Any business owner who believes in holding on to every customer may never see the business reach its maximum earning potential.
By Mark E. Battersby
Most business owners know whether their business is profitable. Not all of them, however, are aware that some customers simply don’t make money for them, or not enough money to warrant the amount of services demanded, or provided.
The solution is simple on the face of it: make those customers profitable, or cut them loose. Improving a customer’s value to your business isn’t always easy, but it always begins with learning just how much a customer costs, as well as how much he pays.
Keeping tabs on costs
The often repeated “80/20” rule states that a large majority (80 percent) of any business’s earnings come from a very small number (20 percent) of customers. Those who don’t necessarily buy a lot, but who also don’t demand a lot of service, may be good customers. Others may buy more but require so much assistance that they’re actually costing you money.
The best way to evaluate the profitability of a customer is to keep track of all interactions with that customer over a period of time. One week is obviously not enough, and a year is too long for most types of businesses. Gross profit margins are the most commonly used factor, but you can’t assume that a customer is not profitable simply because that margin is below average. That’s where other factors, including costs, come in.
Many businesses allocate some portion of their overhead costs to customer service. More often, however, costs reflect only the cost of the product sold or the services performed. Missing from this measurement is the time, support, effort and ultimately the total cost required to meet the customer’s needs. Analysis that reveals the total cost by customer, rather than by product or services, often produces startling results that will shift the focus of profitability discussions.
“Cost accounting” is the process of allocating all of an operation’s costs associated with generating a sale or performing a service, both direct and indirect. Direct costs include things such as the total wages paid workers, the salaries of supervisors and supplies expended. Indirect costs are all of the other expenses associated with keeping the operation going.
Establish systems, create goals
An analysis of customer profitability compares the costs of all of the activities used to support a customer or group of customers with the revenue generated by that customer or customer group. Various costing techniques can be used to determine the profitability of customers—and to estimate the cost of doing business with particular customers or with groups of customers that require similar service levels.
It’s not usually practical to identify the profitability of individual customers, unless there are only a few of them. Customers may be grouped by size, market or types of products.
To set up an effective cost accounting system, the help of an accountant or CPA might be advisable. It can get complicated. The money invested in professional guidance should be well worth it, leaving only the question of what to do about any “bad” customers.
From bad to profitable
The first step to turning unprofitable customers into valuable assets is determining whether the relationship can be improved. Any business owner who believes in holding onto every customer, no matter what the cost, may never see his or her business reach its maximum earning potential.
No one wants to lose customers, but there’s no clear rule of thumb on how to “reform” a problem customer. Each situation is different. If the problem is one of slow payment with a small customer, for example, shipment could be postponed until they’ve paid. The same approach may work for larger customers if the business has enough leverage. As an alternative, a price increase to offset the higher cost of extending credit could be implemented.
Worried about the customer going elsewhere? Sometimes that’s a good thing. Problem customers become problems for competitors.
Keeping profitable customers
In the past, the importance of focusing on customer retention was not as important; “stickiness” came naturally. We had, in many instances, a personal connection with our service providers. That has changed. Vendor relationships are often impersonal, customer loyalty has vanished, and large corporations and virtual storefronts regularly (and usually electronically) ask crowds of straying customers why they’ve moved on. Keep in mind that it is five times more profitable to spend marketing and advertising dollars to retain current customers than it is to acquire new ones. There is a solution—and once again, it involves costs.
Do you know how much of your business’s resources you allocate to marketing and new customer acquisition? Most importantly, do you know how much you should be spending, and at what amount it becomes a losing proposition?
Many small businesses use a combination of guesswork, perceived funds available and gut feel to set their marketing budgets. Understanding the lifetime value of new customers allows business owners to take a longer-term and more realistic view of attracting new business to make their companies more efficient and profitable.
Customer acquisition cost is calculated by dividing total acquisition expenses by the total number of new customers. Simple enough; but not surprisingly, there are different opinions as to what constitutes an acquisition expense. For example, rebates and special discounts do not represent an actual cash outlay, yet they have an impact on cash flow (and presumably, on the customer).
The specific calculation depends on the nature of the customer relationships, which are often divided into two categories. In contractual or retention situations, customers who do not renew are considered “lost for good.” The other category involves customer migration situations, in which a customer who does not buy (in a given period or from a given promotion) is still considered a customer because they may buy at some point in the future.
To compute the cost of acquiring a customer (CAC), the operation’s entire cost of sales and marketing over a given period, including salaries and other related expenses, is divided by the number of customers or prospective customers acquired in that period. CAC calculations must also account for the cost of turning prospects into customers.
In order to compute the Lifetime Value of a Customer (LTV), the gross profit margin expected to result from that customer over the lifetime of the relationship is computed. Gross margin would take into consideration any support, installation and servicing costs over the projected life of the customer relationship.
Solutions and more solutions
There are a number of strategies for resolving the “Best Customer/Least Profitable Customer” conundrum, including:
- Increasing the profitability of already profitable customers.
- Identifying unprofitable customers and realigning them to better manage costs.
- Pricing products and services more effectively.
- Improving internal processes and establishing a reliable method to predict the impact of business decisions on total system costs.
- Improving negotiation processes with customers (discounts, quantity of deliveries, order size, payment terms).
The one thing that many business owners often ignore is whether their best business decision may actually involve “firing” some of their worst customers. It may seem contrary to basic business practices, especially in a bad economy, but having the wrong customers can be costing a business in unexpected ways and holding it back from real success with the temptation of short-term revenues.
Stuck in dealings with minimum profit margins, your ability to service new and more profitable customers could be compromised. A business can also experience increasing employee turnover due to burnout from servicing abusive or demanding customers, adding the additional expense and time of recruiting and training new workers.
Part of the challenge faced by many business owners is how to extract the operation from those relationships without burning bridges. Often, simply communicating new credit or service policies clearly and openly as a business decision (and not just to one customer at a time) will cause problem accounts to look elsewhere. Make it a policy, not a reaction.
Accounting for costs means more realistically pricing goods and services to ensure that costs are fairly covered by revenues. Cost accounting can prove invaluable when it comes to determining real profits and finding out what a particular job actually costs. If detailed enough, that cost accounting can also reveal what your “best customers” actually cost you and your business, as well as the revenues they bring you.