All customers are not created equal. For most businesses, a small percentage of customers drive a major percentage of profits. Other customers, while generating cash flow, can actually cause your business to lose money on each transaction. Your biggest customers may not necessarily be your best customers. Your goal should be to focus on growing sales with your most profitable customers, finding ways to increase profits on less profitable customers, and possibly to let unprofitable customers take their business elsewhere (painful as that may seem).
The key is to first analyze each customer: how much they spend, how many resources their business ties up, and — most importantly — the profits you make on their business.
Individual Customer Analysis
Let’s start with analyzing each of your customers. To make the process easier, start with one of your smallest customers to make the process of gathering data simpler. For that customer, determine:
- Total spending per specific period of time. Use weekly, monthly, or yearly figures; choose a time period that makes sense for your type of business.
- Cost of goods or services provided. For now, leave out fixed costs like rent, utilities, and other overhead. Focus on the actual cost of the goods provided or your direct costs to provide a service.
- Cost of additional “services.” Some customers require more administrative or sales support than others. Evaluate this customer against your “average” customer: Do they call more frequently to check on order status? Do they tend to return more products? Do they require unusual administrative processes? Capture the additional cost (if any) of servicing the customer. (You may be surprised what hidden costs you find, especially in regards to your “best” customers.)
Do the math. Do not include overhead and fixed costs in the calculation. Take the customer’s purchased gross revenue and subtract the cost of goods (or services) sold, (sometimes called gross margin), minus the specific, additional cost to service this particular customer. What remains is the profit margin for the specific customer for your business.
Here’s another way of looking at this to make sure the difference between revenue and profit is clear: Think of a customer who purchases only your premium product, which has the highest gross margin. This customer may buy relatively less than another customer who purchases only your low-margin products. But, which of the two customers makes you the most money? If you evaluate customers only on sales volume, you might be misled about which customer is better for your business from a profit viewpoint.
Evaluate each customer using the same basic methodology. The end result is a breakdown, by customer, of profitability.
Factor in Other Variables
In theory you should then focus on growing the most profitable customers, but it’s not that simple. Other factors do play a part. A less profitable customer can still provide tangible benefits like:
- Signing long-term contracts and agreements.
- Purchasing a variety of products or services.
- Providing referrals or enhancing your business image through association. (Being able to say, “We provide services to the university,” for example, may help your salespeople close other deals.)
- Enabling entry into growing markets or market segments.
For example, imagine you run an engineering firm. A large customer contracts for electrical engineering services. They have negotiated a relatively low rate, making them less profitable, but the constant flow of work allows you to keep a full-time electrical engineer on staff, thus letting you take on other smaller, but much more profitable jobs. Keeping the large customer, even if margins are relatively low on their work, could make perfect sense. If you are their provider of choice, it could dramatically improve your firm’s reputation in your area and make winning other business much easier.
Change Your Focus
Once you have determined your most profitable customers (and your least profitable customers) then it’s time to adapt your strategy accordingly.
First, look at your least profitable customers. Do you lose money on any of them? If you’re like most companies, you probably found at least a few customers that negatively impact profit margins. If so, consider letting them go, raising prices to more profitable levels, or changing how you service them so you can make a profit on their business. In some cases, all you may need to do is find ways to reduce the cost of “additional services” (like unnecessary support calls) so your total costs for servicing that customer are decreased and your profits automatically increase without raising prices.
Next, focus on your most profitable customers. How can you increase the amount of business you do with those customers? Can you sell additional products or services? Should you offer different payment or service terms to encourage greater spending? Most importantly, look closely at what makes this group profitable, and try to apply what you learn to your “average” customers.
Your ultimate goal should be to change how you deal with customers at each level: least profitable, most profitable, and “average.” Work hard to convert average customers into more profitable customers and least profitable customers into average customers. But no matter what, take great care of your most profitable customers as they can be the lifeblood of your business.
The information provided is presented for general informational purposes only and does not constitute tax, legal or business advice.