How to Work Out Which Customers Actually Make You Money

Revenue tells you who your biggest customers are. It does not tell you who your best customers are. A simple profit-by-customer review, done once a quarter, usually shows that a handful of accounts carry the business while a few quietly cost you money.

Why big customers are not always profitable ones

Most SME management accounts stop at gross margin by product. Everything below that line – delivery, sales time, customer service, credit control and the cost of waiting to be paid – sits in overheads and is either spread evenly or ignored.

That hides a lot. Robert Kaplan of Harvard Business School, writing on customer profitability, says the same pattern shows up in nearly every study: 15 to 20 percent of customers generate 100 percent or more of the profits. In one example in the same article, the least profitable 5 percent of customers caused losses equal to 30 percent of annual profits.

The causes are familiar to any finance director. Kaplan lists small order sizes, custom work, rush and just-in-time deliveries, heavy pre- and after-sales support and generous payment terms as the things that push up the cost to serve a customer.

How to work out profit by customer in five steps

1. Start with gross margin by customer. Pull 12 months of revenue and cost of sales by customer from your accounting system. If you cannot get cost of sales per invoice, apply your standard margin for each product line.

2. List your cost-to-serve activities. Typical ones are deliveries, order processing, sales visits, customer support, returns and credit notes, rebates and collections effort. Keep it to the five or six that really move the numbers.

3. Put a rate on each activity. Divide the cost of the team or resource by the hours or units it delivers. Kaplan's article shows the idea: a department costing $70 an hour that spends 24 minutes on a transaction gives a cost of $28 per transaction. A sensible rate per order, per delivery or per support call is enough.

4. Add the cost of credit. A customer who pays in 150 days ties up far more of your cash than one who pays in 45. Estimate it as the average balance they owe you multiplied by your annual borrowing rate.

5. Rank and re-segment. Sort customers from most to least profitable. Consultancy West Monroe recommends grouping customers by actual profitability rather than by tenure or revenue. In its case example, a client spreading logistics costs evenly found its largest customer was carrying too much freight cost, while smaller customers were being subsidised.

A worked example

For example, take a hypothetical Doha building-materials distributor with two customers. Each buys QAR 2 million a year at an 18% gross margin, so each brings in QAR 360,000 of gross profit. Customer A takes 50 large deliveries a year and pays in 45 days. Customer B takes 400 small, often urgent deliveries, pays in 150 days and needs QAR 40,000 a year of a coordinator's time.

Assume each delivery costs QAR 350, each order costs QAR 60 to process and the company borrows at 7% a year.

Same revenue, same margin on paper – yet Customer A earns more than three times as much. Without this analysis, both look equally valuable in the monthly MIS.

What this means for your business

In Qatar and across the GCC, long credit terms and project-based billing are common, especially in contracting, distribution and services. In India, many SMEs sell through distributors and large buyers who push for longer terms and frequent small orders. Both patterns make the cost of credit and the cost of service bigger than most owners assume.

The answer is rarely to drop customers. It is to price and serve them on purpose. Kaplan suggests offering a menu of priced service options so that customers who want extras pay for them. In practice that can mean a minimum order value, a charge for urgent delivery, an early-payment discount or moving routine orders to an online portal.

Talk to your customers before you change anything. A fair conversation backed by numbers usually goes better than a surprise price list.

Your next steps

• Export 12 months of revenue and gross margin by customer this week.
• Pick your top 20 customers by revenue and estimate their deliveries, orders and support time.
• Agree simple activity rates with your operations and sales heads.
• Add a cost of credit using each customer's average balance and your borrowing rate.
• Rank the list, and flag any customer whose profit after cost to serve is below 5% of their revenue.
• For each flagged customer, choose one change: pricing, terms, order size or service level.
• Repeat the review every quarter and add it to your MIS pack.

If you use NexCFO, its MIS reporting and AR collections features can be a starting point for the data in steps one and four.

Your biggest customer and your best customer are not always the same – find out which is which before you set next year's prices.