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Performance improvement strategies built on customer profitability measurement make so much sense that it is remarkable that they are not the norm. One barrier to adoption is that initiatives must begin with business metrics that matter. In most organizations relevant data exist, though not often in the form or format needed, and clearing the hurdles that lie in the path to understanding customer profitability often requires that the organization accept a degree of imprecision in its measurement. Solutions often involve estimation and judgmental allocation, which is anathema to many CFO's, particularly in today's business climate. Ventana Research recommends therefore that companies initiallyattack the tough issues outlined here as non-financial demand chain problems in order to combat organizational inertia.

Defining "Customer" - The challenge of simply defining the customer dimension confounds many organizations. Functional perspectives on the customer differ in demand chain, finance and elsewhere, often with justifiable logic. Within silo-ed applications, an appropriate definition of "customer" in functional context is often self-evident. It's easy to rationalize sub-optimal solutions in deference to project deadlines and other pressures. The result can be inconsistency across applications even within a business area.

It is our belief that companies must reconcile these inconsistencies address them with a little work by a committed organization. A small group of business and IT representatives can be chartered to conduct a requirements gap analysis and outline a small number (three is a good choice) of options aimed at short-term resolution consistent with best practices and organizational objectives. These options can then be brought to a cross-functional decision-making body for final arbitration.

Customer data integration - This endeavor has been known to occupy entire careers. Issues abound with respect to physical and logical integration, much has been written about both, and a number of vendors offer solutions. The point in highlighting the topic here is simply to suggest that an elusive ideal business solution should not prevent pursuit of what is immediately doable. If nowhere else, customer data is almost always retrievable in some form from sales and order processing systems - a "bill-to" designation for instance. This can provide a jumping-off point for debate if other options don't present themselves, a catalyst for evaluation of other systems and viewpoints.

Value metrics - With some customer dimension as reference point, relevant metric definitions on that dimension can be pursued. Two metrics commonly applied are customer lifetime value and customer profitability. Lifetime value as a concept comes from marketing, especially direct marketing circles. Customer profitability has financial roots. The latter is arguably an extension of the first, accounting for costs as well as revenue.

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 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:

1. Agree and understand that precision and rigor is the ultimate goal, but not necessarily an immediate requirement.
2. Focus on what is doable now, but maintain a vision of (and launch a parallel effort to achieve) the ideal solution.
3. Start from a foundation of sound, defensible business logic and apply it consistently.
4. Like in any good negotiation, expect that all parties will come away a little dissatisfied.

It is imperative that companies resist the temptation to tackle this as a one-off effort, making use of spreadsheets for instance. As more information becomes integrated into the derivation process, the metric will change. Robust support and the dynamic use of the resulting metrics in context with all other customer information is the objective. That can only happen in the context of a consistent performance management foundation.