Customer Profitability Analysis: Definition, Formula & Benefits

Customer lifetime value is a metric that provides you with the overall revenue an average customer generates over the course of their complete relationship with a company.

Yet, there is another comprehensive metric called customer profitability that allows businesses to learn how much profit a customer generates. In fact, an increasing number of companies are turning to a customer profitability analysis strategy thanks to the benefits it brings them.

Therefore, we will examine what customer profitability analysis entails, why you should monitor it, and the best practices for applying it to your business.

Customer profitability analysis (CPA): What is it?

Customer profitability analysis is a managerial accounting technique that enables businesses to find the total profit a customer generates. 

For example, your customer, Sam, generates 30$ in sales but the cost spent on this customer is 25$, including acquisition, service and selling. By applying the customer profitability analysis, we can say that his customer profitability is 5$.

Finding out which customers are profitable for your company and which are not is what CPA is all about. A customer who produces more revenue than the CAC (customer acquisition costs) – the costs it takes to acquire, sell to, and serve them is likely to be profitable. 

Companies determine the CPA for each individual customer or for the total customer base. By segmenting your customer base according to CAC, CPA enables you to focus your marketing, customer relationship management strategies, and operational effort on the more profitable customer groups. 

How to calculate customer profitability?

Depending on the data at your disposal and the metrics you want to monitor, you can determine the profitability of your customers using the customer profitability formula below. 

Customer profitability formula

Businesses can determine customer profitability by calculating the annual profit per customer. To compute their yearly per-customer profit, here is the formula:

Annual profit = (Total revenue generated by the customer in a year) – (Total costs incurred to serve the customer in a year)

The following financial sources can add to the total revenue generated by the customer:

• Recurring purchases
• Upgrades to the higher plans
• Cross-buying relevant products

On the other hand, this is what adds to the total cost to serve the customer:

• Customer service
• Loyalty perks
• Operational costs (Marketing costs a.k.a customer acquisition costs, Shipping costs, Return costs, etc.)

Customer Profitability Analysis: Step-by-step Guide

This section will cover the steps you need to perform a CPA and how to use the results of the analysis to make decisions that will have an impact.

Step 1: Segment your customers

First, let’s discuss segmenting customers based on how much they have spent on your products. Some companies have clearly defined customer segments but if you haven’t done it before, you should start doing it now.

You can begin by categorizing your customers based on demographic and geographic information. Even without empirical data or a sizable study, you can identify these segments because you are familiar with your company and its products. 

Creating customer personas is one excellent method for customer segmentation. Based on user data (demographic data), poll data, market studies, and other sources, you can start developing these.

Yet, the RFM analysis is the most effective customer segmentation method you should try. RFM analysis is a weighted analysis of your customers’ recency, frequency, and monetary data. This implies that you can build segments on:

• How recently a customer bought from you
• How frequently a customer has bought from you
• How much a customer has spent

The end output is an effective matrix to comprehend important customer segments. This enables you to strategically decide which groups need your engagement the most.

Step 2: Collect the data

Moving on to Step 3, it’s time to look for the data, including your revenue and customer costs. 

You do have the data, but it is hard for you to discover every bit of information connected to each and every customer. Therefore, we have some tips for you to collect more detailed data:

• If you collect data on your own, you should select a sample of customer service queries to identify the customer group that engages with your business most frequently. Then, you just need to focus on this group and search for all the necessary data. This tip will narrow the research scale and make the process much easier and faster.
• Get in contact with other departments within your company to gather all the necessary information if you can’t handle this task alone.
• Use third-party tools to assist you with tracking all costs and revenue, collect data, and get reports on your business automatically. These tools ensure better accuracy than tracking manually, especially when there are tons of data to be tracked and calculated. Besides, you can easily keep track of real-time data. That means when something unusual happens, you can quickly figure it out and solve it. There are hundreds of options out there and TrueProfit is a great one for calculations and automated real-time profit analysis to start with.

TrueProfit can automate eCommerce accounting by precisely and instantly obtaining data from all sources. And there is even more you can do with full control from just one single dashboard. 

Step 3: Apply the customer profitability analysis model

Finally, it’s time to use the CPA and incorporate the information you obtained from your company. We will use the following example to better illustrate how it functions. Keep scrolling!

Customer profitability analysis example

Your business sells solar panels based in the US and caters to the needs of customers in 2 segments: A and B. Your business must offer fulfillment, shipping, and customer support for the acquisition, servicing, and retention of your customers.

Each product costs $300. Segment A bought 3 items, totaling $900 in revenue while segment B purchased 9 items, which gave you $2,700 in revenue.

Segment B may seem much more alluring when you look at the revenue that each segment generates for your company. But there’s more than that! You will reconsider your decision if you take into account the following hidden costs.

	Segment A	Segment B
Fulfillment cost (per item)	$20	$70
Shipping cost (per item)	$40	$150
Customer service cost	$20	$200
Total	$200	$2,180

Segment A is based in the US, so the fulfillment and shipping costs are much cheaper than that for Segment B which is based abroad. Moreover, Segment B is provided with a frequent after-sale service as part of the deal. 

When you plug in these values in the CPA formula, you get the customers’ behavior and profitability given by the following table:

	Segment A	Segment B
Total revenue	$900	$2,700
Total costs	$200	$2,180
Customer Profitability	$700	$520

If your company reported 100 customers in Segment A and 50 customers in Segment B, you might believe that Segment B contributes to two-fifths (60%) of your annual sales. 

You may come to the conclusion that you ought to concentrate on this smaller collection of customers who account for a greater proportion of yearly revenue. 

	Count	Sales by Segment
Segment A	100	$90,000
Segment B	50	$135,000

However, you would then be allocating more resources to a less profitable customer group based on the additional analytical granularity provided by the aforementioned Customer Profitability Analysis.

	Count	Sales by Segment
Segment A	100	$70,000
Segment B	50	$26,000

Overall, your business will gain a more precise understanding of which customer segment is the stronger driver of your total profitability by looking at customer profitability rather than just sales.

4 benefits of applying customer profitability analysis

You can gain a profitability perspective on the company and make data-backed decisions by conducting a customer profitability analysis. There are more advantages to analyzing customer profitability than you think, including:

#1. Improve operational effectiveness

When a customer base is producing lower earnings, it is not always the customers who are to blame. However, there may be a few issues with the company’s internal processes that increase your customer acquisition or customer retention costs. 

Let’s say the less profitable customer segment uses a lot of resources to address the same product issue repeatedly. It might be advantageous for the business to incorporate a feature into the product itself that addresses the problem rather than devoting resources to that persistent problem.

Therefore, conducting a customer profitability study would not only reduce operational costs but also improve your product for prospective customers.

#2. Reduce cost influences

Customer segmentation based on how much profit each customer is generating is one of the most popular tasks used in the CPA. 

Based on whether groups are producing an acceptable level of revenue compared to the investment you are making for them, you can easily segment them.

It is true that you will need to provide good service to segments that generate high returns. However, for the segments that generate low returns, it is best to stop providing support to them to reduce the cost factors.

#3. Focus on the right segment

Through customer profitability segments, you may find that the market segment you are contemplating as your target market is also the market segment that generates the least profit. While an ignored market is generating more revenue.

CPA makes it simpler to figure out this fact and enables you to direct your resources to the most profitable section. That typically means you can focus your marketing efforts and resources on customer groups that bring in the most value.

Specifically, once the customer segmentation based on profit range has been conducted, it can be used for other purposes. It is necessary to record the characteristics of the customer group that generates the greatest profits, so you can use them for future customer acquisition strategies.

To draw in more of these customers, marketing teams can center their campaigns on these groups. Additionally, marketers can choose what offers to make based on the profitability range.

#4. Customize your retention strategy

Companies can concentrate on their retention strategies for each group once the profit segments have been defined. They will only need to provide a service of the highest standard to their most profitable customers. 

You can determine exactly how much you can spend on increasing customer loyalty by using CPA. Designing loyalty programs based on a customer segment’s profit margin is much simpler and more effective.

4 mistakes to avoid while doing customer profitability analysis

When conducting a customer profitability analysis, you should avoid the following things:

#1. Considering that every product is the same

In this kind of scenario, you may presume that every product is equivalent. All products, though, might not have an identical effect on your company. You must know that every product is unique when conducting a customer profitability analysis. 

To measure the effect properly, you must take into account all differences. It is more difficult to determine the impact of a particular product in multi-product enterprises. However, accurate customer revenue calculations result in higher levels of customer retention.

#2. Not tracking all the costs involved 

Sometimes it’s easy to overlook additional expenses when calculating customer profitability. Inability to monitor these expenses will lower profitability as a whole. Any business can incur expenses for sales, marketing, handling, warehousing, transportation, and more.

It is always preferable to carefully do your research and factor in all expenses when formulating an equation. This is because each of them will have an effect on your company in some manner.

#3. Determining profitability based on customers rather than products

If profits are determined against the customer, customer profitability analysis may not be accurate. Keep in mind that one should not look at how much profit was made from a single customer when calculating customer profitability analysis.

Profit from the product must be used to gauge the process. The profitability structure’s main point of emphasis must be the product. Each product’s profitability needs to be determined.

#4. Selecting the wrong time frame 

The proper time frame must be chosen when performing the customer profitability analysis. Longer time periods are required for better outcomes. This is beneficial because you can accurately estimate the customer lifetime value.

The time period must include the aspects of product usage. You cannot be certain if the customer experienced product adoption when the time frame is too short. Therefore, using customer profitability analysis over a lengthy amount of time is best. It’s recommended that this one should have multiple years on the same calendar.

3 best practices of customer profitability analysis

Having a customer profitability analysis is one thing. The implementation of your business is a different matter. The best practices listed here will enable you to get the most out of customer profitability analysis.

#1. Identifying your top-performing customers

When it comes to boosting the profitability of your eCommerce company, knowing which of your customers will be most profitable is essential. You can make more wiser decisions about how to best service these customers if you have more knowledge about them.

To evaluate their performance and comprehend their purchasing behavior, you should analyze their spending patterns over time. You could, for instance, keep tabs on how long it takes them to make an order. A regular customer with big orders is more likely to stay.

#2. Analyzing and understanding your most profitable customers 

It’s critical to recognize the common characteristics of your most profitable customers. This will enable you to spot patterns in the kinds of goods they are interested in and the length of time they spend on your website before leaving.

Then, you can apply them to the rest of your customer base and come up with proper strategies to cater to their needs. 

For instance, you can tell that sales of sweaters aren’t doing well if you see that customers spend a lot of time browsing the section without ever making a purchase. Before you start losing customers, you should act quickly.

#3. Providing better incentives for profitable customers

Retaining customers is one of the best methods to increase profitability. As you won’t have to spend as much money on acquiring new customers, it will also help you lower your customer acquisition costs.

It is good to provide incentives that reward your best customers with discounts or free shipping. These rewards will entice them to keep making purchases from you, boosting their customer lifetime value.

Moreover, some businesses provide loyalty programs where customers can earn points for certain transactions. These points can be exchanged for gift cards or discounts on upcoming transactions. This is one of the best ways to keep customers returning and entice them to make larger purchases over time.

Final words

Customer profitability is more than just the money a customer brings to you. Businesses can establish the right goals for each customer by using customer profitability analysis to help them concentrate on the right customers.

This analysis is a very advantageous process, but it still has some drawbacks. As a result, you should take the time to thoroughly assess every aspect of a customer’s relationship with your business to uncover insights that significantly affect your analysis and bottom line.

See what proper tracking looks like at trueprofit.io