INTRODUCTION:
Inflation affects businesses by reducing their revenue, profitability, and the purchasing power of customers. Inflation creates resistance and reduces consumption, so the businesses face many problems like losing customers, lower profit margins, higher expenses etc. This challenge is evident in most of 1st quarter results for the financial year 2024. The growth has been tepid or the margins have been under pressure reflecting in lower profitability growth. To overcome this problem, businesses have to examine costs at a more granular level. One of the tools to control cost is to analysis the customer needs and preferences- Customer Profitability Analysis (CPA)
DEFINITION:
Customer Profitability Analysis (CPA) is a method of measuring the profitability of each customer or customer segment. CPA assigns costs, both direct and indirect and revenues to customers based on their activities and transactions, rather than to products, units, or departments. CPA is a managerial accounting method that allows businesses to determine the overall profit a customer generates.
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”.
WHY IT IS CRITICAL TO MONITOR CPA?
Measuring and analysing customer profitability is vital to business success. This is because CPA allows you to identify which customers help you make money and which customers are making you expend your resources without much return. CPA brings improvement to existing business processes by generating valuable insights to frame strategies for business growth. Companies can evaluate their customer segment and determine the cost of acquiring and retaining them. CPA helps to streamline sales process by understanding the customer needs and preferences.
CUSTOMER PROFITABILITY FORMULA:
- Annual profit = (Total revenue generated by the customer in a year) – (Total expenses incurred to serve the customer in a year)
- CPA= (Annual profit) x (no. of years customer stays with company)
The total revenue generated includes the following sources:
- Recurring revenue
- Upgrades to the higher products or services
- Cross-buying relevant products
The expenses incurred includes the following sources:
- Cost of goods sold including customer service
- Maintaining a customer success team
- Loyalty perks
- Operational cost
BENEFITS OF CPA:
CPA reduces costs by determining the necessary costs for luring and keeping successful customers. It increases operational effectiveness. It focusses on right customer segment to enhance profits of the business.The Marketing teams can design their campaigns based on attributes of most profit-generating customer group.CPA helps business decide various deals and discounts to offer for wide customer ranges.It brings business improvement by improved customer satisfaction and value and increased market share.
PROCESS OF CPA:
- Identify the customer base:
This step involves segmenting customers based on demographics, geography, behaviour and other factors. This segmentation helps businesses to understand the unique needs and preferences of different customer groups and to make their products and services accordingly.
- Collect data:
This step is to collect data on sales, costs, marketing expenses and customer service costs. This
Data can be collected from various sources, including sales reports, financial statements, and customer surveys.
- Analyse data:
The collected data is analysed to determine each customer/segment profitability. This study helps businesses understand which customers/segment are most profitable and which are not.
- Identify drivers of profitability:
This step involves analysing customer retention rates, product margins, and marketing effectiveness. By understanding the key profitability drivers, Business can develop strategies to optimize customer value and enhance customer loyalty.
- Develop strategies:
The strategies developed include targeting high value customers with special promotions, reducing costs associated with low value customers or improving customer service to attract them.
- Implement and monitor strategies:
This step involves tracking customer behaviour, analysing sales data and measuring customer satisfaction. The monitoring process helps to evaluate their strategies effectiveness and adjust accordingly.
CRITICISM OF CPA:
Implementing CPA can be time consuming and expensive and requires significant investment in data analytics and software tools. It does not take into account the non-monetary benefits a customer brings to the business. E.g.: Brand Loyalty, word of mouth. This focusses on short term profitability while ignoring long term customer relationships. This may lead to less attention to customers who are not currently profitable but can potentially become profitable.
CONCLUSION:
By examining Customer Profitability rather than just sales, the company will gain a more accurate insight into which customer segment is the stronger driver of its overall profitability. CPA can be used as a financial performance indicator which looks at the revenue that each customer generates. The expenses incurred can be made flexible with the help of ABC as well. Activity Based Costing-ABC is a modern tool that plays a significant role in degerming the useful and wasteful activities in a business entity and thereby allocating the resources in a useful manner.
(This article is written by Sowmiya S, Audit Executive at R V K S And Associates)