How to Run a Customer Profitability Analysis When Your Margins are Trending in the Wrong Direction
A key component of profitability analysis is looking at your customer base to see which customers (types/segments) best help your company meet profitability goals. To address profit margins trending in the wrong direction, a business needs to know which customers to provide premium experiences to versus which unprofitable customers to renegotiate with or to slowly phase out.
In a customer profitability analysis, you’re able to look at individual customer (or customer type/segment) profitability and uncover insights like time spent serving a particular customer’s needs as compared to revenue gained. In accessing this data, you can learn which customers are least profitable.
Many SMB businesses are subject to the 80/20 rule: Eighty percent of revenue comes from 20 percent of customers. By doing a customer profitability analysis you can segment your customers to find out which have the best revenue and income ratios and subsequently which have the best profit margin ratios. This is key to creating viable growth strategies and moving your profit margins in a positive direction.
In doing your analysis, you may learn the profit potential of a customer is most impacted by location, customer demographic, or spend. Some common examples include:
Same-day delivery services are most profitable within X miles of your warehouse.
Field service contracts are least profitable when locations are more than X miles from nearest international airport.
Online sales are most profitable when customers order in quantities of X or more.
Don’t risk planning your growth strategy around your least profitable type of customer, product, or service. Instead, inform your revenue growth plan around the data from your customer profitability analysis.
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How to Run a Profitability Analysis
The most straightforward way to determine whether you run a profitable business is by calculating profitability (margin) ratios for gross profit, operating profit, and net profit. Ratios paint a clear picture of your efficiency as compared to dollar amounts; your revenue (and overall profit number) may be growing, while your profit margins (percentages) are trending in the wrong direction.
Use the following equations to dial in on these key customer profitability numbers:
Net Profit = (Operating Profit + Any Other Income) - (Additional Expenses) - (Taxes)
Gross Profit = Net Sales - Cost of Goods Sold
Operating Profit = Gross Profit - (Operating Costs, Including Selling and Administrative Expenses)
Net Profit Ratios
Net profit margin (profit margin) is a key metric because it’s your big-picture view of profitability. Keep in mind some industries have high-profit margins, while others are razor-thin.
To understand your net profit margin, as a point of comparison, use industry standards as a benchmark. Perform an internal quarter-over-quarter and year-over-year comparison to assess your performance regularly and use that data to drill down into what components are driving profit margins both positively and negatively.
You may notice increasing sales and marketing expenses driving costs up and profit margins down as you focus on new customer acquisition. You may see skyrocketing freight charges or increasing product returns driving costs up and profit margins down. Use these clues to investigate the root cause. Are the commonalities customer-related, product or service-related? If customer-related, where are the customer attribute commonalities?
Gross Profit and Operating Profit Ratios
First and foremost, keep your eye on the stability of this ratio. Second, consider both short-term and long-term fluctuations and what each might mean.
Short term: Your gross margins shouldn’t fluctuate drastically from one quarter to the next. One of the few things that could cause a severe fluctuation would be if your industry experiences a widespread change that directly impacts your pricing or cost of goods sold (COGS). If you see extreme fluctuations, you likely have your eye on what caused a spike in costs or sales.
Longer-term: Profit margin erosion over time is a more typical issue that creeps in slowly, oftentimes as a company is rapidly growing. One of the things that can move this ratio in the wrong direction is a disproportionate increase in operating expenses (when compared to increase in sales). If your revenue is growing but your customer retention numbers are not looking good, drilldown into your cost of sales, customer acquisition costs (costs to acquire). New customers are typically not as profitable as existing customers in large part because the cost to acquire them is higher than the cost to keep them.
If you suspect operating costs are creeping up, perform a comparative analysis of your operating expenses and ratios with a side-by-side comparison, using 2+ years of data. Scan your analysis to identify the reason for outsized expense increases and decide whether it warrants drilling into. The root cause may take some investigation, but if the impact is significant enough, it’s worth tracking down.
Run Customer Profitability Analysis to Address Eroding Margins
If your margins are trending in the wrong direction, a customer profitability analysis can help you get back on course. Use the data to uncover unprofitable customers, increasing costs, longer-term profit margin erosion, and more—then use that information to make the necessary changes to ensure max profitability now and in the future.
