Customer Profitability Analysis - In The Belly Of The Whale
Quick recap. The 2010 - 2021 was good for startups - including B2B SaaS companies. Low (even negative) interest rates turned on a firehose of VC funding. Not even COVID could stop these businesses as a combination of lockdowns causing physical activity to move to the digital world and stimulus packages lead to even more revenue and even higher valuations.
During this period, companies were encouraged to grow at all costs. ARR (Annual Recurring Revenue) growth was the Great God to which homage must be paid. The role of the CFO was primarily to secure the next round of VC funding. Actually being profitable was even seen as something wimpy and wrong. Any money made should be directly invested in growth - more digital marketing, more salespeople, more engineers and product managers to build out the features necessary to sell to more customers. Cost control was less taking a back seat, more bound and gagged in the trunk of the SaaSmobile.
We are no longer in that world. Rising interest rates are turning off the cheap money hose. Investors now expect growth AND profitability from these companies. Cost control (black ink rather than red) is the new black.
Leaders of these companies will now go through five stages of loss: Denial, Anger, Bargaining, Depression, and Acceptance. The sooner you get to acceptance, the better. Because then you can do something about it.
You need to stop burning cash. Your biggest expense is headcount. So you exit a bunch of roles that are deemed non-essential (typically, HR, talent acquisition, may be some operations people). You might cut back on your sales and marketing (although this is dangerous - you don’t want to go into a contraction spiral of less revenue), your service and customer success teams (again risky because the last thing you want is churn) and your engineering team members working on non-essential products. Obviously you will start with team members who are not high-performers. Now if your hiring and management processes were strong then there should not be many of these - but yours weren’t and there are a few.
But what do you do now? How do you cut your costs without harming your revenue and further reducing profitability?
You need to start looking at your customers. Not all customers are equal. You should know who your highest revenue customers are - and in most organisations this resembles a power law distribution with a short head of big customers providing an outsized share of your revenue against a long tail of much smaller customers. But depending on the markets you serve, this long tail could still be the bulk of your revenue. You may have some idea of your average Customer Acquisition Cost (CAC) and an average Customer Lifetime Value (CLT). But that’s it.
Now if you are accurately tracking the time costs of your sales teams in each deal, the cost of the campaign that brought the customer in, the cost of implementation, support, and services, and the engineering and product costs associated with the products that this customer consumes, you can estimate customer profitability. But I suspect that very few organisations are doing this - because they haven’t needed to and other priorities (i.e. revenue growth) have taken precedence.
So why does this matter? Well, research indicates that customer profitability does NOT follow a power law / pareto curve. It follows a whale curve:
The whale curve for cumulative profitability (see picture) usually reveals that the most profitable 20 percent of customers generate between 150 percent and 300 percent of total profits. The middle 60-70 percent of customers break even and the least profitable 10-20 percent of customers lose from 50 to 200 percent of total profits, leaving the company with its 100 percent of total profits.
Bear in mind that profitability for many startups is a negative number currently. 20% of your customers are losing you money right now - wiping out the profits from the rest of your customers.
So what does this mean for startups?
Firstly you need some data:
You do not need microscopic precision, you need a fair and reasonable allocation of costs against a customer’s revenue.
Unless you have robust tools in place for tracking staff time (your biggest expense) and linking that in a fair way to a customer, this is all very hard to do. Staff don’t like doing this but the argument “If you don’t fill out your timesheet, this company will cease to exist” has a certain power to it.
Depending on your product architecture, have a method for allocating non-salary expenses to customers (e.g. marketing, infrastructure).
Use proxies for time if the direct data is hard to obtain (e.g. time to close for salesperson time, # of ticket requests for service desk time).
Then you need to use that data to make some decisions:
Do the low-profit customers have any shared characteristics? (size, industry, geographic location, product and services mix, length of relationship.
Do you need to restructure how you sell, deliver and service your products to a particular customer segment to make them profitable?
Can the product teams engineer any of these costs out and therefore should these features be prioritised on the product roadmap?
Does your pricing align with your costs and adequately compensate you for your efforts?
Should you be targeting unprofitable customer segments in your current and future sales and marketing campaigns?
Are you really that bothered if unprofitable customers churn? And conversely, are you doing your best to keep your most profitable customer segments?
If you need to explain what you are doing to your investors - at the most extreme end, why a 20% reduction in existing ARR may be necessary to save the business in the long term - then this analysis will be critical tool in getting everyone on board.
All of these options and more should be on the table when you discuss how to make your business profitable. There is no single answer to this challenge. The good news is that once you have done this, you can run your business in a far more effective way going forward. Good luck and god speed getting out of the belly of the whale curve and into the bright light of profitability.