What is customer profitability, and how does it affect your business?



Published: 31.5.2021, Authors: Elina Ojala, Senior Manager & Eero Soralahti, Senior Manager

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Pricing and cost management get into a new kind of spotlight when the goal is better customer profitability

What does customer profitability mean, and why is it significant for the entire business? Where to start improving profitability, and why is the income statement not enough to map your trip? Once you have found the building blocks of profitability, how can you impact them and put the changes into practice? In this blog post, we will answer these questions and more. Welcome to explore customer profitability with us!

In this table of contents, you will find shortcuts to the most interesting points:

1. What is customer profitability?

Customer profitability (CP) refers to the profit that a customer brings to a company over a certain period. Thus, customer profitability tells you how much is left under the line when all the customer's costs are deducted from the revenue brought in by the customer.

Why is it worth considering customer profitability separately - why aren't we just talking about profitability? The averages don't tell the whole story behind the key figures. The income statement can even lead you in the wrong direction when you want to understand which customer relationships or product lines are profitable or unprofitable. That is why we need to take a more profound look at profitability.

Pricing and cost management are inseparable pairs for customer profitability. Later in this article, we will walk you through both viewpoints. Additionally, you will also learn to know some practical ways to improve profitability. As a result, you can better nurture your key customers and viable product lines. You also won't accidentally cut back on actually profitable activities, "throw the baby out with the bathwater," as the saying goes.

Customer profitability is not about analysis, measurement, reporting, and consulting. All of the above are useful as the first steps of your journey, but they are just means to get you towards better profitability.

Customer profitability

 

Customer profitability unveils the profitable and unprofitable customers hiding behind the averages

Traditionally, we are accustomed to evaluating the success of companies with top-level metrics, such as quarterly revenue or profit made during a financial year. We often measure a customers' gross margin but may refer to other costs as averages: a company may monitor, for example, the average cost of customer service in euros.

However, by looking at customer-specific profitability, a company will find information that is crucial for running a business – and that would otherwise be invisible:

  • Which customers are the most profitable?
  • Which transactions and customers have been unprofitable?
  • Which products should we offer to which customers?

There are many different methods for developing customer profitability in the expert toolkit. If you are already familiar with pricing and cost management, you may want to jump to the end of this article to learn more about practical ways for profitability improvement!

The income statement is insufficient to monitor profitability

It is common to seek answers to profitability problems from the income statement and balance sheet. Actually, those mandatory documents were once developed to meet taxation needs, and they do reveal top-level information about a company's revenue and expenditure streams. But they do not provide detailed enough information about customers.

Important information is lost if you keep reading the income statement only. Bonuses and compensations paid to customers, for example, are hidden because they do not appear in the final turnover. It is also impossible to obtain accurate information on customer maintenance costs, such as handling complaints.

When you want to understand customer profitability in the light of numbers, you need to start from a different direction: looking at activities and functions. It gives you an idea of the value accumulated during the production process. Remarkable differences in profitability between customers will emerge.

Only after you clearly see the value addition path:

  • you can decide what precise measures to take while minimizing adverse side effects, such as the loss of potentially fully profitable customers or functions; and
  • you can evaluate if customer profitability is consistent or whether, for example, individual product batches or deliveries fluctuate remarkably.

Customer profitability depends on both pricing and cost management

Wouldn't it be simple to upgrade the prices? Or what if we emptied the stock by pushing the prices and shipping costs as low as possible? If you shoot in the dark, you can sure win – or lose as well. The customer may not accept higher prices but will turn to a competitor instead. The margin on your mass sales will shrink if cheap bargains lead to lots of customer service work and complaints. In addition, you may unintentionally cause a decline in the overall market price levels and undermine the price perception of your brand.

So how do you start looking for the right price and optimal return? The waterfall model of revenue generation describes the journey from gross price to profitability through costs. Thus, minimizing costs or maximizing prices are not goals themselves. They are just tools. Selling both an expensive premium product and low-cost batches can be profitable if costs are under control. You must carefully consider the effects of price changes in the market, too. The waterfall can flow high or low as long as it does not dry empty.

To improve profitability along the waterfall, you must systematically turn over each stone between the customer price and final profit.

Next, we will discuss pricing and cost management from the customer profitability perspective in separate chapters. Finally, we will return to illustrate how they work together to improve customer profitability.

2. Pricing and customer profitability

How to find an optimal price for a product or service? You can give everyone the same price or offer each customer a tailored price solution. The optimal way often lies somewhere between these ends. To find it, you need to identify both the customers' needs and desires and the company pricing management capabilities.

A suitable price strategy helps in price setting

Pricing is one of the most efficient ways of improving a company's customer profitability levels without committing significant investments. Changing pricing strategy or merely altering or structuring the current pricing strategy will likely result in a high return on the input effort. It is fundamental to understand different approaches to pricing strategies. Only after that will you know how to price and why a specific method is the best for your business. Once the understanding is sufficient, the next step is to ensure a pricing model that fits the business design.

Cost-based pricing is often the first step in improving the situation. Costs and inputs are accurately identified at the product level - preferably even at the transaction level - and you will ensure that the price covers them. The model is safe and popular. Its problem is that it does not consider the competitor landscape or the customer's willingness to pay and may therefore cause under or overpricing.

Market-based pricing broadens the perspective. In this model, you will position your product or service with competitors. Are we going to battle for the lowest price or find our niche on the premium level? Like cost-based pricing, this model leaves the customer in a passive role. Competitors do their thing, and you will add your value to that.

Value-based pricing solves the mentioned challenge points - if done correctly. Its starting point is a genuine desire to understand your customer's values ​​and the possibilities to exceed your customer's expectations. Service design methods are beneficial in gathering customer understanding. . When you do value-based pricing correctly, it is an easy way to increase profitability. At the same time, when you understand what the customer values, you know when the customer is willing to pay more.

To find the optimal price, you need to understand the customers' needs and the pressures and competition on the market, not to forget the different cost items. Let's take the example from the world of luxury bags. Once you find the right niche, you can sell a bag for a high price and very profitably (and at a much more expensive cost structure) than a plastic bag at your local market checkout. Both do their job as shopping bags, but the luxury bag also holds other values. On the other hand, if two wholesale operators buy the same amount of luxury bags from the manufacturer, one may need more sales or administrative resources than the other. Therefore, you cannot isolate pricing and cost control from each other.

READ ALSO: How to reap the benefits of value-based pricing?

“Price getting” describes the reality

Tacit information between sales agents, decisions made on the go, and "we have always done this way"-phrases: does it all sound familiar? Still today, many companies seek the correct prices using these means. It is good to correct the course before it is too late.

Discounts are essential tools for any salesperson. Unlike you might think, discounts and customer profitability are not mutually exclusive. It is possible to guide customer behavior with discounts and thereby even improve customer profitability. However, a common pitfall waits soon after the sales are closed. That is to say; companies do not often monitor the realization of discounts at the customer level.

Salespeople can give discounts for various reasons, but an essential purpose is to increase sales. Ultimately, sales teams will do their best to bring in revenue, but too generous discounts can lead to problems when small acts accumulate into large streams. Let's say a customer receives a fixed percentage discount based on estimated sales of 1MEUR, but the number of completed orders turns out to be ultimately much lower. What are the consequences for profitability?

You should, therefore, link the discounts to sales potential and actual buying behavior. Most importantly: existing discount practices should be reviewed regularly. With the help of discounts, you can also guide customer behavior in the desired direction.

Dynamic pricing and customer profitability in the b2b frame

Let's now go back to find a balance between iron-cast and tailored prices. We know that dynamic pricing is vital for many sectors in the consumer business, such as tourism and travel. Daily price changes may not be that common for b2b sales, but there are still opportunities for flexibility.

Seasonal fluctuations can affect both the cost of providing the service and customers' willingness to pay. For example, a logistics operator may raise prices during the Christmas peak if he knows the season is the most important for their customers. With the help of higher prices, that logistics company can cover higher costs due to, for example, seasonal labor and thus ensure the quality of service even when volumes increase. This strategy is possible when customers are carefully segmented based on their needs and willingness to pay. Then prices can be successfully and dynamically differentiated to segments according to the situation.

READ MORE: How to profit from dynamic pricing in any business?


We have now addressed pricing: the other side of customer profitability. Next, we will look at how the other side of the same coin, i.e., cost management, relates to customer profitability.

3. Cost management and customer profitability

What do you need when you produce a new item? Materials, of course, but many functions too, such as the assembly phase labor input, transportation, and wholesale distribution. It is usually possible to count these costs accurately, but it is not enough for the whole picture.

The final price must also carry its share of office work and the company's premises. One must also reflect risks such as sudden outages in the customer price, to that the best possible service can be guaranteed in every situation. Even though the value creation process in expert services and the project industry is slightly different, it is possible to break down their cost structure similarly.

What are the different cost elements?

When you want to improve customer profitability, you must carefully review how the different cost items behave. You need to approach costs from several directions to ensure that all venues are found and exploited. One commonly used premise is to look at how costs behave as volume changes.

Fixed costs

Fixed costs will remain the same no matter how much sales you will make. Each customer bears a share of these fixed costs. If fixed costs dominate the cost structure, such as in a paper mill, maximizing the utilization rate is your priority.

 

 

Variable costs

Variable costs will agilely vary according to the volume of production. The term Cost of Goods Sold (COGS) provides one perspective. It often refers to the (primarily variable) acquisition costs. The more production there is, the more electricity and materials you will need. Similarly, other customer-specific cost items may increase. Labor costs can also be variable when it comes to contract or commission wages or temporary labor. If variable costs dominate the cost structure, managing profitability at the product or transaction level is vital.

Semi-fixed costs

Semi-fixed costs increase one leap at a time. Let's take an example. Imagine a production line that can equally make 1 or 10,000 products a day at a fixed cost. If the daily need grows by more than ten thousand, an expensive investment in the next line is required. Before moving on to the next step, it is worth checking whether you need to re-allocate customer-specific costs to avoid cutting down customer profitability. If semi-fixed costs dominate the cost structure, it is essential to stretch the current cost structure to the highest possible production volume and transition to the next levels so that the utilization rate is never too diluted. Especially when making pricing decisions in fast growing companies, it is important to estimate the development of semi-fixed costs.

How should you manage cost items?

Earlier, we explained why the income statement and averages are not enough when interested in customer profitability. It is, of course, essential to know the total costs, that is to say, the mass that you at least must cover with sales. You can always do rough actions based on annual averages. However, there is a risk of imprudent cuts and loss of viable business operations – in other words, throwing the baby out with the bathwater. At worst, an entire product line will be shut down, for example, even if most of its customers have been profitable.

Therefore, it is worth disassembling the whole. The more detailed you know your cost drivers, the more precise measures you can take to fix them. You must be able to drill to top-level profitability from all directions and at all levels: up to the level of customer segments, customers, products, or projects, and ultimately to the level of individual transactions.

When you research the costs, the following questions are vital:

  • What are the most significant cost items for this customer?
  • Are there differences between customers in terms of highlighted costs and their levels?
  • What deals with the customer have been particularly unprofitable or profitable, and why? What can you do with this information in the future?
  • What will happen to the customer-related costs if unexpected changes appear (will the customer order less than expected during the following year, for example)?
  • Should the pricing or discount policies for this customer be changed? Or should the customer product mix be guided towards more profitable level?
  • Should this customer be tied to extended volume contracts to ensure the continuity of utilization rate? On what price level would this be profitable?

Small actions can turn a seemingly unprofitable customer into a profitable one. Let's take an example. At the contract stage, sales and the customer have agreed to use rail transport. Later on, there is a sudden change, and goods will fly to their destination via air freight for one reason or another. Thus, the mere share of freight can either demolish profitability or restore it to a better level.

When you know your cost elements, it's easier to see, among other things, whether you should price certain services at an additional price or whether they surely will fit inside your fixed price package – also when changes will occur. With the help of an expert, you can identify the best methods, create the conditions for their day-to-day implementation and finally put the new practices into action.

4. From theory to practice – how to improve customer profitability?

Pricing may be the single most effective driver for improving profitability, but sustainable customer profitability improvement is even more about process development and strengthening the entire business. To improve customer profitability, we must first identify the factors that affect it. In this article, we have gone through both price and cost perspectives.

Only after we have recognized the elements can we let the actual transformation work begin. We need to examine what the figures tell us about profitability, and how the situation could be improved step by step from poor to good – or from good to excellent. Updated processes need to be put in place at all levels of the organization, not to forget regular evaluations. This way, we can ensure that customer profitability turns to real profits, not just a management team vision.

READ ALSO: Customer Profitability Management

Next, we will walk you through some examples of what our experts particularly focus on in their projects to improve customer profitability.

Is your pricing based on customer values and requirements?

Knowing the customer-specific – or even transaction-level – cost structure is essential to make profitable pricing decisions. Using averages may allocate too much of the total cost to a particular customer, causing their price to climb unnecessarily high. Thus the customer will have to subsidize other, unprofitable customers on their behalf. In the worst case, the customer can turn their back to you altogether. Simultaneously, some other customers may require more than the average amount of attention and nurture, and the price they pay may not be enough to cover it all. It is then necessary to decide whether we want to increase the price or improve profitability by other means.

The customer-specific waterfall model helps determine whether the customer's price is high enough concerning the cost. If there are no apparent reasons for low profitability in terms of cost, you can consider price increase through value addition. For one customer, the most crucial thing may be that the product is of high quality; for another, environmental sustainability is the most important criterion, while the third wants better customer support.

Once you know your customers, it is possible to convert these values ​​into measurable euros, which you can then note in pricing. Highly profitable customers can serve as examples for others, but do not forget this: you cannot do value-based pricing if you don't know the values your customer appreciates the most. Therefore, it is important to start the journey by carefully segmenting the customers.

What should you do if customer profitability falls into the red? Sometimes the product portfolio and the customer profile simply do not match. Trampling down the prices there doesn't change anything for the better. On the other hand, some customers may have an estimated lifetime value to justify an initial loss. The customer may open doors to new markets, for example. Maybe you know that this customer recommends your product or service to others? All in all, without a review of customer profitability, we would not even consider these options.

From cost recognition to profitability management

Identifying costs one function at a time and allocating costs on customer level must be done by analyzing the needs of each company and its customers - there is no ready-made formula for that. All models should be applied with caution, as none of them can fully consider the individual processes of each company, all the reasons for the costs, or the possibilities to alter them.

  • First, it is worth describing the specific company's operating model, like their order-delivery process.
  • The next step is to identify the spots where costs and their differences arise.
  • Furthermore, we should assess the usefulness of the available data. Is it relevant for cost decisions? Are the numbers accurate enough?

Based on these preparations, we can determine a precise work plan can that fits the company's unique needs like a glove. By looking at the level of customer relationships and even individual transactions, we also can find real-life surprises outside the process description, such as expensive complaints or overly generously promised express deliveries. Once we identify these as part of the cost data, we can create policies for both cost anticipation and sustainable pricing.

Huge fluctuations are often revealed when cost levels and profitability are first addressed at a detailed level. Improving from good to excellent often is a slow and demanding path, but you can achieve quick wins by targeting measures at exceptionally low-profit sectors.

Do we understand the role of our product in the market?

The goal of pricing development is not to push prices as high as possible. Especially in the b2b world, the most important thing is to look at price optimization from a chain-wide perspective: in which segment do prices have the potential to evolve upward, where do we need to sell a bulk product or service? It is a matter of optimizing the product mix. At best, it leads to a win-win situation: low costs for the producer, high value for the customer. Thus, efficient customer profitability management brings benefits to the entire value chain.

A customer-specific view also helps to see the different strategic roles that a customer relationship and the product or service can play. Arising from these, you can build road signs to support sales and pricing. Do you want to maximize profitability or launch something new and increase volume, even if the margin remains low and the share of costs higher?

Compliance is the key to prevent price leaks and keep costs under control

You have now walked a long way with us. As you surely remember, we started by analyzing. Next, we took a look at the pricing strategies and turned every stone to control the costs. You have mirrored the various opportunities in your particular business situation and noticed what steps you need to improve your profitability. In the end, of course, those activities still need to be incorporated into each working day of the different teams.

Whether we talk about compliance, sales enablement, or organizational discipline, it's all about the same issue: everyone working with pricing or costs needs to understand the shared rules. Everyone should know their responsibility in improving customer profitability, without forgetting the importance of coordination. The best way to succeed in this is to include whole organization, from top management to sales, in the journey. Additionally, clear guidelines and streamlining customer paths will be helpful tools in this.

Price leaks can occur if the sales team deviates from the agreed framework. In practice, this may mean that one key account manager accepts an overly tight schedule, another takes time-consuming customizations, a third changes the mode of transport from train to plane, and a fourth promises additional discounts. On the other hand, you need to keep costs, prices, and customer profitability under regular monitoring. Is the product mix as expected? Will the customer place orders as expected? What to do if they don't meet the terms of the contract?

There are no ready-made models, but the solution must always be tailored to the company. One proven way is to build clear paths for most orders to run seamlessly and predictably. The fewer sudden and unexpected changes there are, the better the customer profitability.

Ask more about improving profitability

As mentioned above, the actions are unique for every company. Some will have to start by identifying the most significant cost items. At the same time, someone needs detailed pricing or cost management tools not only for customer level but transaction level as well.

Customer profitability is not about analysis, measurement, reporting, or consulting. The previously mentioned are just tools to get you started on your profitability improvement process. There are many small and larger rocks to turn over along the way, but at the end of the route awaits a goal worth all the effort: a more vibrant and sustainable business that creates real value.

Sounds complicated? No worries: in the end, it's just a puzzle where the right pieces are individual and unique, according to the needs of the company and its customers. Customer profitability should not become an extra burden for the management. Dedicated professionals can help to search for the right pieces and put the puzzle together – adding both profitability and peace of mind to daily business operations.

Book a free 30 minutes sparring session

If you want to improve your customer profitability, we are happy to sparring with you! You can book a meeting directly from the calendar of our expert Antti Kuusenmäki or leave a contact request via the form.

 

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