Not all customers are equally profitable. Different customers have different needs, and hence different costs to serve. The overall profitability of a business is a function of the profitability of individual customers and customer groups.
Many businesses measure customer satisfaction but they do not measure customer profitability. A profitable customer is a buyer who yields a revenue stream which exceeds by an acceptable amount the costs incurred to serve that customer. Customer profitability can be measured individually by customer, by market segment, or by channel.
Unfortunately, most businesses are poorly equipped to understand how costs relate to specific customers. Traditional approaches to accounting allocate costs to individual products, but not to customers who are the drivers of these costs. While the average costs in a business may decline as volume increases, there can still be significant leakages of profitability due to the higher costs involved to serve some customers.
In many firms, some costs are assigned to specific products or product groups sold to specific customers or customer groups. All other costs are allocated among all products and customers. For example, all sales and marketing expenses are usually averaged across product and customer groups alike. Because the true costs are rarely classified by customer group, the real costs to serve customers remain hidden from view. This means that some customers are being overcharged while some others are being subsidized.
The general approach for dealing with customers or segments which are less attractive due to lower profitability is to improve their profitability through one of three approaches:
- Reduce the costs to serve. This can be done by focusing Lean techniques and other process improvement methodologies onto the value chain activities that serve the customer group or segment. In addition, products and services may be redesigned to drive out costs.
- Increase the price to increase the total revenue obtained.
- Improve the product mix offered to the customer or segment. Tightening the mix to eliminate unprofitable products can improve the profitability of a customer group or segment.
Where these approaches are not workable or prove ineffective, the firm should consider de-emphasizing the segment or customer group in marketing, or exit the segment or group altogether and focus resources only on the most attractive segments.