Customer-Profitability-Analytics

Customer
 Profitability
 Analytics
 

 
Faced
 with
 a
 host
 of
 competitive
 forces
 and
 their
 accompanying
 pricing
 pressures
 it’s
 not
 enough
 just
 to
 
grow
 anymore,
 a
 financial
 institution
 must
 grow
 profitably.
 
 

 
The
 key
 to
 growing
 profitably
 is
 to
 develop
 business
 tactics
 and
 strategies
 around
 customer
 level
 
profitability
 analytics,
 including
 the
 lifetime
 value
 of
 each
 customer.
 A
 popular
 definition
 of
 marketing
 
describes
 such
 business
 tactics
 and
 strategies
 as:
 “The
 science
 and
 art
 of
 finding,
 retaining,
 and
 growing
 
profitable
 customers.”1
 
 

 
For
 this
 article,
 we
 will
 define
 customer
 profitability
 as
 the
 sum
 of
 the
 net
 profit
 or
 loss
 of
 each
 of
 the
 
customers’
 accounts.
 Therefore
 account
 level
 profitability
 analysis
 is
 the
 building
 block
 upon
 which
 to
 
analyze
 customer
 profitability.
 It
 is
 also
 the
 building
 block
 to
 analyze
 product
 profitability,
 line
 of
 
business
 profitability,
 branch
 profitability,
 regional
 profitability,
 and
 ultimately
 organization
 profitability.
 
 

 
Part
 1.
 Customer
 Acquisition
 &
 Origination
 Costs
 
The
 cost
 to
 acquire
 a
 customer
 varies
 by
 context,
 but
 can
 generally
 be
 calculated
 as
 the
 cost
 to
 generate
 
a
 response
 divided
 by
 the
 response
 rate2.
 

 
For
 example,
 let’s
 assume
 you
 are
 going
 to
 try
 and
 acquire
 new
 customers
 using
 traditional
 direct
 mail,
 
such
 as
 a
 postcard.
 The
 first
 option
 is
 to
 randomly
 send
 postcards
 to
 a
 specific
 area.
 The
 next
 option
 is
 to
 
send
 postcards
 to
 a
 targeted
 list.
 Let’s
 assume
 that
 the
 random
 option
 costs
 $.50
 and
 yields
 a
 1%
 
response
 rate.
 Let’s
 assume
 the
 targeted
 option
 cost
 $.70
 and
 yields
 a
 4%
 response
 rate.
 

 
Acquisition
 cost
 =
 cost
 of
 sending
 postcard/response
 rate
 
Random
 Option=.5/1.0%=$50.0
 
Targeted
 Option=.7/4.0%=$17.5
 

 
In
 this
 example
 it
 is
 clear
 that
 using
 a
 target
 list
 is
 worthwhile,
 despite
 the
 increased
 initial
 cost.
 
However,
 the
 key
 point
 is
 not
 whether
 to
 use
 a
 target
 list
 or
 not,
 the
 key
 point
 is
 to
 measure
 the
 cost
 of
 
acquiring
 a
 new
 customer.
 

 
In
 addition,
 acquisition
 costs
 should
 include
 administrative
 expenses
 related
 to
 existing
 customers
 
acquiring
 new
 products,
 such
 as
 origination
 costs,
 which
 could
 be
 calculated
 as
 a
 set
 fee
 amount
 or
 a
 
percentage
 of
 original
 balance.
 

 
Part
 2.
 Cost-­‐to-­‐Serve
 Analysis
 


 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
1
 Philip
 Kotler
 and
 Gary
 Armstrong,
 Principle
 of
 Marketing,
 Prentice
 Hall,
 2001
 
2
 Customer
 Profitability
 and
 lifetime
 Value,
 Elie
 Ofek,
 Harvard
 Business
 School
 Publishing,
 copyright
 2002
 

In
 the
 world
 of
 banking
 the
 cost-­‐to-­‐serve
 variable
 is,
 well,
 quite
 variable.
 Some
 customers
 may
 put
 
extreme
 pressure
 on
 certain
 channels
 such
 as
 branch
 visits,
 while
 other
 may
 hardly
 require
 any
 cost
 to
 
serve
 at
 all.
 

 
Cost-­‐to-­‐serve
 metrics
 can
 be
 calculated
 as
 the
 channel
 multiplied
 by
 the
 cost
 of
 using
 the
 channel3.
 For
 
example,
 

 
#
 of
 branch
 visits
 x
 cost
 per
 visit
 
#
 of
 calls
 x
 cost
 per
 call
 
#
 of
 atms
 transactions
 x
 cost
 per
 transaction
 
Etc.
 
=Cost
 to
 Serve
 

 
In
 addition,
 certain
 products
 require
 accounting
 for
 maintenance
 expenses,
 which
 can
 usually
 be
 
expressed
 as
 a
 percentage
 of
 outstanding
 balance.
 

 
Part
 3.
 Customer
 Break-­‐Even
 Analysis
 
Once
 the
 acquisition
 and
 the
 cost-­‐to-­‐serve
 costs
 have
 been
 calculated,
 the
 next
 step
 is
 to
 perform
 a
 
break-­‐even
 analysis
 to
 determine
 the
 sales
 activity
 required
 to
 realize
 a
 profit
 from
 the
 customer.
 

 
Account
 revenues
 can
 generally
 be
 calculated
 as
 net
 interest
 margin
 x
 balance
 +
 fees.
 However,
 we
 also
 
need
 to
 include
 a
 risk
 component,
 which
 can
 be
 expressed
 as
 a
 provision
 amount
 and
 a
 charge
 off
 
amount.
 One
 could
 use
 probabilities
 multiplied
 by
 balances
 or
 just
 prorated
 amounts
 for
 provisions
 and
 
charge
 off
 expenses.
 

 
Taking
 into
 account
 revenues,
 expenses,
 and
 risk
 we
 have
 the
 following
 break-­‐even
 equation:
 

 
(Net
 Interest
 Margin
 x
 Balance)
 -­‐
 Loan
 Loss
 Provision
 -­‐
 Charge
 off
 =
 Acquisition
 &
 Origination
 Costs
 +
 Cost
 to
 Serve
 

 
One
 can
 then
 readily
 calculate
 the
 margin
 required
 to
 breakeven
 by
 solving
 for
 required
 Net
 Interest
 
Margin
 as
 follows:
 

 
Net
 Interest
 Margin
 =
 (Acquisition
 &
 Origination
 Costs
 +
 Cost
 to
 Serve
 +
 Loan
 Loss
 Provision
 +
 Charge-­‐Off)/Balance
 

 
The
 math
 is
 easy.
 The
 difficulty
 lies
 in
 accurately
 calculating
 the
 equation
 components,
 especially
 cost
 to
 
serve
 expenses.
 
 

 
Part
 3.
 Lifetime
 Value
 Analysis
 
The
 value
 of
 a
 customer
 is
 more
 than
 just
 the
 initial
 revenue.
 A
 lifetime
 value
 analysis
 provides
 a
 
prediction
 of
 the
 net
 profit
 attributed
 to
 the
 entire
 future
 relationship
 with
 a
 customer.4
 An
 unprofitable
 


 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
3
 Evalution
 of
 Customer
 Profitability
 Analytics
 Vendors,
 Celent,
 September
 2007
 

customer
 in
 the
 first
 few
 years
 may
 turn
 out
 to
 be
 a
 profitable
 customer
 in
 future
 years
 and
 

consequently
 have
 a
 positive
 lifetime
 value.
 


 

Calculating
 a
 lifetime
 value
 for
 each
 customer
 has
 the
 benefit
 of
 quantifying
 the
 long
 term
 relationship
 

with
 the
 customer
 and
 providing
 insight
 into
 developing
 optimal
 strategies
 for
 each
 customer.
 For
 

example,
 you
 might
 decide
 to
 “fire’
 certain
 unprofitable
 customers,
 reward
 others,
 and
 identify
 

profitable
 cross
 sale
 opportunities.5
 


 

Inputs
 needed
 to
 calculate
 a
 lifetime
 value
 include:
 retention
 rate,
 discount
 rate,
 contribution
 margin,
 

retention
 costs,
 and
 the
 time
 period.6
 


 

! ! ! (1 + ! ! !)!!.!
 
+ )!
=  ×   (1 −    ×  

!!! !!!


 

CLV=Customer
 Lifetime
 Value
 

GC=Annualized
 Gross
 Contribution
 

M=Relevant
 Retention
 Costs
 Per
 Customer
 Per
 Year
 

r=
 Annualized
 Retention
 Rate
 

d=Annualized
 Discount
 Rate
 

n=Time
 Horizon
 (in
 years)
 


 

A
 simplified
 version
 that
 assumes
 long
 lasting
 values
 for
 contribution
 margin,
 retention
 rate,
 and
 

discount
 rates:
 

=  ×(1 1+ )
 
+ −


 

Of
 course
 customer
 profitability
 analytics
 is
 easier
 said
 than
 done;
 easier
 to
 compute
 in
 an
 academic
 

sense
 than
 in
 reality.
 However,
 it
 is
 important
 to
 recognize
 that
 growth
 and
 market
 share
 does
 not
 equal
 

profitability,
 so
 a
 financial
 institution
 needs
 to
 grow,
 but
 grow
 profitably.
 In
 order
 to
 grow
 profitably
 it
 

must
 measure
 profitability.
 The
 best
 way
 to
 measure
 profitability
 is
 via
 the
 lifetime
 value
 of
 the
 

customer,
 which
 relies
 on
 accurate
 account
 level
 profitability
 accounting.
 


 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
3
 www.wikipedia.com,
 Customer
 Lifetime
 Value,
 7/9/12
 
5
 Evalution
 of
 Customer
 Profitability
 Analytics
 Vendors,
 Celent,
 September
 2007
 
6
 www.wikipedia.com,
 Customer
 Lifetime
 Value,
 7/9/12