Customers: the new window to enterprise profitability

by Ann Heebsh with contributions from Brian Handly and John Parker

Profit is the measure of a company's success. But how can you best measure profitability? By product, organization, channel, line of business, brand or customer? The truth is, each of these factors into a company's overall profit. The varied and complex interactions of these elements make up the profitability of the enterprise and, ultimately, tie it back to specific customers.

Larry Selden and Geoffrey Colvin, authors of Angel Customers & Demon Customers, wrote that most managers simply don't understand how their customer portfolio determines their ultimate bottom line: the value of the company. "Until a company starts managing its highly diverse customer portfolio, it can't hope to maximize shareholder value," the authors explain. The solution, they argue, is to manage the enterprise "not as a collection of products and services, not as a group of territories, but as a portfolio of customers."

Certainly there is a connection between customer behavior and the bottom line. Most companies know that certain customers and segments, like certain products, are more valuable. Unfortunately they have yet to discover just how profitable-or how unprofitable-they really are.

Customers who have found value in their relationship with the company are returning value to the company. They are the ones pushing up profitability. However, a large percentage of customers-in some cases 50% or more-actually erode a company's profitability for a variety of reasons.

This creates the need for insight into changing and managing these relationships to increase profit. The real indicators of how profitability is generated and destroyed lie in the answer to the question, "Why?"

• Why are some of the high-revenue customers unprofitable?
• Why is one customer, or one customer segment, a better investment for dwindling marketing dollars?
• Why are some products and services more profitable than others?

Know what you need to know
Companies too often fail to pull full value from profitability measurement because they incorrectly perceive the measurement to be a valuation of the customer. In fact, understanding the underlying drivers is much more important than the resulting metric.

Knowing why a customer is profitable provides actionable insight that can guide segmentation, demand generation, channel investments, product developments and staffing decisions. Therefore, the clearer measure is how effective the company is at managing the relationship. Companies need to ask themselves: What business changes (like product bundles and service strategies) can be made to make customer relationships more profitable? Conversely, what customer actions or behaviors make those relationships less profitable?

Measuring profitability at a granular level opens a window to better management decisions and better customer relationships by providing insight into how, when and where the business may be failing to manage to profitability. A company's processes and strategies for acquiring, retaining and servicing its customers help determine the profitability of its customers. It affects the value of the company and, ultimately, the share price.

Traditionally, companies have approached profitability calculations through aggregation and "disaggregation" of data from financial accounting systems. This is a typical top-down approach using assumptions, allocations and averages.

But profit numbers based on averages alone do not reveal where the real cost drivers exist. Neither do they provide the kind of detail managers need to make swift, sound decisions. They do nothing to answer the question "Why?" Truly actionable information is what management wants and needs. What are the drivers of profit and loss that influence the customer profitability metric?

Get all the details
Today, customers can interact with a company through a growing array of touch points, including mail, the Internet, telephone, an agent or a retail storefront. Properly assessing the costs associated with a particular customer's choice of touch points is just as important as measuring the operational revenue derived from the actual purchase of the product or service. Profiting from a customer's relationship can only happen if the company understands precisely how that relationship affects the company.

This view of profitability measurement involves a model for knowing the drivers of profit or loss at every intersection of the company/customer relationship. This means evaluating customer behavior. A behavior-based model attaches costs and revenues to customer activities, looking at a level of information much more granular than when allocated from financial accounting systems. It's an approach in which profitability calculations begin at the lowest level of the company/customer relationship.

Activity costs and revenues are assigned to transactions and interactions that the customer has across the enterprise. Costs that are indirect (not based on transactions) should also be captured, including the expense of establishing, maintaining and closing a relationship. For example, this would allow businesses to assign the expense of establishing a new market or opening a new retail location to the customers it supports. Capital and risk have a significant impact on profitability and should also be factored into the model. Each of these elements independently provide insight into profitability, but all totaled, they provide a measure of return to the shareholders. (See figure 1 for a definition of the terms used here.)

In taking a detailed, granular approach to calculating value, the company has the flexibility to view profitability across many dimensions including not only customer, but also product, channel, geographic area, line of business, etc. Having such a single enterprise view of profitability affects business decisions and process changes in an array of areas, from marketing programs to product and customer service strategies.

Manage the relationship
It should go without saying that the customers who contribute the most value to an organization should be the customers who receive the most in return. Rightfully, companies plan and implement marketing strategies around their "best" customers. But they need to remain cautious about potentially undervaluing or "de-marketing" their other customers.

Every customer has the potential to be profitable. Some of today's most profitable customers were often yesterday's unprofitable ones. RBC Financial Group Vice Chairman Jim Rager has been quoted as saying, "There is no such thing as an unprofitable customer. If we can't make money on a client, then it's not the client's fault-we have to change something in the way we operate. We can either charge the customer more, because we have not got the price right or we need to take our costs down or we need to stop selling the product to them and find something more suitable to their need."ⁱ

Oft-quoted industry estimates indicate that it costs companies between six and ten times more to acquire new customers than to keep the existing ones. Assuming that's true, it's critical that companies establish "profitable value propositions" for both the "best" and "worst" existing customers. A profitability model and process that provides detailed insight into the metric allows companies to maximize their existing investment in customers.

Segment your customers
Historically, companies have taken a two-dimensional approach to customer value segmentation: either high or low revenue. Detailed profitability information begins to further micro-segment the customer base since profitability provides a view into cost.

When accounting for expenses, risk and capital costs some of the best revenue producers turn out to have low profitability levels. Likewise, a low-revenue customer could be a high-margin customer. This additional dimension provides information so appropriate programs can be developed to retain, grow or change the relationships (see figure 2).

Further segmentation leads to more detailed, relevant and profitable customer relationship management strategies and tactics. SouthTrust Corporation, prior to being acquired by Wachovia, developed a high-value program, leveraging its Teradata Warehouse and detailed customer-profitability model. Over a four-year period, SouthTrust realized an increased retention of high-value clients by more than 10%. With detailed profitability information at their fingertips, managers tracked and analyzed the effect in dollars of a program to (1) know precisely the return of the program with a before-and-after view of profitability and (2) optimize the investment already made in the company's customer relationship management (CRM) tools.ⁱⁱ

The success of any CRM program or strategy requires a consciousness of costs. Associating costs with customer activities and understanding the value of the customer provides essential insights as to where to expand, where to economize and where to improve operating efficiencies.

Use profitability to drive strategy
If you have an unprofitable product or service, does that mean the customers who purchase, own or use the product or service are unprofitable? NO! Product profitability used as the basis for customer profitability serves only to highlight the relative profit between product bundles, not profit among customers.

For example, an organization may choose to allocate 90% of call-center expenses to products A, B and C. Historically a company would take the product averages and allocate them down to every account for those products, thus building a customer view. A better practice would be to only allocate the call-center expenses to the customers who use the call center. Taking it a step further, companies could allocate based on cost drivers such as call frequency, call duration and service level.

A profitability model based on these types of behaviors and transactions has the flexibility to get to this granular level of detail. Such a model provides insight into the cost and revenue drivers of both product and service offerings.

Leveraging its Teradata Warehouse and customer value measurement, RBC Financial Group redesigns product and service packages. In one case, analysis showed that 60% of customers with a certain product and service package were not profitable. The detail showed a high direct expense associated with the customers' channel behavior. A closer look showed the package did not include lower-cost service channels such as Internet banking. By changing the product and service mix of the package and designing a program to encourage and incent customers to use the lower-cost channels, they increased customer satisfaction as well as the profitability of the customers and the package.ⁱⁱⁱ

A behavior-based profitability model helps companies better analyze product and service mix to determine the effectiveness of bundling strategies, down to how they relate to specific customers and segments. In turn, businesses can use the information to develop tailored offerings based on anticipated usage patterns, or they can redesign products to increase customer value and the average value of new customers, as well as decrease channel costs.

Analysis of behavior around a product bundle told one major financial company that a change in the bundle would better address the needs and channel preferences of a select customer base. They also found they could further increase the profitability of those customers by charging a higher fee for the redesigned product bundle.

Why? Because the customers perceived there to be additional value in the redesigned product set. That meant the company could develop offers and price points based on current customer usage patterns and the resulting impact on margins. They used this information to help refine new customer promotions and offers while reducing the risk of acquiring undesirable customers.

Invest in customer service
How does measuring enterprise profitability affect customer service? It reminds the company of what's important. Companies often fail to make a quality lasting impression in the minds of customers. A good customer service experience may leave an impression that lasts for several months; a bad experience will last a lifetime.

The decision to de-market customers can have the underlying effect of forcing the company to squeeze more revenue from a shrinking base. This squeeze, in turn, can lead to an increasingly short-term focus on profitability from each interaction, serving only to further undermine ongoing customer relationships. Service decisions should be based on an enterprise view of a customer's profitability, and analysis should be done to understand the drivers.

While de-marketing may have a role at times, it should be treated with great care and caution. Certain behaviors drive more cost than others, but understanding the detail behind unprofitable relationships shows how to manage them to profitability. It is crucial that companies seize the opportunity to strengthen the company/customer relationship in a profitable way.

In talking about defining customer value, Martha Rogers, a founding partner of Pepper and Rogers Group, says, "The reason we go through the effort of measuring customer value is because it is important to manage customer relationships based on their value to us." She goes on to say that "it's now more important than ever to differentiate the needs and the value of each customer-understanding the value and knowing what to do-what behaviors and messaging to change-to increase that customer's equity for your company."^iv

Build an enterprise profitability model
Before a company can begin reaping the benefits of enterprise profitability, it first has to have a model that will accurately reflect the impact of a broad spectrum of management decisions. A good model will:

• be able to grow and evolve as the company grows and evolves.
• support a single view of the business, not a narrow or "siloed" view.
• provide insight into the drivers of profitability and how to manage to increased profitability.
• serve as a roadmap to a lower long-term cost of ownership.
• deliver detailed profitability based on the business rules of the company.

It can be risky-and even counter-productive-to approach the construction of a profitability measurement program with preconceived actions already in mind: for example, which products could be re-priced, which customers might be "de-marketed," or which facilities should be closed. A well-built profitability model, proactively maintained to reflect continuing changes in the business and its customer relationships, will be of far greater use to the company than a model biased toward justifying a specific management objective.

Look to the future
There are two types of profitable customers-those that are currently profitable and those that might be. Understanding the customer is the key to building profitable relationships, and a solid customer profitability model will help the company understand what is happening at each interaction and with each relationship in the current time period. The challenge then is to interpret and apply that information to manage change and maximize the lifetime value of the relationship.

In Angel Customers & Demon Customers, Selden and Colvin write, "It's time for action. Right now, someone in your industry is beginning to understand how customers are the ultimate source of shareowner value. That company's managers will figure out who their most profitable and least profitable customer are. They'll find ways to delight the best customers and get more of their business, and they'll find ways to make unprofitable customers profitable-or let them go, to become unprofitable customers of some company that can't tell the difference."

So the important question is not whether doing business with certain customers reduces a company's profits and shareholder value. The answer to that question is clear. The better question is why doing business with certain customers reduces the company's profits and shareholder value. A customer profitability model can help you find the answers. T

Ann Heebsh is a marketing manager with Teradata, focused on profitability analytics. She works with consultants, partners and clients globally on the framework to better understand the drivers of revenue and cost from a single view of the enterprise. Contact her at ann.heebsh@teradata-ncr.com.

Brian Handly is a senior business consultant with Teradata and is dedicated to the development and implementation of Customer Profitability Solutions for clients including major U.S. and Canadian companies. Contact him at arthur.handly@teradata-ncr.com

John Parker is a senior business consultant with Teradata. His expertise lies in the areas of cost accounting, customer and product profitability modeling and strategic analysis. Most recently he has been consulting on the creation and uses of detailed, account-level profitability solutions. Contact him at john.parker@teradata-ncr.com.

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ⁱ Quoted by Cathy F. Burrows, Director, Enterprise Information & Customer Management Support, RBC Centura Bank in her presentation "Knowing Your High Value Customers: Growing Profitability Through Detailed Value Analysis and Targeted Marketing", an online seminar hosted by DM Review and sponsored by Teradata, 9/14/04 (http://www.teradata.com/t/page/126945/index.html)

ⁱⁱ 2004 TDWI Best Practices In Data Warehousing Award: Business Performance Management

ⁱⁱⁱ Same as footnote i.

^iv "Building Customer Value: An Interview with Dr. Martha Rogers"