Customer profitability analysis measures the profit each customer actually generates after price discounts, rebates, the cost of serving them and the cost of the credit they take, not just the gross margin on what they buy. Service costs are traced to customers through activities such as order handling, deliveries and support calls. The result often shows that some of the largest customers earn little or nothing, while smaller, simpler customers are more profitable than they look.
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Why look at profit by customer rather than by product?
Product costing tells you what an item costs to make or buy. It says nothing about what it costs to win, serve and collect cash from the person who buys it. Two customers buying the same products can differ hugely in the discounts they negotiate, how often they order, how much delivery and support they need, how many items they return and how long they take to pay.
ACCA’s article on activity based management describes customer profitability analysis as allocating overheads to customers using activity based principles to get a more accurate view of the profit or loss each customer generates. Traditional costing assumes that a customer with positive contribution must add to profit, which ignores the fact that many so called fixed overheads, such as customer service time, are customer specific. ACCA notes that such exercises have produced surprising results, with apparently best customers often turning out to generate losses.
How do you build a customer profit statement?
Work down from list price to the customer’s true contribution in layers, sometimes called a price and cost waterfall:
- Gross sales at list price.
- Less invoice discounts: trade, volume and promotional discounts given on the invoice.
- Less off invoice deductions: year end rebates, settlement discounts taken, listing fees, marketing contributions and free stock. This gives net revenue.
- Less cost of goods sold, which gives gross margin by customer.
- Less cost to serve: order processing, picking and packing, delivery, sales visits, account management, customer service calls, returns handling and any special packaging or labelling.
- Less cost of credit: the financing cost of the money tied up in the customer’s unpaid invoices, plus collection effort and bad debt experience.
- Customer contribution. Optionally deduct a share of general overheads to reach a fully costed customer profit, but keep contribution visible.
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How are service costs and overheads allocated to customers?
The standard approach is activity based costing. Group costs into activities, find the driver that causes each activity’s cost, work out a cost per unit of driver, and charge each customer for the drivers it consumes. Typical drivers are number of orders, order lines, deliveries, sales visits, support calls, invoices and returns.
ACCA’s First Electric example shows how this works. The supplier costed meter reading at $20 a visit, customer service at $30 a call, invoicing at $10 an invoice and complaints at $25 each. An easy customer cost $30 a quarter, one meter reading and one invoice, but customers who were out when the reader called needed repeat visits and phone calls. The analysis showed First Electric made a loss on 20% of its customers and only broke even on a further 30%, which explained why a successful campaign that grew its customer base from 30,000 to 40,000 had reduced profit.
Not every overhead has a sensible customer driver. Head office costs, the finance director’s salary and the audit fee do not change with any one customer. Leave them unallocated or show them separately; spreading them by sales value adds nothing and can mislead.
How should discounts and rebates be treated?
Discounts and rebates belong against revenue, not in overheads, so customer net revenue reflects the price actually earned. This is also how the accounts treat them. FRS 102 paragraph 23.43 treats consideration that varies because of discounts, rebates, refunds and similar items as variable consideration to be estimated within the transaction price. Paragraphs 23.62 and 23.63 say payments to a customer, such as cash, credits or vouchers, reduce revenue unless they buy a distinct good or service from the customer. A listing fee paid to a retailer is therefore usually a reduction in that customer’s revenue.
VAT follows the discount type. HMRC’s VAT Notice 700 (section 7.3.2) explains that an unconditional discount reduces the value for VAT, a prompt payment discount is based on the amount actually paid, and a contingent discount, for example one earned by buying more later, is accounted for on the full amount until it is earned, when a credit note adjusts it. Our page on VAT on credit notes and discounts covers the mechanics.
How do you cost the credit a customer takes?
A customer who pays in 90 days ties up three times as much of your working capital as one who pays in 30, and that money has a cost. Estimate the average balance outstanding for each customer, using annual net sales multiplied by its debtor days divided by 365, then multiply by your cost of finance, such as your overdraft rate. Add the cost of chasing, and any history of write offs.
The law gives some leverage here. GOV.UK guidance on late commercial payments says that agreed payment terms between businesses must usually be within 60 days unless a longer period is fair to both, that payment is late 30 days after the invoice or delivery where no date is agreed, and that statutory interest of 8% plus the Bank of England base rate can be claimed if no other rate is agreed in the contract.
What does the analysis look like for two customers?
Illustration only. A wholesaler compares two customers, assuming a cost of finance of 8% and activity costs of £15 per order, £40 per delivery, £150 per sales visit and £60 per return.
| Line | Customer A | Customer B |
|---|---|---|
| Sales at list price | £120,000 | £80,000 |
| Invoice discount (10% and 2%) | (£12,000) | (£1,600) |
| Year end rebate (2% for A) | (£2,160) | nil |
| Net revenue | £105,840 | £78,400 |
| Cost of goods (60% of list) | (£72,000) | (£48,000) |
| Gross margin | £33,840 | £30,400 |
| Orders (400 and 50) | (£6,000) | (£750) |
| Deliveries (200 and 25) | (£8,000) | (£1,000) |
| Sales visits (12 and 4) | (£1,800) | (£600) |
| Returns (30 and 2) | (£1,800) | (£120) |
| Cost of credit (90 and 30 days) | (£2,088) | (£516) |
| Customer contribution | £14,152 | £27,414 |
Customer A buys 50% more at list price but contributes about half as much as Customer B. The gap comes from the discount and rebate, frequent small orders and deliveries, returns and slow payment, none of which shows up in a product margin report.
What should you do with the results?
ACCA’s First Electric example splits the responses into two kinds. Operational actions reduce the cost of serving customers: First Electric moved to one meter reading a year with estimated bills in between, and let customers submit readings online. Strategic actions change which customers you serve and on what terms: it priced loss making customers above competitors and offered discounts to profitable ones to keep them.
For most businesses the practical levers are minimum order values, delivery charges or consolidated delivery days, charging for special services, tightening credit control, and tying rebates to behaviour that lowers your costs rather than to volume alone.
What are the common mistakes?
- Dropping a customer to save allocated costs. ACCA warns that cutting loss making products or customers may not save the costs allocated to them, and that some overheads are fixed and will not fall if activity falls. Check which costs would really go before acting.
- Losing linked sales. ACCA also notes that customers often prefer to buy everything from one supplier, so dropping some lines or customers can reduce demand elsewhere.
- Treating rebates as marketing overhead, which flatters the customer’s margin.
- Running the analysis once. Customer behaviour changes. The ACCA and KPMG report on profitability and cost analysis describes one client finding that 20% of its customers did not even generate a profit, and recommends reviewing the model as part of the annual planning cycle.
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Related Accountapedia entries
- Unit economics: customer acquisition cost and lifetime value
- Contribution margin explained
- Working capital management
- Variable consideration: rebates, discounts and bonuses
- Pricing methods: cost plus, value and competitive pricing
- The balanced scorecard
Sources
- ACCA: Activity based management
- ACCA: Profitability and cost analysis An Eye on Value
- Financial Reporting Council: FRS 102 September 2024 tmKYWO6
- GOV.UK: Vat guide notice 700
- GOV.UK: Late commercial payments interest debt recovery
- GOV.UK: Charging interest commercial debt
Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 19 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.