Accounting skills can unlock customer profitability

Quality customer data plus management accountancy skills add up to profitability. By Richard Barrett, head of EPM marketing, Business Objects.

Customer profitability reporting is high on the corporate agenda and rightly so. Marketing staff spend vast sums on securing new business without fully understanding whether these customers will ever be profitable or how long they will have to be retained before they recoup the cost of acquisition.

With minor improvements in customer retention having a dramatic impact on the bottom line, many organisations are diverting more resources towards retention marketing. But even this may not deliver improved profitability if large numbers of unprofitable customers are being inadvertently retained.

Having invested large amounts to get a ‘single view’ of the customer, organisations are now realising they need analysis tools. The key one is customer profitability reporting.

Passion and understanding

In ‘Mastering customer value management; the art and science of creating competitive advantage’, Kordupleski and Simpson wrote: “Companies that capture and use customer data with the same kind of discipline, passion and understanding they give to operational and financial data are learning that this business practice is well worth the time and money invested.”

There is an important role for management accountants here. Working alongside marketing and customer analytics, they can ensure the resulting data is reliable with any costs and capital assigned to customers reconciling with the general ledger and the balance sheet.

It is widely recognised that retail banks are at the leading edge of customer profitability reporting and there is evidence that some are gaining real value. First National Bank of South Africa claims payback in just months (read First National Bank’s case study). However, nearly half of banks are not satisfied with the information provided by their customer profitability.

This could be because of an over-dependence on customer relationship management (CRM) systems for providing reports of customer profitability. Although many CRM profitability measures rely on traditional cost accounting methods, this approach is too simple to be useful in retail banking where much of the cost is driven by individual customer behaviour.

Recognising these shortcomings, some banks now see activity-based costing (ABC) as a superior method for calculating costs and profitability.

But whichever system is used, the message from those implementing them is the same: there is still some way to go before achieving robust and reliable information.

Achieving a single view of the customer

The first hurdle for any organisation is gaining an integrated view of the customer. It is important to see all their accounts as well as a history of their balances and transactions. This means extracting information from individual product systems and building a complete view of each customer in a data warehouse. The basic information can be enriched with external data on socio-demographics, lifestyle and credit ratings.

Deducting the cost-to-serve

Having identified each customer’s revenue - which can involve spreading year-end discounts and rebates - the operating costs of serving and supporting the account need to be deducted. Typically this starts with activity units’ rates calculated in an ABC system. These can then be factored by the actual number of transactions for calculating past profitability.

The right level of detail

In some industries and in some product areas, customer behaviour can be fairly homogeneous. Consider customers borrowing money from a bank through an unsecured loan. They all make a monthly payment and receive a periodic statement, so they cost the same to service. The differentiating characteristics are factors such as age, income and purpose of loan. If this were the only type of product, implementing customer profitability reporting at segment level would probably be adequate for generating reliable information.

However, when it comes to current (checking) or savings accounts, everything changes. It is possible to have two accounts with identical average balances but with completely different profitability. This is because one account holder has few monthly transactions that are all through self-service channels, while the other has a large number of transactions all done using counter services or by post. When there is this level of diversity in behaviour, customer profitability should be calculated at the level of the individual account. Going to this level of detail enables banks to identify unprofitable customers even in the most profitable segments.

How long to measure profitability for

Few customers are going to be profitable across their lifetime. Most will have different requirements for other products and services at each stage in their lives. Some customers may never be profitable. Other customers will be profitable but will go through periods when they are loss-making - for example, during student years.

Customer profitability reporting should therefore consider both current profitability and some measure of lifetime profitability. However customers can be fickle. Advances in data mining and predictive analytics cannot help predict how long a customer will remain loyal, yet alone what products they may require in the future.

Reporting customer profitability on a monthly basis is probably far too frequent as the results are likely to be erratic. Predicting and reporting lifetime profitability will at best be highly speculative. The ideal lies somewhere in between. You could, for example, measure customer profitability regularly over a trailing six or 12 months to smooth monthly variations and perhaps project their likely purchases and profitability forward over the next five to 10 years. This should provide information that is relevant and, more importantly, leads to action. One consequence of projecting customer profitability forward over several years is the need to discount revenues and costs back to the present using a net present value (NPV) calculation.

Assigning capital to customers

It is equally important to allocate a risk weighted cost of capital to customers for the purposes of profitability measurement. Only then can you calculate the return on capital employed at the account level. Similarly, bad debt provisions that are typically held at the product-of-business-unit level need to be assigned to customers based on their credit rating and how long they have been with the company.

The need for actionable information

Reporting customer profitability alone does not give actionable information. You also need to know which products they buy and which channels they use for servicing their account. There are two ways of achieving this:

• select a true, multi-dimensional ABC application that can handle multiple cost objects such as customer, product and channel in a single model
• work at the transactional level and calculate the individual profitability of every account, then produce consolidated reports by customer, product and channel.

Customer profitability reports should be used more as a guide to inform decision making rather than providing definitive criteria for selecting and deselecting customers. Customers are not naturally profitable - companies have to work at getting them there. That means developing an in-depth understanding of what makes a customer profitable. It also entails trying to change the behaviour of the entire customer base so they consume fewer resources and costs. This requires measuring and tracking the cost of key business processes, understanding which are fixed and which variable – and implementing initiatives that encourage people to change their habits.

Customer profitability reporting can never be prescriptive. Decisions will always have to be made about how to treat customer acquisition costs or how best to assign capital to individual accounts. It is imperative to consult managers and develop a method that combines sound accounting practices with commercial reality. Sounds like just the job for a management accountant.

Customer value conference

Customer value – from retention to profit optimisation is a one-day conference with workshops focusing on measuring and managing customers to optimise profitability. It will take place on 13 November 2007, at the CBI in London. The price is £599 + VAT, with an early booker rate: £499 + VAT on all bookings confirmed on or before 12 October 2007.

To book

Telephone +44 (0) 20 8849 2244 to make a provisional booking
Fax +44 (0) 20 8849 2460
Email Mastercourses@cimaglobal.com
Or visit the conference web page. 

October 2007

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