Customer profitability (CP) is the difference between the revenue

Revenue

In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....

s earned from and the cost

Cost

In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this...

s associated with the customer relationship in a specified period.

According to Philip Kotler,"a profitable customer is a person, household or a company that overtime, yields a revenue stream that exceeds by an acceptable amount the company's cost stream of attracting, selling and servicing the customer"

Uses

Although CP is nothing more than the result of applying the business concept of profit

Profit (economics)

In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs of a venture to an entrepreneur or investor, whilst economic profit In economics, the term profit has two related but distinct meanings. Normal profit represents the total...

 to a customer relationship, measuring the profitability of a firm’s customers or customer groups can often deliver useful business insights.

Quite often a very small percentage of the firm’s best customers will account for a large portion of firm profit. Although this is a natural consequence of variability in profitability across customers, firms benefit from knowing exactly who the best customer are and how much they contribute to firm profit.

At the other end of the distribution, firms sometimes find that their worst customers actually cost more to serve than the revenue they deliver. These unprofitable customers actually detract from overall firm profitability. The firm would be better off if they had never acquired these customers in the first place.

Challenges

The biggest challenge in measuring customer profitability is the assignment of costs to customers. While it is usually clear what revenue each customer generated, it is often not clear at all what costs the firm incurred serving each customer. Activity Based Costing can sometimes be used to help determine the costs associated with each customer or customer group. For components of cost not directly related to serving customers, the calculation of customer profit must use some method to fully allocate these costs to customers if the total of customer profit is to match the operating profit of the firm. If the firm decides not to allocate these non-customer costs to customers, then the sum of customer profit will be greater than the operating profit of the firm.

Cautions

Like other profit measures, customer profitability is historical. It is a financial summary of what happened in a previous period. And although the past is often indicative of the future, it is easy to imagine situations in which relationships that were unprofitable in the past might become profitable in the future (and vice versa). The forward-looking measure of the value to be derived by serving a customer is called customer lifetime value

Customer lifetime value

-Definition of Customer Lifetime Value:In marketing, customer lifetime value , lifetime customer value , or lifetime value is the net present value of the cash flows attributed to the relationship with a customer...

. Unprofitable customers can have high customer lifetime values (and vice versa).

The ABCs of unprofitable customer management

Michael Haenlein and Andreas Kaplan (2009) propose a six-step approach for dealing with unprofitable customers, a framework they refer to as the ABCs of Unprofitable Customer Management

• Step #1: Avoid their acquisition in the first place
• Step #2: Bear in mind potential rescue operations
• Step #3: Catch the possibility of abandonment
• Step #4: Draw up a cost—benefit analysis
• Step #5: Ensure familiarity with your environment
• Step #6: Facilitate biting the bullet

Other sources

• Haenlein, Michael and Kaplan, Andreas M. (2009), “Unprofitable customers and their management.” Business Horizons, 52 (1), 89-97.
• Kaplan, R.S. and V.G. Narayanan (2001), “Measuring and Managing Customer Profitability.” Journal of Cost Management (September/October): 5-15.
• Pfeifer, Phillip E., Haskins, Mark E., and Conroy, Robert M. (2005), "Customer Lifetime Value, Customer Profitability, and the Treatment of Acquisition Spending," Journal of Managerial Issues, 17 (1), 11-25.
• Helgesen, Ø. (1999) "Customer Accounting and Customer Profitability Analysis - Some Theoretical Aspects and some Empirical Evidence", SNF Working Paper, No. 67.