It is very possible to have a positive net income and have customers that generate losses. However, because your profitable customers cover these loses you don’t see it unless you do a customer profit analysis. Customer profitability analysis requires you to determine the activities, revenue and cost of each customer. The surprising outcome of doing a customer profitably analysis is your least profitable customer could be the customer who generate the top 20% of total revenue. You cannot judge the profitability of customers simply based on how much they pay you.
Example of customer profitability analysis
Suppose you had a consulting business, and to deliver value to the customers you do the following:
- Answer emails
- Monthly one hour consultation
- Taking phone calls
- Prep work for consultation
- Billing and collection
- Follow up calls
- Overhead
Based on you and your staff’s salary you decide the cost of providing your services are as follows:
| Activity | Cost |
| Answering email | $1 per email |
| Monthly one hour consultation |
$200 per hour |
| Taking phone calls | $3 per phone call |
| Prep work for consultation | $200 per hour |
| Billing and collection | $3 per invoice |
| Follow up calls | $50 per call |
| Overhead | $10 per labor hour |
Your price takes into account that your average customer does the following
| Activity | Cost | # per month | Cost |
| Answering email | $1 per email | 10 emails per month | $10 |
| Monthly one hour consultation |
$200 per hour | 1 hour per month | $200 |
| Taking phone calls | $3 per phone call | 3 phone calls per month | $9 |
| Prep work for consultation | $200 per hour | 1 hour of prep work | $200 |
| Billing and collection | $3 per invoice | I invoice per month | $3 |
| Follow up calls | $50 per call | 1 follow up per month | $50 |
| Overhead | $10 per labor hour | 3 labor hours per month | $30 |
| Total cost of servicing average customer | $502 |
Based on this you charge a monthly rate of $600.
However, here comes “Mr. I want the whole world but I never pay on time”. Let us take a look at how much he is costing your business
| Activity | Cost | # per month | Cost |
| Answering email | $1 per email | 20 emails per month | $20 |
| Monthly one hour consultation |
$200 per hour | 1.5 hours per month – he often runs over | $300 |
| Taking phone calls | $3 per phone call | 5 phone calls per month | $15 |
| Prep work for consultation | $200 per hour | 1 hour of prep work | $200 |
| Billing and collection | $3 per invoice | 3 invoices per month | $9 |
| Follow up calls | $50 per call | 1 follow up per month | $50 |
| Overhead | $10 per labor hour | 3 labor hours per month | $30 |
| Total cost of servicing average customer | $624 |
“Mr. I want the whole world but I never pay on time” costs $122 more each month than the average customer. He causes a loss of $24 each month ($600-$624). However, you don’t notice this because his account is wrapped up with others customers account and unless you do a customer profitability analysis you don’t know for sure. If you are feeling stressed about a customer, it might be time to do an analysis. Customers that create losses should be fired.
On the other end, of your bad customers are your “good, better and best” customers. You may want to create priority level services for your best customers to show them how much you appreciate them. By doing this, you reduce the chances of them going to a competitor.
In summary, every small business owner falls prey to bad customers. Knowing who these bad customers are and getting rid of them will improve your overall bottom line. On the other hand, knowing your best customers help you serve them better.