Customer Profitability Analysis

Activity Based Costing (ABC) is best known for its appilcation in computing product costs, but firms also find it useful in determining the cost of serving customers and as a basis for evaluating the profitabilty of a specific customer or group of customers. Why is this important? Most managers agree that 80% of their profits come from the top 20% of their customers and most important, the bottom 20% of their customers are unprofitable. For example, to compete with Walmart,Best Buy works hard to attract profitable customers and equally hard to discourage the unprofitable customers which those that are price shopping and looking for discounts and promotions and comparing prices to Walmart. Best Buy studies demographic and sales data for each store location to identify profitable and unprofitable customers. Customer profitabilty analysis idetifies customer service activities and cost drivers and determines the profitability of each customer or customer group. Here, customer service include all activities to complete the sale and satisfy the customer including advertising, sales calls, delivery, billing, collection, service calls, inquiries and other forms of customer service. Customer profitability analysis allow managers to:
Identify most profitable customers
Manage each customer’s cost-to-serve
Introduce profitable new products and services
Discontinue unprofitable products, services or customers
Shift a costomer’s purchase mix toward higher-margin products and service lines
Offer discounts to gain more volume with low costs-to-serve customers
Choose types of after-sale services to provide
How to calculate Customer Profitability Analysis
The first step of CPA is to create a simple model of revenue by customer on the one hand, and total business unit costs and overheads on the other.
Second, subtract the direct product and service costs from each customer (costs of good sold/cost of sales) to arrive at a gross margin per customer.
Third, it should be possible to