What Drives Profitability
Written By: Glen Petersen
Published On: March 21 2006
Businesses normally approach marketing as an art form as opposed to a measurable process. Outdated modes of measure, such as past purchasing patterns, and other by-gone bits of data are used to project sales, which unfortunately do not aid accurate planning. The total customer experience, which spans from sales to field service, comprise the go to market process. These functions define the customer's sense of the value received, but do not provide an accurate window into the realities of the marketplace.
Part Two of the Assessing the Drivers of Sales Performance series.
Assumptions of Market Process Metrics
The metrics associated with the go to market process reflect a curious assumption: they seem to assume that inconsistencies in functional behavior have a minimal impact on customer behavior. This may have been a reasonable assumption in the past, but today's marketplace is characterized by a much more sophisticated buyer. The aggregate behavior of the go to market process impacts revenues, margins, and cost. If each function seeks to maximize its productivity, the sum will be less than the individual parts. A functional view of optimization forces an internal perspective and what is needed today is a market or customer orientation. In other words, what type of metric will provide such a market orientation? The answer is customer profitability. In this context, the go to market process is managed on the basis of optimizing the profitability of a portfolio of customers. Customer profitability in turn is determined by the behavior of the customer.
The simplest method to prove this notion to the organization is to calculate the profitability of various customer groups. In most situations there will be a prevailing feeling that customer volume is directly tied with profitability; however, this contention is often in error. For example, in retail stores, high volume purchasers may only purchase when items are deeply discounted and have a propensity to return items after they can be effectively resold leading to write-offs. For manufacturers, large volume customers often demand large discounts and other special terms or services. As a result, when the true net profit is calculated the results are often counterintuitive.
Another important concept to customer profitability is lifetime value. A straight forward example of this is demonstrated by a bank providing services to teenagers. While a teenager is likely to generate very little, if any, profit for the bank, when that same person goes to college and receives a degree, his or her income will increase, and other transactions will rise. Later, he or she may need a mortgage or other services. Thus over time, the profitability of the individual changes, and in this case, increases. Therefore to assess the desirability of an individual or company, one needs to assess their lifetime value. (See figure 1 and 2)
Figure 1. Customer Life Cycle: Business to Consumer
Figure 2. Customer Life Cycle: Business to Business
In both of these examples, the customer starts out below the zero profit line implying that it costs more to acquire and service the customer than the customer's transactions generate in terms of gross profit. Over time, transactions increase and the customer becomes more profitable. In the consumer example, the customer has a physical lifetime and at some point ceases to be a customer. Even in a business to business type of transaction, a customer can go out of business or take business elsewhere, thus creating a curve that resembles the business to consumer model.
Now let's assume that an organization has calculated the profitability of each customer and has segmented the customer base into groupings according to a hierarchy of profitability. Next, assume that after studying the behavior of the low and negative profit contribution customers, it is determined that a marketing program can be devised that will move 5 percent of the negative customers into low profitability, while propelling 5 percent of the low profitability customers to medium profitability group (see table 1).
Table 1. Customer Values
Moving 5 percent of the customers in each of the two lowest profit groups will yield a 35 percent increase in profit contribution and the actual bottom line results can be significantly higher based on the level of fixed costs not incorporated into the profit contribution numbers. What this example demonstrates is that by understanding the profitability of customers, it is possible to create highly focused programs that have tremendous profit impact.
Remember that the issue of alignment of purpose regarding the go to market process was caused by applying revenue and cost objectives in the aggregate. When this is done, it is impossible to effectively consider the impact on customer behavior and ultimately on profitability. Customer profitability allows the organization to better understand and predict the impact of spending across the go to market process.
Targeting Prospects and Managing Customer Behavior
It is important to realize that assessing customer profitability and life cycle value allows an organization to recognize what type of customer it really wants. The sales organization is no longer chartered to garner just any prospect, but is instead mandated to find those prospects that have the highest potential for superior profitability. Also note that profitability increases by the degree to which customers exhibit certain types of behaviors, so the thrust of the go to market process becomes the creation experiences that fosters desired behaviors and reduces the probability of negative behaviors. Over time, these experiences allow the organization to be able to more accurately predict cause and effect and thus to be able to more effectively plan and budget.
What are the behaviors that are linked to growth and profitability? Obviously, customer awareness about the product or service is linked to the life cycle model. They (prospects) need to try the product or service and be satisfied, and then expand or extend their purchases with the given supplier. Following this logic and sequence, one can extrapolate the following:
Awareness. Including number of inquiries, attendance at events, and visits to web site
Trial. Including number of trials, samples, RFPs, quotes, evaluations, etc., and initial purchases
Expand and Extend Purchases. Number of repeat purchases or the frequency thereof; increases in share of wallet (current purchases versus potential volume); upgrades to higher profit margin product/services; use of productivity tools provided by the supplier (e.g., e-commerce); favored or exclusive supplier status; timely payment; level of items returned; level of complaints.
Retention. Renewal of purchase contracts, including services such as warranties; operating philosophy to treat supplier as a partner; formal partner agreements with customers; willingness to be a reference; number of referrals provided; non-participation in blogs or other negative forums; unwillingness to defect to a competitor despite the attractiveness of the offer; willingness to return to being a customer after defecting to a competitor.
Recommendation. Willingness to recommend the product/service and/or offer testimonials.
It should be clear that this non-exhaustive list of behaviors are directly correlated to the profit life cycle curves presented earlier. These metrics, in addition to customer profitability, provide significant insight into what is working for the company and what is not. The go to market process must be fine-tuned to foster these behaviors cost-effectively and thereby maximize the profit of the customer portfolio. Senior management is no longer relegated to war stories as to what happened in the market. In other words, decision-making moves beyond anecdotes regarding customer behavior to predictive analysis.
Using this new framework for understanding what drives revenue and profitability, it should be obvious that managing customer behavior is the key to long-term profitability and that lifetime customer profitability must be a fundamental organizational performance metric. It is customer profitability and customer behavior metrics that enable the organization to create alignment within the go to market process. All other metrics will either be internally focused or they will fail to provide a meaningful cause and effect relationship to support decision-making.
Tomorrow: What are the drivers of sales force performance?
This concludes Part Two of a three-part series. Part One described the go to market process. Part Three will discuss sales force performance.
About the Author
Glen S. Petersen is an internationally recognized speaker, writer, practitioner, and thought leader in the CRM and e-business industries. As a visionary and early adopter of sales force automation (SFA), in 1986, Petersen led one of the first successful national implementations of SFA in the United States. He has held senior level management positions with system integration and end user organizations. As a consultant, he developed a number of proprietary facilitation techniques to help organizations to better understand technology, and how to rally around a single threaded, phased implementation approach. Prior to founding GSP & Associates, Petersen was senior vice president at ONE, Inc. and Ameridata. He has authored six books including Making CRM an Operational Reality and ROI: Building the CRM Business Case.
Glen Petersen can be reached at firstname.lastname@example.org