De-Averaging Your Customers to Determine Profitability

If you are selling to small and mid-sized companies, it’s a common (though often false) assumption that all your customers contribute to your earnings, and that it’s only a matter of how much.  If you do make that assumption, it’s likely that you have averaged all your customers’ earnings contributions to your bottom line.  However, by doing so, you may not have recognized that some customers contribute a great deal of profit, some break even for you, and some actually cost you money.

Fact is, if you don’t know your individual customer’s profitability down to the net level – after thoroughly allocating overhead, deliveries, cost of credit, marketing, collections, etc. – you probably don’t really know which customer makes you money, which contributes no profit, or which one costs you money.

Here’s how to go figure it out: The best way to discover the profitability of every customer is to map each one on a risk-profit graph. This approach to rating a customer’s status is called “de-averaging.”

Map Your Customers by Their Profitability and Risk

a scatter plot x-y graph showing how to map your customers based on profitability

Start by creating a simple graph (shown above) that rates Risk and Profitability on the X and Y axes.  By plotting your customers in each quadrant, you can generate a visual indicator of each customer’s value to your bottom line.  Their position will also help guide you to take remedial action for the unprofitable / high-risk customers, while determining which “keepers” to reward.

Take a closer look at the kinds of customers that end up in the four risk categories:

  1. Bottom left: Customers unlikely to pay you back.

    For this customer, you may know from talking with other customers that recent payroll checks have bounced, and he might even be delinquent with another business across town.
    – It will be hard to move him into a better quadrant, and you may consider suspending his account all together, or moving him to COD.

  2. Top left: Customers typically 60+ days out on A/R.

    This could be a great customer.  He regularly buys high-margin products, but he has cash flow problems.
    – Ask him to pay down the line.  Then, monitor his credit more frequently and be ready to take more aggressive action if the risk worsens.

  3. Bottom right: Customers who will eventually pay, yet are not profitable.

    This customer is low risk: He’s shown evidence that his credit line isn’t maxed, and his credit score remains high.  But he is so slow to pay that he actually costs you money. If you could just get him to pay on-time, he could be moved to a better quadrant. This may be a simple matter of enforcing existing A/R policies, or putting strict new ones in place.

  4. Top right: Customers who are high profit and low risk.

    These customers are keepers, because they have great cash flow, are not speculating, and they pay on time.  These are the customers you bend over backwards to keep happy.

How to Map the Grid

To map your customers, establish an index system, where each customer is assigned a profitability number (say, 1-100, with 100 being high profitability) and a risk assessment (1-100, with 100 being low risk), which can be plotted on the graph.  To determine how many points each customer gets, go through each line item of your costs for that customer, plus all of your overhead costs.  Then, proportionally allocate these costs to each and every customer.

Metrics for the Risk Factor include:

  • How quickly they pay, e.g. net 10, net 30, net 60, net 90, 90+.
  • What is the customer’s credit rating?
  • Do they have a bankruptcy in their past?
  • Have you ever had to place a lien on them?
  • Did the customer’s slow pay cost you missed buying opportunities?
    If so, how much, and how much can be allocated to the level of the individual customer.
  • Did the customer’s slow pay cause you to tap your line of credit, and what is the allocated cost of that debt?
  • Did the customer use a credit card to pay, and what is that allocated cost?

Metrics for the Profitability Factor include:

  • How many hours of staff time does the customer consume, e.g. when estimating, designing, and purchasing products from you?
  • Is the customer eating up field staff or technical support, causing your staff to provide time-consuming favors, when they really should be selling?
  • Number of site deliveries for every $1,000 of spend.
  • How much cost can be proportionately allocated to each customer for overhead, including rebate management, marketing, advertising, publicity?

Once you use these points to calculate the risk and profitability ratings, it’s time to plot your customers.  If you find customers in undesirable locations (bottom left and bottom right), you don’t have to automatically cut them loose.  In fact, for customers in the bottom right (given the low-risk rating) you can help improve their profitability by assessing fees or modify pricing.

Because they are low risk and high profits, customers in the top right quadrant are the ones you want to pay the most attention to (e.g. free deliveries, rebates, special pricing), so you maintain their loyalty…and their high profitability.

For customers in the top left quadrant, who are high profit and high risk, you want to move to the top right, by helping them find paths to lower their risk to you.

By de-averaging customers, you see that the overall profitability of your business does not indicate that you’re making money from each and every customer. Once you gain insights into their true cost to you, consider using a credit management company like BlueTarp to reduce the risk further.  BlueTarp protects you from risk, provides upfront payments on B2B sales, and streamlines the customer experience, so you can focus on growing your business.


Interested in learning more?
Check out this article to learn four ways A/R automation can cut costs while improving customer experience.