Customer Profitability

In almost all high-tech start-ups (and actually also in most Fortune 500 companies), profit aggregation only happens at business unit or company level and not at customer level. That is mainly because customer responsibility is in Sales. And Sales usually only cares about revenues because that is the key indicator they are measured on. Most managers do not see customer profitability as a priority because they make the false assumption that profits can be optimized by simply adjusting fixed costs (usually meaning human resources). However, understanding customer profitability is important for two reasons:

1. If you have non-profitable customers it has an impact on your bottom line; in order to address this you have to know which customers these are
2. Especially in start-ups, customer profitability relates to opportunity costs, which matters much since resources are scarce and growth goals aggressive

The key in realizing the importance of customer profitability in start-up companies lies in understanding opportunity costs. Opportunity costs are profits you could generate if you spent the resources on alternatives. Thus, sales resources spent on a customer that requires quite a lot of efforts should better be spent on another customer bringing in the same revenue but requiring less efforts.

Example:

Account manager A has three customers with 100.000 USD/EUR revenues p.a. each. They require all of her time, equally spread across the three of them. Each customer has the following profitability:

Customer Profitability A = 100.000 USD/EUR p.a. – 33% of the account manager’s annual costs

Account manager B has three customers with 100.000 USD/EUR revenues p.a. each that only take up 75% of his time. Therefore, each customer has a profitability as follows:

Customer Profitability B = 100.000 USD/EUR p.a. – 25% of the account manager’s annual costs

The remaining 25% of his time the account manager can spend on managing another customer with the same profitability, also bringing in 100.000 USD/EUR p.a. revenues. Therefore, account manager B generates 400.000 USD/EUR revenues (33% more than account manager B) with the same effort just by managing more profitable customers.

As this example points out, it is not only the fixed personnel costs of your sales force that matters for total company profitability but also individual customer profitability. Therefore, each customer’s profitability should be calculated based on their contributing revenues and the company resources these customers require.

Now, there are two practical difficulties with calculating customer-associated costs:

1. While measuring customer-specific costs is fairly easy in consumer direct marketing settings, it is rather difficult in high-tech sales. Time that people spent on customers is usually not recorded.
2. Sales people’s productivity varies largely. That makes it difficult to compare associated costs. One not so productive account manager might create more costs on a customer than a more productive account manager, therefore making this customer less profitable then he could be if managed by another sales person.

To address point 1. you can start with high-level estimates. You can guess, survey or even for a limited time record the resources spent by company functions like administration, finance, presales, and top management on e.g. customer visits, customer calls, and contract reviews. Count the number of customers per customer segment managed by one account manager and then compare. Measure the helpdesk support load per customer. Then put a cost value to all customer-related activities like resolving a support issue, having top management involved, developing a non-paid feature or communicating with the customer.

To get a feeling on productivity in point 2., you can compare the profitability of account managers that serve similar customers. However, customer management also varies by region and even within one rather homogeneous customer segment, customer profitability can be different. That’s why it can be helpful to compare how customers are actually managed in detail and how account managers spend resources. For example, do some account managers have the tendency to frequently set up an on-site meeting or pull in top management? Or do others rather meet every customer request even though that might not always be necessary?

Now, once you have a good estimate on your customer’s profitability the big question is:  What do you do with the results? Abandon all less profitable customers? Generally reducing the total sales efforts by assigning more customers to each account manager?

Well, the answer is not so simple. Reducing costs might result in losing the customer and in fact is often not so easy to do in practice. And letting a customer go is a very tough decision and requires quite solid data to justify it. Therefore, a better way is to educate your sales force that not only revenue but also customer profitability matters. Try to identify best practice examples. Create a consciousness for being careful with using company resources. Encourage your sales people to consider costs for customer requirements before fulfilling them.

Focusing more on customer profitability certainly requires a paradigm shift for usually strictly revenue-oriented sales organizations. But if you don’t do it, your company will not grow as much as it could. Plus, you will end up with less profitable customers, which will hurt your bottom line.

© Stephan Hesslich