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Unit 3: Analysing Profitability of Customers

resulting from additional marketing investment. Customer segments or individual customers Notes
may be further investigated through ad hoc analysis, lists of customer segments may be
automatically generated, or alerting rules may be applied to customer segments to automatically
notify relationship managers when profitable customers have executed a transaction.
Within any given customer base, there will be differences in the revenues customers generate
for the firm and in the costs the firm has to incur to secure those revenues. While most firms will
know the customer revenues, many firms are unaware of all costs associated with customer
relationships. In general, product costs will be known for each customer, but sales and marketing,
service, and support costs are mostly treated as overhead. Customer profitability analysis (CPA)
refers to the allocation of revenues and costs to customer segments or individual customers,
such that the profitability of those segments and/or individual customers can be calculated.

The impetus for the increasing attention for CPA is twofold. Firstly, the rise of activity-based
costing (ABC) in the 1990s led to an increased understanding of the varying extent to which the
manufacturing of different products used a firm’s resources (Cooper & Kaplan, 1991; Foster &
Gupta, 1994). When using ABC, firms first identify cost pools: categories of activities performed
within the organization (e.g., procurement). For all cost pools, cost drivers are identified: units
in which the resource consumption of the cost pool can be expressed (e.g., number of purchase
orders). Costs are then allocated to cost objects (e.g., products) based on the extent to which these
objects require certain activities (measured in cost driver units). Once it became accepted that
not every product requires the same types and same levels of activities, it was a small step to see
that customers, too, differ in their consumption of resources. The size and number of orders, the
number of sales visits, the use of helpdesks, and various other services can be very different for
each customer. Consequently, some customers incur more relationship costs than others, leading
to different levels of customer profitability. Although this has long been recognized, it fits
better in the logic of ABC than in the traditional costing systems. Secondly, information
technology makes it possible to record and analyze more customer data—both in type and in
amount. As data such as number of orders, number of sales visits, number of service calls, etc. is
stored at the level of the individual customer; it becomes possible to actually calculate customer
profitability.
It is considered good industrial marketing practice to build and nurture profitable relationships
with customers. To be able to do this, a firm should know how current customer relationships
differ in profitability, as well as what customer segments offer higher potential for future
profitable customer relationships. CPA can deliver such knowledge. While many publications
extol the virtues of knowing which customers are profitable and which are not (Cooper &
Kaplan, 1991; Jacobs, Johnston, & Kotchetova, 2001; Shapiro, Rangan, Moriarty, & Ross, 1987;
Storbacka, 1997), most publications provide no more than a cursory description of the actual
implementation process of CPA. One notable exception is the case description by Noone and
Griffin (1999) set in the hotel market. Firms operating in industrial markets face specific
implementation issues however. These issues are related to characteristics such as the use of
account management and personal selling, indirect selling via distributors, maintenance and
repair services, demonstrations of equipment at customer sites, and extensive discounting and
bonus structures for customers and distribution partners. The objectives of this article are to
develop a general approach for the implementation of CPA in industrial firms and to share what
was learned from the actual implementation of such a process in one national subsidiary of a
multinational industrial firm.

3.1 Managing Customer Profitability

Before heading towards the discussion about what is meant by customer lifetime value, we must
understand the concept of managing the customer profitability.

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