Are You Leaving Profitable Customers Behind?

4 Step Customer Profitability Analysis

If you’re like many marketers, you know how to determine your sales forecasts and whether your promotions are profitable, but not which customers are.

Therefore it’s important to segment your customer base to determine the distribution in terms of: best shoppers, high potential shoppers, occasional shoppers (although it’s often only sale items), past shoppers who no longer buy, and prospects who’ve never bought anything. The rule of thumb is that the best 20 percent of customers generate 80 percent of revenue. In my experience, the actual numbers can be even more skewed.

The most extreme case of customer sales concentration I ever encountered was in a business that targeted wealthy individuals. One geographic region’s top customers comprised less than 5 percent of the total customer base. Yet these customers were responsible for over 95 percent of revenue. While revenues appeared strong, this market was at risk since if conditions changed or a few key customers left, it would have a disastrous impact on results.

4 Steps to analyze your customer base

To help you determine where you should focus your marketing efforts, here are four steps to assess your customer file.

  1. Break customer base out by level of spend. Assess the influence of your top-, average-, and lowest-performing customers, ordering customers by total sales over the past year. Break ordered list into tenths. Create cumulative total sales column, starting with the customer with highest purchases. Calculate cumulative total sales percentage by dividing the cumulative total sales by total sales for the entire year. With this information, you can determine the percentage of total yearly sales each tier of customers generated.
  2. Compute top tier’s turnover rate. In general, organizations tend to keep the same level of top customers. By contrast, the actual buyers in this tier changes from year to year. Calculate the turnover rate by ordering these customers by sales for the last two years. Compare the names of the top customers in each year. Determine which customers were in the top tier in both years. Divide this number by the total number of top-tier customers from the first year to determine your retention rate. Subtract your retention rate from one to get your turnover rate.

    Turnover rate = 1 – [number of top-tier customers in both years 1 and 2/number of top-tier customers in year 1]

  3. Determine customer profitability. Short term, customer revenue must cover total variable costs (i.e., product, fulfillment, and bad debt) or your firm will go out of business. Any additional funds contribute to marketing and overhead expenses. Since your goal is profitable customers, you shouldn’t spend money romancing customers until they cover their fully loaded costs (aka positive customer contribution).

    Positive customer contribution = [customer revenue – total variable costs] > 0

  4. Calculate true customer profitability. To be truly profitable, a customer needs to produce more revenue than his fully loaded costs (i.e., total variable costs, marketing, and overhead associated with servicing this customer). Once this occurs, this customer is worth continuing to market to at the current level.

    Truly profitable customer = [total customer revenue – total variable costs – applicable marketing costs – allocated overhead] > 0

As this analysis shows, all customers aren’t created equal. To maximize revenues, you must target your marketing to those segments with the greatest profit potential.

Do you have any other suggestions to help increase customer profitability? If so, please include them in the comment section below.

Happy marketing,
Heidi Cohen

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Photo credit: HenriBergius via Flickr

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