The framework, known as Customer Profitability Management Cycle (CPMC), offers guidance on how to analyse, measure and manage customer value to support the implementation of strategies that increase this value and thereby improve shareholder value. The CPMC is designed to give all companies, from those just starting to measure customer profitability to those with well-developed profitability models, insights that can help them to sustain effective profitability management strategies.
Step 1: manage customer segmentation
All customers are not the same. The first step in the CPMC is to split your business’s customer base into segments and, as the profitability cycle matures, assign a value to each segment.
Companies generally use segmentation in order to serve customers’ needs better, categorising customers according to personal characteristics, preferences or behaviours. But, in order to maximise their value as assets to the company, customers should be segmented according to their profitability.
The value they provide arises from a combination of three sources:
- Customer margins: income received minus the cost of serving customers.
- Customer lifetime value: customer margins multiplied by the duration and strength of their relationship with the company.
- Customer impact: the effect of customer referrals and other behaviours that influence stakeholders’ actions.
Customer value can be measured and managed with reference to each source.
Step 2: measuring customer margins
To enhance customer margins and so boost profits, a simple way might be to increase your prices. In competitive markets, where demand is highly price-inelastic, the reduction of non-product costs eg. those of marketing, order processing, relationship development and so on – allows companies to increase revenues without adjusting prices.
Activity-based costing (ABC) systems can help companies to calculate and assign such costs and thereby calculate the profitability of each customer. Alternatively, a managed reduction in customer demand can also result in higher levels of profitability per head. For example, by charging fees for small orders, a firm can divert its resources away from short-term, unprofitable customers who require high levels of service and instead use them to help develop longer-term relationships with high-spending customers who are likely to be more profitable in the long run.
Step 3: managing customer lifetime value
Customer profitability varies over time. As such, Customer Lifetime Value (CLV) is likely to be a more useful measure than a single-period metric. By calculating CLV, firms can differentiate customers who have made one-off purchases showing profitability in one period from those who have established a relationship with the company and are more likely to generate higher profits in the longer term.
Different methods of calculating CLV exist, and all share three essential elements: profits, retention rate and discount rate. CLV can be increased by focusing on customer margins and/or by improving the duration or strength of the relationship between the consumer and the producer. Customer retention is a key part of CLV. It is improved by enhancing the value provided to the customer over time. The costs of acquiring a customer are repaid by retained customers.
Step 4: measuring customer impact
Customers can create or destroy value in ways that fall outside the reach of CLV. They have the capacity to affect corporate profitability by influencing the perceptions and actions of others. Customers have an impact on other customers, your company’s employees and other groups, through their transactions and communications. Specifically, they can affect others by:
- Recommending a product to other consumers – or warning them not to buy it.
- Serving as role models to legitimise the use of the product
- Using the product in a way that affects brand image.
They can share their experience in consumer communities, providing tips for the company and solving problems for other customers. Company representatives participating in these forums can use the knowledge gained to improve services to non-participating customers.
Step 5: managing customer profitability
Several strategies are available for managing the components of customer profitability. A carefully formulated and clearly articulated strategy can lead to a dramatic improvement. For this to happen, you must also have a logical system for measuring and reporting performance for each customer segment.
A comprehensive system for managing customer profitability will have measures for:
- Product and service value
- Brand value
- Relational value
- Customer margins
- Lifetime value
- Customer impact
It can also include measures of customers’ perceptions, attitudes, brand awareness, satisfaction, loyalty and other indicators relating to profitability.
Firms recognising the value to be gained through increased customer profitability also recognise the need for relevant data on sales, costs and customer behaviour. Appropriate data, measures and reports can vary across companies and segments and over time, as the nature of the value proposition evolves. Some firms may already have customer data ready for slicing and dicing, housed in their datawarehouses. For those companies for which existing data is insufficient to estimate CLV, an investment in software, profitability calculating expertise and reporting plan development may be worthwhile.
Alternatively, calculations may be based on rough estimates, which can prove informative for managers, who often develop a stronger sense of the importance of costs and customer retention to profitability. Companies that begin with rough estimates will see increasing value over time, as revenue and cost histories evolve and resulting CLV estimates become sharper.
By focusing more carefully on the various components of customer profitability, including customer segmentation, customer margins, CLV and customer impact, you can maximise the overall value that your company obtains from its customers.
Liz Murby is a former technical issues manager at CIMA. This article is contributed by CIMA (The Chartered Institute of Management Accountants) and it first appeared in Financial Management, CIMA’s monthly magazine for its members. It is based on ‘Managing customer value’, a Management Accounting Guideline published by CIMA, the American Institute of Certified Public Accountants and the Society of Management Accountants of Canada.
