CIMA Insider May 200326

TECHNICAL | IDEC

Customer profitability analysis (CPA),according to the 2000 edition ofCIMA’s Management Accounting

Official Terminology, is the “analysis of therevenue streams and service costs associatedwith specific customers or customer groups”.

Say we have two customers, X and Y, whohave generated similar revenues for ourbusiness over the past year. Both pay theirbills on time and their revenue growth ratesare comparable. We might think these cus-tomers are of equal value to our business,but X has been a customer for years, gives usall of his business, refers friends and associ-ates, pays electronically and demands littlein the way of extra attention. Y, on the otherhand, has recently been reacquired for thethird time in three years through significantprice concessions. He buys our lowest-margin items, changes his orders at the lastminute and requires a lot of customer care.

So are X and Y generating similar returns?Probably not, but a conventional manage-ment accounting system might not show this.Such a system seeks to determine the costof individual products. Product costs arederived on the basis of an allocation of directcosts and an absorption of indirect costsusing some base such as direct labour hours.A more advanced system might determineproduct costs on an activity basis, recognising

that many costs are attributable only on aproduct- or batch-specific basis.

The problem is that many costs relate notto the products but to the way in which theyare served to customers. Such costs mayinclude those of selling and order-taking;distribution; discounts; marketing; admin;and quality control. Even some productionand purchasing costs may be customer-specific, especially where goods are verycustomised and have a high service content.It’s possible to attribute them to individualcustomers by using appropriate cost drivers.For example, selling and order-taking costsmay be attributed on the basis of the num-ber of sales visits to a customer. Once this isdone, it is possible to report business perfor-mance on the basis of customer profitability.

CPA is likely to show that X is more prof-itable to us than Y. This may seem obvious,but it’s not something that a traditional costreporting system could be relied upon to dis-close, given that customer-specific costs arelikely to be treated simply as fixed overheads.

In recent years many firms have claimedto have moved from being “product-centric”to being “customer-centric”. Customer rela-tionship management (CRM) initiativesare usually at the forefront of their efforts.Their belief is that understanding customerbehaviour and profitability is key to gaining

Are they always right?Bob Scarlett

Customer profitability analysis can determine which of your company’s patrons

are most valuable to the business – and which of them aren’t pulling their weight

a competitive advantage. CRM initiativesare associated with developments in bothinformation systems and organisation. Forexample, financial services companies havereorganised themselves so that one person isresponsible for delivering all products togiven customers. At the same time, they haveset up databases holding information on thefirm’s dealings with particular customers.

CPA is intended to provide a guide foractions to be taken through a CRM initiative.Its aim is to determine the profit margingenerated by each customer. It’s often foundthat a small number of customers generate ahigh proportion of the total profit, while therest contribute little, as illustrated by thesimple graph (left). This ranks customers byorder of profitability and shows that:l the first 20 per cent of customers account

for 80 per cent of the firm’s total profit;l the next 40 per cent of customers gener-

ate a much smaller profit; l the last 40 per cent of customers actually

lose money for our business. These findings may prompt obvious

actions. Low-margin accounts can be trea-ted in a number of ways. Sales to suchcustomers can be automated or routed viabrokers or wholesalers. In extreme cases,some accounts can be closed. But thecustomer-centred view of a business associ-ated with CPA and CRM must have a long-term, strategic dimension. The crux of thisis that loyal customers are more profitableover time. It costs less to serve them andthey probably refer others to your business.They may also pay a premium to continuedealing with you rather than switch to anunfamiliar supplier. You therefore need totake a life-cycle approach to dealing withcustomers and potential customers.

CPA and CRM underpin a customer-centred, strategic approach to business, butthey do not themselves provide it. A com-pany cannot simply install a CRM databaseand expect the strategy to appear and startyielding results. n

Bob Scarlett is an accountantand consultant

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Customer profitability analysis