Measuring customer profitability can provide terrific insights.  Understanding customer profitability can help assure that products are marketed and directed to the customers and prospects most likely to be profitable.

In order to create effective measurements, you need to think of the process as assigning revenue and costs to customers.  A good system will identify the characteristics of both profitable and unprofitable customers and products.

Remember, there are no generally accepted accounting principles for measuring customer profitability.  Therefore it is important to determine your own rules and make certain that people throughout the organization understand them. It is extremely vital that your overall profitability system be well understood if you intend to use it effectively.  Personnel must recognize what is and isn’t included in determining profitability.  When employees understand measurements and believe the results, they can then help stimulate and drive profitable customer behavior.

Implementing a system

There are several important guidelines to consider when implementing a customer profitability system.  The process starts by clearly stating the profitability objectives and the reasons that measurements are needed.  Banks should also ensure that personnel who deal with loans and deposits understand the broad framework of how the system works.  For instance, they should understand how costs are allocated based on activity, balances, etc. Also, develop credibility for the bases of cost allocations.  They may be based on estimates of your costs or on prior studies, such as the Federal Reserve Bank Functional Cost Analysis.

The most thorough approach to customer profitability is to identify activities attributable to each product.  Activities include issuing the loan or deposit, maintaining and servicing it until maturity, collecting or paying interest, and redeeming or closing the account.  Here are some additional considerations:

• Allocate direct costs easily attributable to each loan or deposit product line.  From there, allocate the costs based on the activities.
• Determine if you want your customer profitability effort to allocate all overhead, including excess capacity.  Decide how you will track how much capacity your system has if the system doesn’t allocate costs associated with excess capacity.
• Don’t get tied up in a great deal of detail.  Estimates are okay.  Try to refine estimates as your system matures.
• Focus on significant activities.  For example, there is an ongoing cost to review financial statements for commercial loan customers each year.  That is a maintenance cost and should be assigned a cost to each customer based on the complexity of the customer’s relationship with the bank.

It’s also important to clearly define and help others understand the “cost of funds” or “earnings credit” used in measuring the profitability of an earning asset or liability, respectively.  It’s not as simple as it may first appear.  There are a variety of methodologies to use for this process.

In the end, there are a number of systems that can prove effective, but banks should understand how their systems compute profitability.  For example, assume it’s August and a customer had a loan for four months, but it is now paid off. In this example, it is important to understand how your system handles partial years.  The best way to understand your system is to recompute how the system determines profitability.

Information is power

Customer profitability information can be a useful tool when negotiating with customers.  In a perfect world, the lender or deposit representative would have a profitability profile of all customer accounts, helping them to more effectively negotiate.

Overall, the entire process can be highly valuable in determining the characteristics of profitable relationships, thus allowing the bank to focus its energies on developing those relationships that are primed to be most profitable.