As a business owner, you might already know your company won't unilaterally appeal to everyone. However, as your business expands, you'll probably come away with a more diverse base of customers — and a need for a customer profitability analysis.
Different types of customers are bound to interact with your business in various ways. That means they'll drive multiple means of revenue and extract unique costs. Put two and two together — they're going to offer you different kinds of profit.
The specific amount of profit you stand to gain from each of your customer groups or personas is known as customer profitability. Here, we'll explore the concept further and give some perspective on conducting a customer profitability analysis.
Table of Contents
- What is customer profitability?
- Customer Profitability Formulas
- How to Perform a Customer Profitability Analysis
- Why does customer profitability matter?
What is customer profitability?
Customer profitability is a measure of how profitable a specific customer is. This metric compares how much revenue a given customer generates with the company's spending on acquiring or retaining that customer — in time, resources, or other costs.
Let's imagine two customers, Patrick and Patricia, and pretend you sell a particularly potent strain of catnip.
Patricia buys your catnip in bulk — so much so that you wonder if she's using it recreationally because nobody has that many cats. She's never returned an order, and she rarely calls customer support.
Instead, she's a low-maintenance, loyal customer.
Patrick, on the other hand, buys his orders in small quantities. He prefers several tiny, individual boxes of catnip to larger orders — more than half of which he returns immediately.
In addition, he's constantly calling customer support about how to calm his cat down after your product "makes her freak out to the point that [his] girlfriend doesn't want to come over to [his] condo anymore."
Patrick is a loyal customer, but his loyalty isn't cheap.
You, the catnip mogul, stand to make more money from one of those customers than the other. Patricia is a more valuable customer than Patrick if their buying patterns hold.
That example is a very high-level, cat-oriented demonstration of customer profitability.
With that concept in mind, here are some formulas that can give you a high-level overview of how profitable specific customers might be.
Customer Profitability Formulas
Customer profitability analyses are detailed, labor-intensive, and difficult to implement. However, some metrics can give you a rough baseline picture of customer profitability.
Though they don't capture the intricacies of a complete customer profitability analysis, these equations can offer you some perspective on how much you make off different customers.
Customer Lifetime Value (CLV)
The first formula is Customer Lifetime Value (CLV). This shows the net profit a customer gains over the time they've done business with your company.
The formula doesn't consider any costs beyond the initial acquisition cost, and it also doesn't give you much insight into why they've stuck with you or what you stand to gain going forward.
Regardless, it's still a valuable metric to track when you want a rough projection of where a customer relationship could head.
What We Like
CLV is most useful if you want an idea of how much revenue any customer has generated (and can generate) for you.
For example, imagine you own a software-as-a-service (SaaS) business. CLV can help you figure out how long a given customer stays with you — so you can decide whether your software needs any changes.
Compare CLV with your customer acquisition cost, and you can even project your business's growth potential.
Average Revenue per User (ARPU)
Another helpful metric in projecting customer profitability is the Average Revenue per User (ARPU). It can tell you how much revenue you're generating from subscribers of a specific service or customers who fit a particular mold.
Like CLV, it isn't necessarily predictive of your customers' behavior. It also only lets you know which customers generate the most revenue — not profit. Still, it provides a solid starting point for understanding your customer profitability.
What We Like
Want to determine if your current strategies are working as well as possible? For example, let's say you're a mobile marketer and want to see if your ad spend is netting you any profits.
Take a quick look at your ARPU and try to find trends. If your ARPU trends upward, you know you're doing something right. If not, you might need a second to adjust your strategies.
Though these formulas can give you a rough overview of your customer profitability, the best way to truly understand the value of your customers is through a customer profitability analysis.
How to Perform a Customer Profitability Analysis
A customer profitability analysis can be nuanced, challenging to implement, and inconclusive. Still, it offers insight into your customer base and earning potential that other equations, analyses, and processes can't.
1. Identify your touchpoints.
Start by determining all the different touchpoints your customers have with your business. Then, make sure you're comprehensive in addressing each one. This includes:
- Customer service.
- Social media.
- Paid marketing efforts.
- And any other way you interact with customers.
Once you've conducted this audit, identify exactly how much it costs to maintain each channel.
Pro tip: Prioritize customer touchpoints by analyzing the cost and ROI of each channel. This will help you allocate resources effectively and ensure that your efforts are focused on the most profitable areas.
2. Segment your customer base.
Next, segment your customer base. One of the simplest, most effective ways to do so is through buyer personas.
HubSpot defines a buyer persona as "a semi-fictional representation of your ideal customer based on market research and real data about your existing customers."
If you can separate your customers on that basis, you'll be able to analyze and identify profitability based on customer behavior and background.
You can also conduct an RFM analysis, which stands for "recency, frequency, monetary." These three qualities can give you an even better look at your audience's behavior, so an RFM analysis can help you segment even further.
Pro tip: Create buyer personas to segment your customer base and gain a deeper understanding of their behavior and needs. This will help you tailor your marketing and sales efforts to specific groups, resulting in more efficient strategies.
3. Determine how much each segment costs and spends.
After you've segmented your customer base, you'll need to find the data relevant to establishing customer profitability.
For example, you want to see how much your personas spend on and cost your business. Generally speaking, you should be able to find these figures grouped by category in your income statement.
If you run an ecommerce business and ship packages, look at your package-return figures.
First, identify the average rate at which a given segment or persona returns packages. Then, use that figure to assign an average cost that buyer persona will generate in returns.
Repeat that process with every customer-business touchpoint. Identify the cost for each interaction or contact. This includes customer support inquiries, marketing efforts, social media campaigns, packaging, and shipping.
Compile the average cost per transaction for each persona. Now, you can calculate customer profitability by comparing that figure with the average revenue each persona generates per transaction.
Pro tip: To establish customer profitability, analyze key financial data and identify the average cost per transaction for each buyer persona. Compare this with the average revenue generated per transaction to calculate the profitability of each segment of your customer base.
This will help you identify which segments are most valuable to your business and make informed decisions on where to allocate resources.
Customer Profitability Example
In the comparison above, Persona B generates more revenue than Persona A, but Persona A is more profitable.
If you took the two personas at face value without conducting a customer profitability analysis, you would get the impression that Persona B is inherently more valuable to your business.
However, given all the other factors beyond the revenue each persona generates, it might suit your interests to pay more attention to persona A. Marketing, shipping, and supporting this customer is much less expensive.
Why does customer profitability matter?
Understanding which customers stand to make you the most money can inform intelligent, strategic business decisions across your company.
A thorough customer profitability analysis can be central to an efficient sales strategy.
By segmenting your customer base and identifying the most lucrative opportunities, you can better understand which prospects will help your business the most and tailor your sales efforts accordingly.
You want to land customers and clients that will help your bottom line. With a customer profitability analysis, you can see who those prospects are and how to reach them.
A customer profitability analysis puts a new degree of insight into your sales process. It can keep you from pursuing prospects that will have underwhelming returns or possibly even lose you money.
Applying customer profitability findings to customer service practices might seem a bit touchy.
But the reality is your company has a fixed amount of service resources. Certain segments within your customer base will utilize these services more than others.
That's not to say you should ignore every persona besides the one making you the most money. You should still offer exceptional customer service to everyone using your product or service.
But there are some ways you can provide preferential treatment without alienating the rest of your customers.
You can offer more profitable customers shorter wait times, more direct lines to your staff, access to exclusive content, and any other steps you can take to accommodate their interests.
Determining Customer Profitability
Customer profitability is an interesting, valuable metric to consider when structuring your sales, marketing, and service efforts.
That said, you shouldn't look at the metric as the end-all-be-all of how to approach your business operations — you still need to provide exemplary service to everyone you interact with.
Editor's note: This post was originally published in March 2020 and has been updated for comprehensiveness.