing its future cash flows through higher expected lifetime value.

Measuring ROC helps you to quantify the potential impact of increasing customer happiness, reducing churn, or driving more referrals. It reveals more about your relationships than a quick look at contract value.

Measuring and managing ROC takes time, which is precisely why it isn’t something that can – or should – be done for every customer you do business with. As such, it is generally best to start with each of your key customers and work your way down.

Looking at your company’s ROC from the top down can help clarify its medium to long-term prospects in ways that traditional financial reporting is unlikely to reveal. Getting to that level of clarity requires a little planning, some good data, a few back-of-the-envelope estimates, and a little elbow grease, it is worth every bit of the effort.

Ask The Right Questions

Determining Customer Profitability

Determining customer profitability really starts with asking the right questions about your customers and your business business. For starters, you need to get a handle on your up-front acquisition and ongoing relationship management costs. The best way to do this is to create a list of questions that will help you reveal the costs associated with selling, on boarding, and servicing your customers. Every business is different so, unfortunately, there is no perfect template for this part. However, this is likely something that your finance team may already have a good handle on – and if they do, that’s great.

With an understanding of your original CAC as a baseline, your next step is to dig into the costs you’re incurring to earn current and future revenue. Finally, you’ll want to examine the expense associated with account planning and ongoing relationship management. By way of example, a list of questions for an enterprise software company might look something like this:

Customer Acquisition Cost (CAC)

  • How much did we spend on marketing to this customer to attract and convert them to a lead?
  • What was the time investment from our sales team on discovery, sales, negotiation, and close?
  • What effort was required by our sales engineering team to setup and configure their instance of the software?
  • How much time did it take our sales operations / accounting team to set up the customer account, bill them, and get paid?

Revenue & Upside Potential

  • What relationship stage are we in with this customer?
  • How much does the customer buy in a year?
  • What is the direct cost (COGS) of the stuff they buy from us?
  • Are the products they buy standard or customized?
  • What are the white-space opportunities with this customer?
  • Are they a source of referrals and new business?
  • How much revenue do we currently receive from customers they’ve referred?

Account Planning & Reviews

  • How much time do we spend in account planning for this customer?
  • With what frequency do we conduct business reviews for this customer and how much time goes into planning and executing them?
  • Outside of Customer Success, which of our teams spend the most time with them?
  • Does our C-Suite visit this customer?
  • Do we have to maintain ‘inventory’ for them?
  • How many invoices do we send them each year?
  • Do they pay promptly?
  • How much customer service do they require?
  • How much white space is there to sell them more stuff?
  • What is most likely to change about their business over the next year?

This short list of 22 items is by no means exhaustive but is a good place to start. Thinking through questions like these can help you put your finger on the direct and indirect costs associated with servicing your customers. In the end, it will help you to develop a much better sense for the true profitability of each relationship.

Calculating ROC

In her excellent perspective document on ROC (link below), Patricia Seybold calculates ROC as follows:

ROC = (CFp + CCEp) / CEr – 1

Where:

  • ROC = Return on Customer
  • CFp = Cash flow from customers during period p
  • CCEp = Change in customer equity during period p
  • CEr = Customer equity at the beginning of previous period

I went no farther than Algebra II in high school, but this is something even I can turn into an Excel formula to track customer value over time. This gives me a good rule of thumb to determine which customers to keep and which ones to de-emphasize.

Managing Your Resources

As much as we’d never want to say this to our customers, the reality is that not all customers are equal. The ROC calculations help you show which ones provide your company with the greatest economic benefit. Be aware that this isn’t a 100% hard and fast calculation – you have to let common sense and other business conditions influence your thinking. It may be that your company signed a small “land” deal with a Fortune 500 company last quarter, and there’s strong potential for business three or four quarters away. Play the long game on those customers – just be aware that your bet may not pay off in the long term, but if you plan and execute well you’ll be rewarded at the end.

You owe it to your business to strategically manage your accounts to maximize the joint value of the relationship. In the end, doing so ensures better outcomes for you, your customers, and your company. At the end of the exercise you may find that you may have to say goodbye to certain customers. This process is never easy, but you have to always be aware of what works best financially for your company.

For Further Reading: