Customer profitability analysis is best conducted with a technique known as

Activity based costing or ABC analysis. Customer profitability analysis helps

the company understand the net profit coming from each customer which can
be calculated by revenue less costs. These costs are not only manufacturing
and distribution costs but also sales costs, marketing costs, services cost and
any other related costs which have to be undertaken to service the customer.

Once the costs are finalized, the customer can be classified into different profit
tiers. This principle is best observed in the banking industry with credit card as
a product. Customers are basically classified into four types

 Platinum customers – Most profitable

 Gold customers – Profitable
 Iron Customers – Low profit but desirable
 Lead customers – unprofitable and undesirable
Lets take credit cards themselves as an example. A credit card company
would always give the best service as well financial and other benefits to the
top two customers. It will at the same time try to attract iron customers and try
to convert these iron customers to platinum or gold customers. Finally, these
companies will have systems in place so as to avoid Lead customers
completely.

It is found that with customer profitability analysis, the firm can correctly
classify customers and also find out which of the customers it needs to hold
on to and acquire more of the same type, and which customers it needs to let
go of. Several times, companies find out that there are customers which they
should have left altogether as the profitability from these customers is
minimum and expenses are more.

One of the major hindrance in calculating customer profitability analysis is to

calculate cost. Calculating cost per customer becomes difficult especially in a
service environment where manpower as well as time also has a cost factor
associated with it. Time spent with each customer is different and therefore
the cost is different. Furthermore there are several non customer related costs
too such as the cost of lost customers. If the firm ignores these costs then the
final cost will be not be the right figure thereby affecting the overall customer
profitability analysis. The customers will be shown more profitable than they
actually are.