Managing CustomerProfitabilityDetermine which customers are most valuable toyour organization,

by Marc J. Epstein, Michael Friedl and Kristi Yuthas

All people may be created equal, but the same can't be said forcustomers. Everyone knows that some customers are more prof-itable than others. Conversely, some are dovmright unprofitable.

Knowing which is which is the all-important question.

Despite enormous variations in profitabil- viding them with, pricing and service lev-ily, many companies continue unprofitable els identical to those received by the mostrelationships with customers, often pro- profitable ones. Why? In most cases, com-

panies simply do not know who the un-profitable customers are. As such, theycannot develop marketing strategies ormanage costs accordingly.

Companies don't necessarily need astate-of-the-art database or analyticstechnology to improve customer prof-itability. Rather, they can follow a com-prehensive approach for measuring andmanaging customer value called thecustomer value management cycle (seeExhibit 1). Because of their unique qual-ifications and abilities, financial man-agers should take the lead in translatinganalysis to action and creating the cul-ture of value.

The customer value management cyclehas five recurring steps.

To demonstrate the concepts through-out this article, the customer value man-agement cycle is applied to a fictitiouscompany called Sagu Systems. Abrief de-scription of Sagu Systems is as follows:

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Sagú is a software cotnpany located inChicago. Us prltnary product, SaguNet-work, is performance monitoring softwarefor corporate networks. Sagu currentlysells SaguNetwork and related cotisultingservices to clients. The market for per-formance management software is ex-panding rapidly, and Sagu is pursuing anaggressive growth strategy. In an effort tomaintain profitability through the growthperiod, the board of directors has man-dated that Sagu analyze the profitabilityof its customers.

STEP 1 ; MANAGE CUSTOMERSEGMENTATIONCustomer segmentation refers to theprocess of dividing customers into groupsfor decision-making purposes. Segmenta-tion allows the company to provide dif-ferential advertising or value propositionsto different customer groups. Segments areoften determined on the basis of customersimilarities, such as personal characteris-tics, preferences or behaviors. Ideally, seg-ments should correlate to behaviors thatdrive customer profitability

Segments are continually redefined asthe process repeats and customer under-standing is refined. For many companies,segments support marketing. Customerscan be grouped based on marketing-re-lated characteristics such as expected re-sponses to advertisements or expected

Exhibit 1 The Customer ValueManagement Cycle

1. Managecustomersegmentation

5. Managecustomerprofitability

2. Measurecustomermargins

4. Measurecustomerimpact

3, Measurecustomerlifetime value

purchasing behavior. As companies movetoward rigorous measurement and analy-sis of customer profitability, they may re-fine segments as they discover newsegmentation parameters.

In the Sagu example, the company be-gins by analyzing current customers andtheir purchasing patterns. The analysis re-sults in the two customer segments (seeExhibit 2):

1, In-House Support: customers within-house IT staff capable of sup-porting die software

2. No In-House Support: customerstacking in-house IT staff capable ofsupporting the software

In steps 2, 3 and 4, Sagu calculates thecurrent and expected future value contri-butions for each segment. In Step 5, Saguuses the results of this analysis to revise themanagement of customer value in eachsegment.

Finally, Sagu returns to Step 1 andrestarts the cycle—resegmenting cus-tomers based on profttability-related be-haviors.

EXECUTIVE SUMMARY• The customer value man-agement cycle presents a com-prehensive model for measuringand managing customer value-ithas five recurring steps,• Step 1 : Manage CustomerSegmentation. Customer seg-mentation refers to the processof dividing customers into groupsfor decision-making purposes.Segments should correlate tobehaviors that drive customerprofitability.• Step 2: Measure CustomerSegment Margins. At a mini-mum, companies should measurerevenue and gross profit by eachcustomer segment. Allocating

sales, marketing and customerservice costs brings this analysisto the next level.• Step 3; Measure CustomerLifetinne Value. The lifetime valueof the customer reflects thepresent value of all expectedfuture flows associated with thecustomer,• Step 4: Measure CustomerImpact. Two critical sources ofhidden customer value are cus-tomer influence and customerknowledge. Customer influencerefers to the influence the cus-tomer has, either through inten-tional action or passive behavior,on other customers, on employ-

ees, or on other stakeholders ofthe firm. Customer knowledgerefers to the actionable knowl-edge that can be gained by thecompany, either through analysisof customer behavior or throughdirect customer input.• Step 5: Manage CustomerProfitability. All of the informa-tion derived from the measure-ment of customer value shouldbe analyzed, and actionabletidbits should be derived. Thisgoes far beyond simple reportingof which segments have beenmore or less profitable. Innovativesegmentation and interpretationof the results can uncover areas

where small improvements can

yield big improvements in value.

Marc / Epstein is a professor ofmanagement at Rice University inHouston. Michael Friedl is CFO atCrestwood Pacific Group inNewport Beach, Calif. KristfYuthas is the information systemsmanagement ctiair at PortlandState University. Their e-mailaddresses are epstein@rice.edu,michael.triedl@sbi-usa.com andyuthas@pdx.edu, respectively. Thisarticle has been adapted from theManagement Accounting Guide-line Managing Customer Value byMarc J. Epstein and Kristi Vuf/ias.

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STEP 2: MEASURE CUSTOMERSEGMENT MARGINSAlthough almost all companies haveprocesses for assessing the profitability oftheir products, most are far behind in as-sessing their customers' profitability.Some customers are highly profitable,some are moderately profitable, andsome are unprofitable. Many people be-lieve that the 80-20 rule can be appliedto customers, which suggests that 20%of the customers are responsible for 80%of ihe proftts. However, results for manycompanies have been far more extreme.

At a minimum, companies should

measure revenue and gross profit byeach customer segment. Allocatingsales, marketing and customer servicecosts brings this analysis to the nextlevel. Selling costs in many organizationsvary significantly between customersand segments. Simple changes in thesales compensation plan that more high-ly rewards profitable deals than less-profitable ones can improve overallprofitability.

Invoicing, credit and collection costsmight also vary significantly Changes lopricing and terms tailored to certain seg-ments will also improve profitability

Exhibit 2 Revenue and Expenses byCustomer Segment (in millions)

SoftwareConsultingTotal revenueCost of goods soldGross marginOperating expensesOperating incDme

In-HouseSupport

60.0£J2

65.024.041.031.79.3

No In-HouseSupport

70.030.0

100.040.060.050.0

14.3% 10.0 10.0%

Total

130.035.0

165.064.0

101.081.719.3 11.7%

Exhibif 3 Operating Expenses Allocatedby Customer Behavior (in millions)

operating Expenses

Sales commissionsTechnical supportOther administrative

Total

In-HouseSupport

4.08.0

16.028.0

No In-HouseSupport

14.021.018.753.7

Total18.029.034.781.7

Exhibit 4 Revised Revenue and Expensesby Customer Segment (¡n millions)

In-House No In-House

' SoftwareConsultingTotal revenueCost of goods soldGross marginOperating expensesOperating income

Support60.0

5JJ

65.024.041.028.013.0 20.0%

Support80.020.0

100.040.060.053.76.3 6.3%

Total I H140.025.0

165.064.0

101.081.719.3 11.7%

To be effective, each company shouldlook at the highesi-cost line items anddetermine whether there is a reasonablebasis under which to allocate the costs tocustomers or segments.

Sagu has historically allocated oper-ating expenses based on total revenue ofthe segment. However, Sagu realizes thatoperating costs vary across segments asa result of different customer behaviorswithin the segments. In particular, salescommission costs are associated withsoftware and consulting sales, and tech-nical support costs are associated withthe number of maintenance requestssubmitted by a customer. Sagu separatesthese costs from other operating ex-penses and assigns them to the segmentsbased on the actual commissions award-ed and technical requests made by eachsegment. Results are shown in Exhibit 3.Segment profits calculated using the newoperating expense numbers are shown inExhibit 4.

STEP 3: MEASURE CUSTOMERLIFETIME VALUE"Customer lifetime value" (CLV) intro-duces a new dimension to understand-ing the value a customer provides.Margin-based calculations focus on theprofits realized in the current period asa result of customer purchases. CLV takesa different approach, It treats customersas corporate assets. Companies that useCLV recognize that the costs of attract-ing a customer represent an investment.They also recognize that the investmentcan be expected to produce additionalfuture income over time. The lifetimevalue of the customer reflects the netpresent value of all expected cash flowsassociated with the customer.

Companies that use CLV recognizethat a customer's profitability in one pe-riod isn't necessarily predictive of prof-itability in other periods, since revenuesand costs can vary significantly overtime. Thus, CLV values customers on thebasis of their expected income-generat-ing potential, rather than solely on theirpast behavior.

Typically, the customer relationship

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begins when the company invests toattract the customer. As the relationshipmatures, the customer's sales volumemay grow and become more profitable.This accumulation should accelerate overtime for two reasons. First, the cost toserve the customer should decrease as apercentage of revenues because the cus-tomer's knowledge of the company andits products, together with increasingtrust, may lead to reductions in promo-tion, training and relationship mainte-nance costs. Second, as the relationshipmatures, the customer may be more like-ly to respond to cross-selling or upsellinginitiatives.

Thus, by expanding the notion ofprofitability to incorporate profits overthe entire lifetime of the customer rela-tionship, marketers have significantly en-hanced their ability to effectively managecustomers for enhanced profitability. Cal-culating CLV requires an understandingof customer retention rates in addition topurchasing patterns and costs for eachsegment, then discounting the values tothe present. Simply put, CLV is the pres-ent value of profits over the expected life-time of the customer or segment.

This analysis can significantly affect acompany's view of a segment with smallinitial purchases but with a long expect-ed relationship, versus a segment with alarger initial purchase but limited repeatpotential.

Sagu, for example, armed with infor-mation about current profitability, canbegin lo assess the long-term value ofeach customer segment. To do this, thecompany will estimate growth in profitsfor each segment and change in size ofeach segment as Sagu loses old cus-tomers and adds new ones over time. Ex-hibit 5 shows the CLV calculations for itsIn-House Support and No In-HouseSupport customer segments during thecoming six years. CLV shows the valueof a segment's customers to Sagu today,based on the discounted value of antic-ipated future profits. To simplify the ex-ample, it is assumed that the operatingmargins of both segments are equal inyear one. Income growth and retention

rates are held constant over the six-yearperiod.

Sagu's CLV analysis provides a newperspective on the relative value of thesecustomer segments. The In-House Sup-port segment is expected to grow at a10% rate, as a result of additions in soft-ware users to existing software packages.

the expected profitability of their cus-tomers. They can provide excellent esti-mates of the value that each customerand segment provides to the companythrough normal purchasing and usage.

But these approaches often fail to cap-ture some potentially significant sourcesof value customers can provide to the

Customer lifetime value ( CLV) is thepresent value of profits over the expected lifetime

of the customer or segment.

Discounting each year's anticipatedprofits back to the present using a 10%rate results in an expected lifetime valuefor the segment of $34.7 million. TheCLV analysis tells a different story aboutthe relative value of the No In-HouseSupport segment. The No In-House Sup-port segment shows a loss of market size,due to a low customer retention rate, anda correspondingly lower lifetime value asa result of this attrition.

STEP 4; MEASURE CUSTOMERIMPACTThe final component of value providedby the customer is customer impact. Ac-tivity-based costing and customer life-time value have enabled companies tomake great advances in understanding

company. Of course, profits resultingfrom current or future sales to customersare the most significant source of valuefor most customer segments. But valuecan be created (or destroyed) by cus-tomers in many other ways that fall out-side the reach of CLV

Two critical sources of hidden cus-tomer value are customer influence andcustomer knowledge. Customer inßuenccrefers to the influence the customer has,either through intentional action or pas-sive behavior, on other customers, on em-ployees, or on other stakeholders of thefirm. Customer knowledge refers to the ac-tionable knowledge that can be gained bythe company, either through analyzingcustomer behavior or through direct cus-tomer input. Through their interactions

Exhibit 5 Customer Lifetime Value (in millions)

Operating Margin {5% Growth)

Retention Rate Existing

Gross Vaiue of Profits

Discount Factor

Net Present Vaiue of Profits

Operating Margin (5% Growth)

Retention Rate Existing

Gross Vaiue oí Profits

Oiscount Factor

Net Present Value of Profits

16.51.10

7.20.91

$6.5

16.50.91

5,90.91

$5.4

In-House Support Customers

26.81.10

7.50.83

$6.2

Year

37,21.10

7.90.75

$5.9

47,51.10

8.30.68

$5.6

57.91.10

8.70.62

$5.4

No In-House Support Customers

26.80.91

6.20.83

$5.2

37.20.91

6.50,75

$4.9

47.50.91

6.80,68

$4.7

57,90,91

7.20.62

$4.5

68.31.10

9.10.56

$5.1

68.30.91

7.50.56

$4.2

$48.7

$34.7

$40.1

$28.9

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with the product, with the company andwith other stakeholders, custotners canaffect value in numerous ways, rangingfrom identifying small errors in technicaldocumentation to significantly influenc-ing the brand's image.

Although influence and knowledgecontributions will always he difficult todefine and measure, even rudimentaryestimates of direction and magnitude can

ally all of the customer impact. Theseloyal clients are very well-known andhighly respected in the software indus-try. Sagu estimates that they are respon-sible for a significant portion of the clientgrowth that contributes to favorable re-tention rates—both through reputationand through referrals. In addition, thesecustomers are very knowledgeable, andare used as testing sites for new software

Value can be created (or destroyed) bycustomers in many other ways that fall outside

the reach of CLV

be valuable. To ignore such contributionsis akin to assigning them a value of $0,which is certainly incorrect, and may robthe company of the opportunity to in-vestigate these increasingly important as-pects of customer value.

Over time, companies that think cre-atively about a full range of sources ofcustomer value gradually improve theirunderstanding of these sources, and theirability to assess and measure them. Em-barking on this process opens new av-enues for innovation in products andmethods, and generates new options formaximizing long-term customer value.

For Sagu to supplement its CLV analy-sis, the company estimates the potentialimpact of each customer segment.Through this analysis, Sagu realizes thata small number of its large clients in thetn-House Support segment generate halfthe revenue of this segment, and virtu-

enhancements and sounding boards fortechnical planning personnel,

The estimated benefits in this scenarioinclude: (1) influencing/referring othercustomers and (2) testing and improvingsoftware prior to release. The sum of thediscounted values of these benefits isexpected to be $6.5 million, as shown inExhibit 6.

STEP 5: MANAGE CUSTOMERPROFITABILITYThis is where the proverbial rubbermeets the road. All of the information de-rived from the measurement of customervalue should be analyzed, and actionabletidbits should be derived. This goes farbeyond simple reporting of which seg-ments have been more or less profitable.Innovative segmentation and interpreta-tion of the results can uncover areaswhere small improvements can yield big

Added Value of High-ImpactIn-House Customers (in millions)

Impact Calculation

Value oí referrals

Value of knowledge gained

Discount factor (10%)

Current value of impact

Total Impact

1

$1.0

0.8

0.91

$1.6

High-Impact In-House Customers

2

$0.7

1.2

0.83

$1.6

Year

3

$0.6

0.9

0.75

$1.1

4

$0.5

0.8

0.68

$0.9

5

$0.4

0.8

0.62

$0.7

6

$0.3

0.8

0.56

$0.6

$6.5

improvements in value. For example:• A segment where technical support

costs are disproportionate could driveimproved documentation.

• Segments with lower expected cus-tomer life could reveal a lack of atten-tion from the customer service team.

• A segment with high revenues but lowprofits might indicate the need to re-tool ihe sales compensation scheme toshift incentives to increase focus onprofits.Sagu has learned a great deal about

the profitability of its segments throughthis analysis and will use this informationto more effectively manage the value ofthese segmems. First, through the Step2 analysis of customer margins, Sagu haslearned that the No In-House Supportsegment has higher operating costs thanwere apparent under the former costallocation system. In part, this was theresult of high maintenance costs for theseclients.

To address this issue, Sagu decided tochange the maintenance agreement itprovides to customers. In the future, cus-tomers will be provided with a limitednumber of technical support hours andwill he charged for any additional time.

Through the CLV analysis in Step 3,Sagu learned that the No In-House Sup-port segment was expected to show prof-itability losses over time, due to lowprofitability growth and retention ratesover time.

As a result of this analysis, Sagu in-terviewed key clients in the segment todetermine reasons for the decline. Theseclients suggested that they needed addi-tional consulting support to help themmake the best use of their software. Saguhas increased efforts to inform customersabout available consulting services, andanticipates both growth in consultingrevenues and increased retention in thesegment as a result.

Finally, in Step 5, Sagu analyzed cus-tomer impact and realized that thecustomers with ihe greatest impact onboth attracting new customers and ongaining valuable knowledge were a sub-set of their In-House Customers. This

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group of clients consists of highly knowl-edgeable users, who contribute productand ser\'ice knowledge to Sagu, and alsoencourage other clients to adopt the soft-ware—either through direct referrals orthrough reputation.

Through the customer impact analy-sis, Sagu has recognized the high valueof these customers to the firm and hasinitiated new policies designed to pro-

them with some prestige and the op-portunity to interact direcdy with otherhigh-powered users to share insightsand strategies with each other and withSagu.

CONCLUSIONBy measuring the profitability of seg-ments and managing customer relation-ships based on customer vaiue, both the

Companies that think creatively about a full rangeof sources of customer value gradually improve their

understanding of these sources.

vide special benefits to these customers.They will receive a discounted rate foradding software seats, which is expect-ed to grow profits more rapidly andstrengthen customer loyalty. And theywill be invited to sit on a newly formeduser advisory board, which will provide

customer and company win. Orientingan organization around measurementand management of customer profitabil-ity can take place immediately, or it cantake many periods, implementing thesestrategies one step at a time, and adjust-ing and refining along the way. Over time

a company will gain invaluable knowl-edge and be able to put it to work for themutual benefit of all stakeholders, •

AICPA RESOURCES

Management Accounting Guidelines• Managing Customer Value• Managing Opportunities and Risks• Impacting Future Value: How to Manageyour Intellectual Capital

AICPA members can download all Man-agemeni Accounting Guidelines for free athttp://fmcenter.aicpa.org/Resources/Management+Accounting+Guidelines/Avatlable4-Management+Accounting+Guide)ines.htm.

Business, Industry & GovernmentFor more information and resources inbusiness, industry and governmeni,please visit the Financial ManagementCenter at www.aicpa.org/fmcenter.

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