How to determine customer profitability

Jeremie Bacon wrote this on Apr 25

Customers are the principal source of revenue for every business but it is easy to forget that they are 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 their profitability.

Anyone who knows me knows that I am a stickler about 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.

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This is easier said than done, of course, but it is important to put in the effort required to figure it out - especially 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.

I’ve written about the importance of evaluating cash flows and ROC (return on customer), and why striving to build value creating and value harvesting 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. I use a basic example for a software company to help illustrate my points.

What is ROC again?

As a refresher, Return on Customer thoughtfully 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

In order to determine the profitability of your customers, you need start by asking the right questions about your business. For starters, you need to get a handle on your up-front acquisition and ongoing relationship management costs. I find the best way to do this is to create a list of questions that will help you reveal the costs associated with selling, onboarding, and servicing your customers. Every business is different so, unfortunately, there is no one-size-fits-all template for this part.

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?
  • How much time did our sales executive spend on discovery, sales, negotiation, and close?
  • How much 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?
  • How often do we conduct business reviews for this customer and how much time goes into planning and executing them?
  • How many times a year do we have to visit them on site and who has to go?
  • 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.

To see what I mean, let’s take a look at this hypothetical example for everyone’s favorite internet sensation, Pied Piper (that’s being tracked in Synap).

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As you can see, Pied Piper has been with us since 2014, currently pays us $75,000 per year, and costs our firm $53,500 per year to service; $35,000 in account management expenses and $18,500 in expenses attributable to cost of goods sold (e.g., technical support and dedicated infrastructure). Based on these expenses, we are earning a $21,500 profit on the account this year! Netting a 29% profit margin is fantastic, but it doesn’t reflect the cumulative profit or loss associated with the customer.

Scrolling down a little further we see that Erlich and the team at Pied Piper cost us $45,000 to acquire originally. So, even though we’re making a profit on them now, that hasn’t always been the case. In fact, as you see in the table  below, we lost money on them for the first two years, finally turning a cumulative profit back in 2016. With a profit margin of 29%, and Return on Customer ratio averaging close to 50% per year it is easy to see that Pied Piper is a great customer for us.

Notice that in addition to tracking our revenue and expenses from this customer, we’re also keeping tabs on the year-to-year change in customer equity. Pied Piper is worth more than the revenue they’re paying us because they are a source of referrals (six per year according to the data) and we’re currently earning $225,000 in revenue from customers they’ve referred to us. In this example it’s easy to see why we’d attribute a positive change in customer equity to them every year.

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To come up with those dollar amounts we need to know a few basic numbers such as how much our sales and success team earn on trailing commissions or upsells, what our average hourly cost per employee by type is (e.g., account management, technical support, sales operations, C-Suite, etc.), and things like that. If you’re not sure what those numbers are, ask your CFO or give me a shout. I’d be happy to help you put together a back-of-the-envelope guidebook. The point of this exercise is to get an accurate estimate of your costs, not a to-the-penny reckoning.

In the real world it isn’t always easy to answer all the pertinent questions that reveal customer profitability but it isn’t impossible. That is precisely why it is so important to develop a method for measuring the profitability of your customer relationships.

You owe it to your business to ask the right questions, organize the data, crunch the numbers, and 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.

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