Over the course of our lives, we develop many types of relationships. Some of them long-term, others are more fleeting. The same is true in business. Low-profit customers can come at a high cost, so it’s critical to have a comprehensive and accurate understanding of your customers to minimize at-risk relationships and maximize profitability. Customer profitability analysis helps companies understand how reliant they are on profitable customers and the resources spent on less profitable ones.
A customer profitability analysis is an evaluation of your customers' buying patterns. Using your customer data, you can apply measurements to key metrics that drive profitability. These include metrics such as how much business a customer generates, how profitable they are in gross margins, loyalty, and what they cost to serve. Leveraging data for actionable information enables you to create a more sustainable and profitable business.
Behaviors that affect profitability
Phocas evaluates different industries and pinpoints specific elements in common that affect profitability such as sales volume and cost-to-serve. Phocas has developed a means to weight these variables so companies can rank customers and better determine a customer’s profitability.
A high cost-to-serve can wipe out the gross margin if the customer drives services through the roof, easily tipping the balance from profit to loss. Here are the different elements of cost to serve.
- Order sizes and frequency of orders: This metric impacts your inventory and handling costs. Frequent small orders incur higher sales administration costs than less frequent and larger orders. Order behavior that varies greatly also impacts your ability to accurately forecast your inventory needs.
- Accounts receivable: The cost to extend credit to a customer is determined by your own capital sources. A customer’s payment history is key to extending credit and payment history.
- The rate of returns and exchanges: Customers who frequently return or exchange items cost more due to additional handling and restocking expenses.
- Sales administration: This is the cost of sales and service calls. Customers who require multiple sales visits or place multiple orders cost more than customers who place orders in one batch.
- Shipping or delivery: Customers who place multiple orders or require same-day delivery increase your delivery costs.
Customer loyalty: Loyalty is important because the cost of replacing customers is expensive. Loyalty is subjective and more difficult to measure. Therefore, we believe objective indicators of loyalty should be measured such as the number of years in the relationship; recommendations to other business and willingness to place large orders.
Categorize customers based on purchasing decisions
Customers can be categorized into four groups based on their purchasing behaviors: Core, Opportunistic, Marginal, and Service Drain. This classification enables you to better understand your customers and serve their needs.
Core customers: Core customers purchase at a higher volume on a regular basis. Their hallmarks are a sustained relationship, low cost-to-serve, and buy a full range of high and low-profit products.
Opportunistic customers: These customers are also profitable customers. However, they buy infrequently when their regular supplier runs out of their stock. They can be classified as high margin, low volume, low cost to serve.
Service-drain customers: These customers are high volume customers but require consistently high levels of service while demanding low prices. They typically have a sustained relationship, but have low profitability due to their high cost-to-serve. In some cases, they may have a negative adjusted gross margin.
Marginal customers: The hallmark of the marginal customer is an abnormal risk of non-payment. They typically purchase infrequently and at a low volume. They tend to require higher levels of service or low prices. These are high risk, low profitability customers.
Strategies to maximize customer profitability
Categorizing your customers enables you to develop a strategy for increasing profitability going forward. The ability to implement an effective strategy, evaluate the results over time, and make adjustments as needed, will empower you to shape customer behavior and move them from one category to another.
Core Customers: Do whatever you can to keep your most profitable customers happy. It’s essential you provide the extra service that separates you from your competition.
Opportunistic customer: These high-margin customers usually place an order when your competitor is out of stock or is priced too high, your sales team should devise a strategy to convert them into loyal core customers.
Service-drain customers: You can improve the profitability of high-volume, service-drain customers by increasing prices, and thus your gross margin.
Marginal customers: Low-volume marginal customers with a negative profit margin should be eliminated to improve your overall profit margin. Instead, use those resources to nurture your relationships with customers who have the potential to become core customers.
Because customer profitability analysis provides a clear picture, you are able to eliminate the customers that are high-maintenance so your sales team can focus on customers who value and will pay for your company’s products or services. As your operations department is freed from the demands of a service-drain customer, they are available to service customers with reasonable needs.
Would you like to learn more about measuring customer profitability?
Watch our on-demand webinar, 'Understanding your customers and maximizing profitability' here.