## 3.2. Customer profitability analysis

Customer profitability analysis combines customer cost and customer revenue analyses and provides information used to determine the value of customers. The information provided by customer profitability analysis helps to understand the customer's industry and its growing potential, customer reactions to changes in selling prices and sales terms, and customer life-time value.

Customer life-time value (CLV) is the net present value of all estimated future revenues from the customer.

For example, assume Friends Company estimates that its customer Motor, Inc. will produce profits of \$60,000 per year for the next four years. Using an assumed discount rate of 7%, the CLV for Motor, Inc. is 3.387 x \$60,000 = \$203,220 (i.e. the factor of 3.387 can be obtained from the Present Value table; n = 4 and i = 7%).

Now let's calculate the net customer profit for the Friends Company's customers.

 Friends Company Customer Profitability Report For the Year Ending December 31, 2009 AutoCo Motor, Inc. Fast Bike LLC Total sales \$ 100,000 \$ 360,000 \$ 450,000 Less: Sales discounts 2,000 8,000 14,000 Net invoice amount 98,000 352,000 436,000 Less: Sales returns and allowances 12,000 15,000 65,000 Net sales 86,000 337,000 371,000 Cost of goods sold 56,000 260,000 302,000 Gross margin 30,000 77,000 69,000 Customer costs: Order taking 175 400 1,100 Order processing (per order), total 126 288 792 Order processing (per item), total 4,375 7,600 8,250 Delivery (per order), total 840 1,920 5,280 Delivery (per mile), total 140 560 2,024 Expedited delivery - 600 3,600 Customer visits 160 320 640 Monthly billing (1st statement) 6 6 6 Monthly billing (reminders), total - 15 60 Sales returns 160 240 960 Restocking 300 510 1,200 Total customer cost 6,282 12,459 23,912 Net customer profit \$ 23,718 \$ 64,541 \$ 45,088

Looking at the table above, we can see that Motor, Inc. is the best customer out of the three. The reason Motor, Inc. is a more profitable customer for Friends Company than Fast Bike LLC is because Motor, Inc. has less favorable sales terms and returns fewer items. In addition, if we look at the customer cost analysis, Fast Bike LLC has more expedited orders than other customers, many returns, a few billing reminders (i.e. late payments), and higher delivery costs.

Therefore, even though Fast Bike LLC generates the highest net sales, it is not the most profitable customer for Friends Company. Friends Company should look into the reason for the high returns from Fast Bike LLC and its late payments (e.g. either a weak financial condition or dissatisfaction with the Friends Company's products or customer service). Finally, Friends Company should look into changing the delivery terms for Fast Bike LLC or negotiate the number of items per order: Fast Bike LLC orders relatively small number of items per order, which increases the number of orders, and thus, the delivery costs to the customer.

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