Challenges and Opportunities of Customer Profitability Analysis, The

Challenges and Opportunities of Customer Profitability Analysis, The

Payant, W Randall

A recent survey by a non-profit trade association revealed that nearly half of the banks responding were not satisfied with the information being provided by their customer profitability measurement processes. Similarly, other surveys reveal many bank executives are equally dissatisfied with the returns received on their large investment in customer relationship management (CRM) technology. These two frustrations point to two interrelated shortcomings found in many bank CRM initiative rollouts; a disconnect between CRM technology and the use of customer profit information and a lack of meaningful insight as to how today’s sales translate into tomorrow’s profits.

The first well-documented shortcoming is that many CRM systems primarily focus on “technologizing” the sales process. Yes, some CRM systems provide a measure of relationship profitability, but this is not the focus of such solutions. Every sale is considered profitable on its own merit. CRM profit analytics are not built with the unique nature of the banking customer relationship in mind. These systems lack in providing insight on how to grow the banking customer’s value. To them, the concepts of customer profit and customer value are synonymous, so the name of the game is simply to push higher-profit products.

The second shortcoming is that many CRM profitability measures rest on traditional cost accounting approaches typically found in manufacturing, wholesaling and retailing environments. With traditional cost accounting, product production/acquisition has already occurred and associated costs measured. Unit costs are determined by dividing assigned costs by the number of units produced. Therefore the cost-of-sale is known at time-of-sale. A customer’s profit contribution is calculated by multiplying the product’s standard unit cost by the number of units sold, minus the revenue received. Simple enough.

However with most banking products, a “sale” simply creates a profit-making opportunity, rather than a known profit contribution. A majority of the product’s revenue and costs occur after the sale. Further, sales revenue and costs at the customer level are often driven by how the customer uses the product and how the bank services the product post-sale. Customer profitability measures used in most CRM systems are retrospective in nature, bound to a prior period accrual accounting view of profit. These measures parse period revenue and costs (preferably standards rather than actuals) to provide a post-mortem ranking of the customer’s contribution within that accounting period. Last period’s ranking of relationship profitability becomes an ever-changing list. Retrospective measures provide little insight into a relationship’s future ranking within the customer base.

While traditional cost accounting plays a role in determining the value of a customer, it alone does not provide a complete picture of the measurable value of the relationship. A more complete picture would be to evolve traditional cost accounting measures to value-based derived measures. As derived, the prospective nature used to value the customer today is a discrete metric that potentially transforms itself into future bank earnings.

Customers are not a homogenous group and shouldn’t be treated as such. Customers that provide greater value should be accorded a higher level of attention…today. Therefore any meaningful CRM initiative must be able to differentiate customers in ways that provide insight into what value-creating potential the customer provides. Ultimately it is insight into value creation in the customer’s relationship that provides actionable information to relationship managers.


Merging value-based views with traditional costing requires an understanding in the differences in the two accounting approaches. As stated, standard costing is retrospective in nature, measuring and parsing period revenue and costs after they have occurred. Organization and product profitability measures rest on such a foundation. Alternatively, value-based accounting is prospective in nature. When applying value-based accounting to customer relationships, alternative views of profitability, not available when measuring organization and product profitability, can be created. Value-based measures project revenue and costs forward, period-by-period, over the life of the relationship, and then apply time value of money principles to common-size projected profit potential.

One value-based concept not found in accrual-based accounting is to realize a customer’s business eventually terminates at some pre-definable date, whereas organization units and product lines do not naturally terminate. The customer’s loan and fixed-term deposit accounts will mature. Even indeterminate maturity accounts (i.e. transaction, savings, HELOCs and credit cards) eventually will close. Profit opportunities exist as long as the customer’s account stays open, but when the terminating event occurs, the profit contribution ends. Yet no matter how unambiguous the future profit is, most bank profitability measures don’t consider the customer’s contribution beyond a short-term accounting period.

To illustrate, let’s assume two customers each have equal-sized loans with identical cost of funding spreads (using matched-term FTP) and servicing costs. Using accrual-based profitability measures, both loans would have identical period profit contributions. The profit calculation does not indicate any difference in the value of the customers. However if the two loans had different remaining lives, the two would not have the same profit potential. Because one of the loans has a longer life, the bank has an opportunity to earn the interest spread over more accounting periods than the shorter-term loan. One meaningful way to differentiate the two customers is to present value the spread income over the remaining lives of the accounts.


To derive the value of the relationship, the customer’s anticipated revenue and expenses need to be projected. The starting point is the customer’s current book of business, including all loans, deposits and other recurring feebased revenue sources. Principal and interest cash flows of loan, deposit and fee accounts with known contractual terms are relatively easy to project over the remaining life of each account. The customer’s direct interest income and expense cash Hows would have to be offset by their associated transfer priced charges and credits to derive the account’s interest spread (margin). The margin can be discounted to determine the account’s present value.

Indeterminate maturity accounts require estimating the account’s behavior into the future. Such principal and interest projections are often based on looking at the account’s history to discern reasonable cash flow patterns. Here is where retrospective profitability systems and a bit of sorcery come into play. While far from an exact science, cash flow projections can be estimated based on a wide variety of product-specific attributes that highly correlate with the individual customer’s cash flow patterns.

Attributes may include the customer’s age and type of account, average balance, balance turnover or volatility, and seasonality to name a few. While there is no contractual termination event to these accounts, all face attrition either through being closed or through the increasing nominal impact of longdated cash flows within the discounting process. As with less ambiguous accounts, their direct interest and expense would have to be reduced by their associated transfer-priced offset to determine the lifetime value of the interest spread.


Once the value of the relationship’s net interest margin is determined, the operating costs to service the accounts, minus offsetting fees, needs to be projected. This starts with the standard unit costs derived from the bank’s activity based cost studies. A product’s servicing and maintenance costs are gathered by each activity to arrive at a standard unit cost for each defined activity. These can then be applied to individual customer accounts based on the anticipated activities to be performed.

Many products have fairly standard and predictable activities that do not vary much month-to-month and are therefore not dependent on customer behavior. Installment and residential mortgages usually have one payment per month and similar maintenance activities. This allows for easy estimates of the activities and associated costs of servicing these like-type accounts. Because the cost of account servicing doesn’t vary much between customers, differentiating customer value for these accounts is primarily driven by the projected amount and timing of the net interest spread.

But other products, such as checking, savings and credit cards, have significant variation, not only in account balance turnover, but also in servicing activities initiated by customer behavior. In these cases, customer-servicing and channel delivery preferences vary substantially. To differentiate customer value, both the individual account’s projected interest spread and the anticipated activities must reflect the unique behavior of the customer. Because people are creatures of habit, historical behavior patterns of individual customers can be assessed and projected into the future. Banks that capture account activities at the individual customer level can use this information to determine if there are established activity patterns. Established patterns can be extrapolated into the future. Standardized activity unit costs can be applied to project servicing costs over the account’s projected remaining life. These costs, net of fees, can then be discounted, along with the projected net interest margin to derive distinct value by customer relationship.


While not relevant to deposit accounts, loan accounts have the potential for loan losses. Financial accounting rules provide the ability to smooth reported earnings by accruing reserves to cover unrealized losses within an entire portfolio. Once an account’s loss is determined, it is charged against the reserve rather than against current earnings. But at the individual account level, a loan is either paying according to terms, or it’s not. It would be premature to assess an expense to the customer for a loss that has not, and might never, occur. Projecting a standard loan loss expense for each loan does little to differentiate one loan’s value from another. This is not to say that credit quality differentiation does not exist, but rather that there are better ways to handle potential loss exposure within the relationship profitability measurement framework. starting point for these rates is the bank’s internal funds transfer pricing curve. The lifetime value of an account is calculated by discounting its projected life-time net interest spread and servicing costs (net of fees) by rates found in the funds transfer-pricing curve. As the same rates are used for each account, only the account’s unique elements contribute to differentiating one customer account’s value from that of another.

With loan accounts, customers have credit ratings (or scores) that suggest some customers’ loans are less risky than others. As such, projected loan margin and operating costs are discounted at rates reflective of the customer’s credit standing, with higher quality customers being discounted at lower discount rates. This does differentiate customer uniqueness respective for credit risk.


As demonstrated, the value of a customer’s relationship is a function derived from several factors. These factors include the types of products purchased, their quantity (i.e. account balance), their net interest margin, their active life and their cost of acquisition and servicing. Wherever there is a meaningful valuation factor that differentiates the relative ranking of one customer’s relationship to another, management has the opportunity to differentiate the customer experience…and increase profits. These value-measurements also provide insight into the factors that create value, so that they can be reinforced to improve profit retention.

The changing nature of banking potentially clouds measurements of customer profitability. securitization and other off-books intermediation processes allow the bank some degree of latitude as to when and how customer’s loan profits are realized. Once underwritten, the bank can sell all or a portion of the loan’s future revenue and transfer ongoing costs to a third party. In such cases, the bank does not realize the same profit recognition as it would had the subsequent sale and transfer of the customer’s business not occurred. To counter-act the effect on a customer’s value measure for bank-initiated actions, systems must be able to shadow sold accounts’ projected revenue and expenses as if they were not sold. This shadowed net income is then added to any remaining “on-books” projected income to get a complete picture of the profit potential the customer provided the bank.

Traditional CRM profit measures do not calculate or provide insight into the value created within the customer’s relationship. Bank customer profitability measures therefore must evolve and, in several respects, move beyond simple cost accounting measures in order to provide insight into the customer’s value proposition. This requires reexamining how the elements of a customer’s contribution are quantified, essentially by combining standard costing methods with value-based accounting. Doing so can link CRM initiatives with meaningful profit information so that customer value can be optimized.

by W. Randall Payant, Director of Research, The IPS-Sendero Institute

Copyright National Association for Bank Cost & Management Accounting 2003

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