How Do You Calculate the Profitability of a Customer?

How Do You Calculate Customer Profitability, Step by Step?

You need four numbers for each type of customer: average yearly revenue, gross margin, the years a customer stays and the cost to win one. Multiply the first three and subtract the fourth, and a spreadsheet with a year or two of history is enough to start.

1. Group your customers by type, using groupings your sales team already recognizes, such as industry, company size or ownership.
2. Find the average yearly revenue per customer in each group from your accounting system.
3. Apply that group's gross margin (the share of revenue left after the direct cost of serving them), measured for the group and not the company average, because discounts and service costs differ from one kind of customer to another.
4. Estimate how many years a typical customer in the group stays, from renewal and repeat-purchase history in your CRM or billing records.
5. Multiply the three to get the gross profit a customer brings over the whole relationship.
6. Subtract what it cost to win one customer in the group, meaning the marketing and sales spend aimed at that group divided by the new customers it produced.

We run it by type of customer as well as account by account, because a ranking of individual accounts tells finance whom to renegotiate with, while a comparison of types tells marketing whom to go after next. The lifetime value comparison on our IMPACT Prospect page does this calculation for your own groups, and the IMPACT scorer on the same page adds what a profit figure can't show, such as how easy each buyer is to reach and how many more of them exist.

Which Costs Belong in a Customer Profitability Analysis?

Three kinds of cost belong in it: the cost to serve the customer, the discounts and concessions they receive, and the cost of winning them. Many calculations stop after the cost to serve, but the cost to win is the one that changes where marketing spends its money.

The first two show up in gross margin when finance measures it by customer or by job, which is why step 3 uses the group's own margin. Overheads that don't change with the customer, like rent or the finance team, stay out, because spreading them across customers by revenue makes every customer look alike. If your question is which product or service makes the most money, the same formula run by offering instead of by customer is on our IMPACT Offering page.

If nobody can say what it cost to win a customer, divide last year's marketing and sales spend for each group by the customers it signed, since a rough figure is far better than leaving the cost out.

How Do You Identify Your Most Profitable Customers?

Run the calculation for every type of customer and put the results side by side, because the gap between types is often far wider than anyone expected, and it usually doesn't match the order of the revenue report.

The biggest accounts often fall down this list, because large buyers negotiate the deepest discounts, expect the most service and are more often won through formal bids that are expensive to prepare and go back out to tender every few years. The contractor's public-bid customers looked attractive for those reasons, with decent contract sizes, buyers easy to find and bids published for anyone to answer, but a public bid is designed to drive the price down, so the work is won at a thin margin and then has to be won all over again.

How Is Customer Profitability Different From Customer Lifetime Value?

Customer lifetime value is the revenue or gross profit a customer brings over the relationship, depending on who calculates it, while customer profitability, as we use it, also subtracts what it cost to win them. That subtraction matters because it shows whether a type of customer that's expensive to win still pays back.

Lifetime value is important because it sets the ceiling on what you can afford to spend winning a customer, and the Channel Selection page uses it to work out how much the contractor can spend to win a property management firm. Comparing the two is the idea behind the LTV to CAC ratio (lifetime value divided by customer acquisition cost), though a dollar figure is easier to compare across types of customer, and how to calculate customer lifetime value covers the formula and the ratio in more detail.

The number needs a second look in three situations:

• A type of customer with little history, where the years they stay is a guess, so use the contract length or a cautious estimate and revisit it once you have renewals.
• Customers who lead to other work, such as referrals or larger projects later (on the IMPACT Offering page, some maintenance customers later buy an installation), which the figure won't show unless you add it.
• A few unusually large accounts that dominate a group's average, which are worth calculating individually before you draw conclusions about the group.

How Do You Increase Customer Profitability Once You Know the Answer?

Aim your marketing at the most profitable type of customer first, then raise profitability within each type by keeping customers longer, protecting margin and lowering the cost to win, although the change of aim usually moves the total far more than the rest.

• Shift your targeting, your offer and your case studies toward the most profitable type, and describe that buyer so sales would recognize them on a first call.
• Stop paying to attract the least profitable type, the way the contractor treats public bids: its public-bid customers were the easiest to find and the least profitable, which is why its written description names any buyer who requires a public bid as a poor fit, and how to turn unprofitable customers into profitable ones covers what to do with the ones you already have.
• Judge marketing by the type of customer it brings in, because in accounts we manage we often see lead volume look healthy until someone checks which segments the leads came from.
• Keep customers longer and protect margin by starting renewal conversations well before contracts end and reviewing the discounts and free extras each group receives.
• Recalculate once a year, because the cost to win shifts as your marketing changes.