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Customer Profitability Is Not a Financial Metric

Demand chain perspective often accelerates resolution.
In simple terms, lifetime value is the discounted present value of expected revenue streams for each customer. It is derived from customer spending patterns, period-to-period customer retention rates and the organization’s internal rate of return on capital. Customer lifetime value derivation calls for a disciplined approach to revenue allocation at the customer level and recognition that timing impacts the value of both money and customers. It also begins to reveal the estimation, allocation and analytical requirements of enabling technology. It’s a valuable stand-alone performance metric, provides a revenue basis for calculating customer profitability, and can also serve as a temporary surrogate for the latter measure. Defining and maintaining this metric is a great incremental step that provides footing for addressing the cost side of the equation.

Assigning costs in order to bring the lifetime value equation into the realm of customer profitability is a stiff test. Collecting and managing heterogeneous cost components, data integration, and dynamic maintenance of the pieces and parts, will test an organization’s cultural and technical will. Most organizations have a handle on product profitability. At the customer level, product-based unit cost and margin factors can be applied as a starting point. Allocations of cost of sales and general sales and administration (GS&A) expenses are more difficult challenges. Standard costing or activity based costing exercises are options. Process management, data capture, allocation methodologies, and, occasionally, probabilistic and judgmental modeling tools can each play a role in reaching resolution.

The process is one of incrementally building a robust profitability metric over time. In most financial circles, profit is a precise concept, with little allowance for the probabilistic estimation that is sometimes applied liberally. Thus, customer profitability is best treated as a metric in support of demand chain (marketing, sales and service) analysis and planning. Its status as a financial performance metric will come with time, after value is established and a higher level of rigor and precision is achieved.

Assessment

Customer profitability definition and measurement necessarily involves cross-functional interests that compound the obstacles encountered. Compromise is unavoidable. Ventana Research suggests that companies take four critical attitudes into this organizational negotiation: