Want to know how measuring customer profitability can help you to boost your profits while streamlining your business? Read on.
Assuming that metrics and financial statements are purely your accountant’s job can be a grave mistake for your business.
You may be in the catering business, the online retail business, the servicing business. But, don’t assume that you don’t have to know your numbers just because your passion doesn’t entail finance.
Fancy portfolios and intimidating graphs aside, your business depends on your understanding of what’s working and what isn’t.
Can you tell what your customers are responding to, and how quickly or how often?
If your operations were turning out to be inefficient and costly, would you even know where to begin to remedy the situation?
If you want to begin tracking your numbers and performance, then customer profitability is a great metric to start you off.
This metric might be able to help you hone in on your ideal target market, making it easier for you to provide better value to your most appropriate customers. In this way, you’re saving time, money, and effort—saving in any one of these three areas of business can significantly widen your profit margin.
Measuring customer profitability can help you refine your business operations which will make you better able to provide a more valuable service to the people who need you.
Where to Begin When Measuring Customer Profitability
If you’ve been in business, even just for a little while, you’ve probably already gathered that there are countless ways in which you can go about measuring customer profitability.
Let’s begin to gather the different components to formulate the right equation for your business.
You want to be tailoring your formula depending on the type of industry you fall into and the infrastructure you’ve chosen to build your business on.
Basically, you want your formula to be relevant to the actual operations of your business and to have it cater to the type of answers you’re looking for.
Needless to say, if you have a question about your business’s profit margins, your customer profitability metric better be able to answer it!
An easy way to start is by gathering information on your customers within certain time frames. Being aware of the time dimension with which you’re operating in with each customer can help you work out averages, tendencies, and trends in your operations and in your customer’s buying habits.
Begin by thinking in terms of historical value. Ask yourself, since your customer’s first purchase, how have they contributed to your business?
Next, think current value. What has your customer been doing over the last month or quarter?
While this time frame may not be accurate to what your client tends to do overall, it can help to discern how your clients respond to different trends, like a new ad campaign or a one-time-only offer.
Then, there’s present value which is different from the current value, in that it looks at the future profitability of any current business you have with your clients. In other words, this time frame carefully gathers data on current contractual relationships.
Last is lifetime value which takes into account all future prospective business you might do with current clients. You have to be intuitive in your projections as to which contracts are likely to renew, change, or grow.
This particular time frame is great for discerning customer loyalty. (It’s also a good way to gauge how much your clients trust you!)
Gathering information merely on how your clients buy can tell you a lot about your business.
Take this opportunity to familiarize yourself with the best habits for your operations. This is the data that you can base the rest of your calculations on.
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Source: How To Calculate Lifetime Value
Measuring Customer Profitability
Starting today, you can hopefully begin to recognize what your particular business needs in order to be correctly measuring customer profitability.
You already have your customer data, so let’s now look at this thing called customer profitability.
An obvious enough term, yes? How much profit does each customer contribute to your company’s overall revenue?
Well, if your business hasn’t first clearly defined who it serves and how successfully it is doing so, it would be hard to gauge, let alone correct or improve, your profit margins.
Let’s, therefore, analyze the two most obvious components of the equation: ‘customer’ and ‘profitability.’
For the most part, it’s fairly easy to recognize who our customers are, especially in the service business. But, take a big corporation, for example.
If you were to ask around the company at different levels and in different departments of the business, the answer to, “Who is the customer?” might be a little different every time.
Whether you decide to stay a small enterprise or you plan to scale your business, your customer, in all probability, will remain the component of your business that has to make a purchasing decision.
This seems obvious but as businesses grow it becomes all too easy to lose sight of the main focus of your business.
Related Post: How To Increase Your Small Business’s Profits
You wouldn’t be the first entrepreneur who found themselves drifting from its core values because of other seemingly important and urgent transactions, meetings, etc.
A sure way of retaining your business’s focus is by constantly assuring that you can easily find your customer in your data.
If you can’t, you might want to redefine your definition of customer or be a bit more discerning when taking customers on.
You have to be able to pinpoint which transactions and accounts directly relate to your customers. This is usually done by creating a customer hierarchy.
Most companies use what’s called a Household algorithm to build upon their hierarchy. And, this is the part of the process where things get fairly technical.
Household algorithms gather pertinent information about your customers, like their names, their region, phone number, emails, etc. This allows you to capture your client’s behavior.
It may sound a little invasive but you’d be surprised at what details you could glean from your client’s name and email alone. The algorithm can then match this information to those related transactions and accounts in your business.
If you cannot easily pinpoint who your customers are then you’ll find it extremely difficult to measure their contribution to your business.
This might make it impossible to continue justifying them as actual customers at all.
Related podcast: How to Productise a Service Business with Meryl Johnston
Now, profitability also seems like an obvious component to measuring customer profitability. The ratio between what you’ve spent and what you’ve kept reflects your profits.
In other words: Profit = Revenue – Cost.
But, which revenues and which costs do we include in your calculations?
Here, we might have to look at your customer’s behavior and your own business’s operations.
In other words, how am I making my revenue? Can I consider my business as having made revenue whenever I simply receive money or when I specifically earn money?
Do I want to be calculating my revenue based on the fact that my business has received money purely because of its operations, i.e. service?
What if I’ve made money off of an insurance claim, or what if a customer has paid interest on a subscription due to a late fee?
You can decide whether you’d include these types of transactions as having “earned” money or not.
This can be a tricky matter so I’ve put together a short list of the 8 key profit ratios to track in your business.
Keep Studying Your Numbers
Knowing and understanding your numbers will allow you to make course-corrections almost immediately and even see some big mistakes before they arrive.
In a recent Facebook Live we did with Chartered Accountant Meryl Johnston, Meryl takes us through how you can improve your profit margins simply by understanding your numbers.
In it, we talked about regularly reading and studying reports as well as getting a handle on your business’s ratios.
To start, reports that are pertinent to have no matter what level your business is at are:
- Profit and loss report
- Balance sheet.
Once you’ve got a flow going, you can add in other reports like:
- Profitability by Customer/Job
- Cashflow Forecast
- Actual Profit Compared to Budget
- Bank Reconciliations
We also touch on the ratios you absolutely need, namely the gross profit margin. But, pay close attention!
Meryl also shared the steps that are most important to establish before immersing yourself in ratios and metrics:
- Have a Chart of Accounts that is aligned with your ratios.
- Make sure that the coding for each particular account you have within the Chart is consistent.
If this is all new to you, don’t feel obligated to apply what you’ve learned to the letter.
Be discerning in what’s right for your business operations and in what accurately reflects your ideal customers.
This may all seem intimidating at first but once you have these components to your calculations up and running, you’ll be able to let the system (and your accountant) do the rest of the work.
Don’t dismiss this part of the process offhand; the entrepreneur who knows and understands these aspects of their business will without a shadow of a doubt be successful.
You don’t have to be lucky in business to generate success.
Want to make sure you’re tracking the right numbers for your business? Grab our free Profitability Pulse Check, and learn more about the most important ratios you need to be aware of for your business.