Credit Guide 05/22: Why and how to calculate customer profitability

Customer profitability is normally assessed through a customer profit and loss account (German: Kundenergebnisrechnung). The customer P&L should be created for each customer, or at least for those making the most significant contribution to the company’s sales. In order to be able to perform this exercise properly, the company needs to have an established controlling function with appropriate software support in order to obtain all the necessary data.

Why is it important to calculate customer profitability?

There are multiple benefits of knowing how profitable a customer is to us, and according to the renowned consulting company Controller Akademie München, here are the most important reasons (the list is not exhaustive):

• Provable assessment and verification of the “feeling” we have for the profitability of each customer
• Knowledge of all costs and efforts invested in the relationship with an individual customer
• Prerequisite for creating the ABC analysis and assessing customer portfolio, and choosing an individual customer service strategy
• An important input to the risk management system, especially for higher exposures
• Contribution margin as a measure of the success of the Key Account Managers of larger and strategically important customers
• Assistance in budgeting / forecasting by matching planned sales per customer and expected profitability
• Discounts management and their quantitative argumentation
• Argumentation in negotiations with customers.

How to calculate customer profitability?

The picture below shows the proposed structure of the customer profitability calculation. How many contribution margin levels will the company use in its calculation depends on the importance of individual cost elements and the ability to obtain quality data from its own systems and tools.

It is important to point out that well-organized controlling function with adequate tools can meet the requirements for calculating the contribution margin up to the level VI. However, one important factor is very rarely in practice adequately covered by controlling, and that is the cost of customer credit risk.

Why is it important to include the implied cost of credit risk in the calculation of customer profitability?

The importance of including customer-specific credit risk costs is best illustrated by a simple example. Suppose you have only two customers, customer X and customer Y. With both customers you realize an annual turnover of 1,000 and you achieve a contribution margin VI of 100. Thus, the contribution margin VI amounts to 10%. Both customers have the same credit terms – up to 60 days. However, if the customer X has a credit rating of BB with a default probability of 2%, and the customer Y has a B- rating with a default probability of 10%, can we say that both customers are equally profitable? If we look at the historical results only, we can conclude that both customers generated the same margin both in absolute and relative terms, but if you were exposed to five times higher risk with the customer Y, you had to “reserve” more of your capital during that period for the event of default of customer Y, than for the event of default of the customer X. Furthermore, the risk / return ratio is by no means the same for customer X and customer Y, and higher risk should carry higher returns. In addition, if you had limited capacity and could sell your products / services to only one of those two customers, which customer would you choose? You would probably choose the customer X, i.e., the one carrying less risk, right?

Key takeaways

• The customer profitability calculation should include the degree of credit risk we take by doing business with that customer (similar to provisioning logic in banks).
• The elements for calculating customer-specific credit risk costs in absolute terms are a function of the probability of default, the recovery rate, and the level of sales on credit.
• Customer profit and loss account is a useful tool for prioritizing customers.
• Knowing the profitability of an individual customer helps structure the relationship by giving a clear view of the risk and return ratio and improves customer portfolio management.

How can CreditAnalyst.eu help you analyse your customers’ profitability?

With our credit analyses, we help you:

• Assign a proper credit rating to your customers
• Calculate the probability of default of your customers
• Calculate the recovery rate in case of a default.

We guarantee a delivery of a risk opinion of any Croatian corporate within 3 days, and of an international corporate within 3 to 5 days, depending on the degree of complexity and available information.

In addition to providing credit analyses of customers of your choice, you can already leverage on our current portfolio of companies that we regularly monitor:

• 24 companies from the Retail sector
• 6 companies from the Consumer goods sector
• 5 companies from the Distributors sector
• 3 companies from the Agribusiness sector
• 3 companies from the Transport sector
• 2 companies from the Construction sector
• 2 companies from the Tourism sector
• 1 company from the ICT sector.

For all queries, please send a message to mario@creditanalyst.eu, the contact form on https://creditanalyst.eu/en/contact/, or call us on +385 98 920 17 13.