Analyst Perspectives

It’s clear that certain customers generate more profits than others, just as some products offer greater economic returns than others, as I’ve noted before. For this reason, efforts to improve customer profitability are not a new trend. Good managers have always looked for ways to achieve the highest sustainable margins. However, at some point, almost all businesses realize that increasing sustainable profitability can’t be achieved simply through increasing revenue or cutting costs. Those straightforward approaches are fine for tactical, one-off decisions, but they’re too simplistic for designing and implementing business strategies.

The practical issue that confronts most executives here is how to measure customer profitability accurately and how to use this information to guide business decisions. It’s a complex task. For decades, retail banks have been trying to deal with the often-repeated statistic that the top X% of their clients (where X is, give or take, 15%) produce Y% of their operating profits (where Y is significantly greater than 100% – that is, they were losing money on a significant portion of their customers). After decades of hit-or-miss application of profitability analytics, retail banks increasingly are using more sophisticated ways of assessing individual customers’ contributions to the bottom line. The fact that after all this time retail banks still grapple with this issue indicates the challenge of measuring customer profitability appropriately to support marketing, sales and pricing initiatives that promote a company’s strategic objectives.

Many of the analytical systems that were necessary to manage customer profitability accurately have been available only for a decade or less. Moreover, today companies have access to a broader and deeper set of data with which to gauge profitability. Systems can process these larger data sets much faster, making them practical for use in executing daily business processes such as quoting and constructing offers in the sales process. Many companies already use IT systems to support pricing and constructing offers, but the intelligence that guides these systems does not necessarily reflect the real profitability of specific customers.

A second, related issue is that, except among innovators, management practices have not evolved sufficiently to take advantage of action-oriented analytics such as customer profitability management. Having the data and the analytic tools are just the first requirement. They must be woven into strategic and tactical management decisions and processes. If nobody is specifically responsible for customer profitability, any attempt to achieve more optimal customer profitability is likely to fail. A company must make an individual or a small cross-functional group responsible for managing customer profitability. I believe this role should be assigned at least in part to the finance organization, since it has no vested interest. This objectivity is important, because often the path to more effective customer profitability management is strewn with instances where the needs or objectives of one part of the company conflict with another’s. If a company does not establish an objective method for gauging the impact and managing the performance of its customer profitability efforts, it is likely to achieve substandard results.

By itself, knowing that certain customers are less profitable or even unprofitable has limited value. Deciding how to deal with such customers and building this action into sales support systems takes the process from an academic exercise and bakes it into core business processes. Developing a customer profitability performance management discipline should be an ongoing focus of senior executives, particularly in the finance organization. Information technology will be a critical component in any customer profitability effort, but executives must also manage strategic, organizational and analytic issues. The payoff from these efforts can be a significant boost to the bottom line.

Companies must develop a focused, consistent approach to managing customer profitability that incorporates four essential elements:

Strategy – What is the corporation’s strategy, and which customer profitability options are best suited to this strategy? A company pursuing a “fashion leader” strategy will likely take a very different approach than one going the “lowest cost” route.

Analytics - Understanding the true economic profits from individual customers or customer classes can be the single biggest challenge facing a company’s program. Developing frameworks for this analysis must be a priority. In some cases the most appropriate metric may be a simple contribution margin on a single transaction; others may require a more involved set of data that examines various costs over a customer life cycle. Banks, for example, have found that some types of customers who once appeared to be unprofitable using simplistic analyses actually had a positive impact on the bottom line.

Information Technology - What data is necessary to assess profitability? Is it available on a timely basis? How should it be collected and stored? Today, many companies have most of the information they need to manage customer profitability, but few have all of it. The information may not be accessible to the right people. The IT architecture may be a problem. At the same time, it is important to avoid overcomplicating data collection if this becomes a roadblock (that is, when “better” is the enemy of “good enough”). Those in charge of the initiative need to have basic tools for understanding IT requirements and assessing alternatives.

Implementation - Companies face various issues in applying their customer profitability strategy. As a rule, narrowly focused customer profitability projects are easier to put into place than those that are broadly based. However, all must be designed and executed from a corporate perspective, otherwise they may fail to enhance overall performance (because they don’t consider all costs) or may not confer strategic or long-term competitive benefits (because they are inconsistent with the company’s strategy). And if customer profitability does not play an integral part in sales compensation management, it’s likely to be less effective because incentives must be aligned with accurate measures of profitability.

Effective management of customer profitability can be an important differentiator of corporate performance. It’s essential for corporations to take a strategic, well-informed approach to customer profitability. To achieve the best results, such an effort must be managed at the highest relevant level within the corporation. Companies must develop a discipline for defining and measuring profitability and establish a consistent framework for working with customers with short- and long-term profitability potential. As usual, information technology is a necessary but insufficient element in managing customer profitability. Companies must develop the analytic and management techniques and executive leadership necessary to make it successful.

Regards,

Robert Kugel – SVP Research