CUSTOMER PROFITABILITY ANALYSIS:

MEASUREMENT, CONCENTRATION, AND

RESEARCH DIRECTIONS

Francis J. Mulhern FRANCIS J. MULHERN is Assistant

Professor in the Department of
Integrated Marketing
f Communications at the Medill
School of Journalism, Northwestern
University, Evanston, Illinois.

ABSTRACT
As marketing activities become more precisely targeted to
consumers through direct and interactive forms of communication,
customer profitability takes on a central role in the development of
marketing strategies. This paper provides a conceptual and
methodological foundation for measuring customer profitability by
generalizing approaches to measuring customer lifetime value in
direct marketing for broader target marketing applications. Particular
emphasis is placed on the precise specification of the inputs into a
profitability analysis and the measures of the degree of
concentration of profits among customers. An empirical analysis
involving the profitability of customers in a business-to-business
marketing context is described, along with research propositions for
future work on the determinants of customer profitability.

© 1999 John Wiley & Sons, Inc. and

Direct Marketing Educational Foundation, Inc.
CCC 1094-9968/99/010025-16
f

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 JOURNAL OF INTERACTIVE MARKETING
INTRODUCTION
Marketing practice is in the midst or a dramatic
transformation, from aggregate-level mass mar-
keting programs to micro-level programs that
feature more customized offerings marketed
through direct and interactive forms of commu-
nication. An important feature of these special-
ized marketing programs is the ability to ad-
dress marketing communications to individual
customers or small customer segments. In se-
lecting which customers to communicate to,
and specifying the content of the communica-
tions, managers can benefit greatly by knowing
the profitability of individual customers. Differ-
ent communication programs can be developed
based on the actual, or projected, profitability
of customers.
Analysis of customer profitability has been a
central tenet of direct marketing for many years
(Shepard, 1990). As interactive forms of com-
munication become more commonplace, direct
marketing concepts, measures, and methods
need to be broadened to encompass more tra-
ditional marketing practices. Accordingly, there
is a need for greater theoretical and method-
ological grounding in these areas to deal with
the varied settings, some quite different from
direct marketing, in which highly targeted com-
munications are now being used.
Customer profitability is the net dollar con-
tribution made by individual customers to an
organization. Customer profitability is referred
to in the literature with several different terms,
including lifetime value (Keane and Wang,
1995), customer lifetime value (Berger and
Nasr, 1998), customer valuation (Wyner, 1996),
customer lifetime valuation (Dwyer, 1989), cus-
tomer relationship value (Wayland and Cole,
1997) and customer equity (Blattberg and
Deighton, 1996). Here, consistent with Stor-
backa (1998), we use the term customer profitabil-
ity since, as we describe below, profitability anal-
ysis in many non– direct marketing applications
does not always involve a sequence of purchases
over an extended period of time, and the term
value has multiple connotations in the market-
ing literature. For example, perceived value is
used to refer to the ratio of perceived quality
JOURNAL OF INTERACTIVE MARKETING
relative to price (Zeithaml, 1988). Customer val-
ues are psychological constructs that pertain to
consumer moral judgments. Most studies in the
marketing literature that have addressed profit-
ability issues have measured profits at the level
of the firm, business unit, product, or brand
(e.g., Anderson, Fornell, and Lehmann, 1994).
The measurement of profits at the customer
level has drawn little attention, not because it
lacks importance, but because of difficulties in
obtaining accurate information on individual
customer purchase behavior. Measuring cus-
tomer profit requires data on individual cus-
tomer purchases and variable marketing costs
over a period of time. Customer profitability
analysis now is possible because of the availabil-
ity of large-scale customer databases containing
a history of purchase transactions (Blattberg
and Deighton, 1991)
As noted by Wyner (1996), customer profit-
ability reconfigures traditional marketing prac-
tice by treating the customer as an asset analo-
gous to other economic units. In this context,
marketing decisions are similar to investment
decisions in that expenditures are evaluated in
terms of expected returns. Viewed this way, cus-
tomer profitability becomes a central tenet of
customer relationship marketing (Morgan and
Hunt, 1994). Knowledge of customer profitabil-
ity can improve decision-making for many as-
pects of marketing including product and ser-
vice development, pricing, and all forms of
marketing communications including promo-
tion and personal selling. Ultimately, customer
profitability provides a metric for the allocation
of marketing resources to consumers and mar-
ket segments. Marketing efforts are best di-
rected at the most profitable consumers. Mar-
keting theorists (e.g., Day and Wensley, 1983;
Schultz and Schultz, 1998) often note that for
most organizations, profits are concentrated
among a small set of customers. However, with
the exception of Schmittlein, Cooper, and Mor-
rison (1993), little consideration has been given
to how customer profitability is defined and
measured. In this paper, we delineate the mea-
surement issues pertaining to customer profit-
ability. Such a conceptualization is important
because profitability measures, and the subse-
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 CUSTOMER PROFITABILITY ANALYSIS
quent assessment of the distribution and deter-
minants of profitability, will become central to
the data-driven world of interactive marketing.
In the traditional marketing literature, few
studies have provided sophisticated analysis of
customer profitability. Berger and Nasr (1998)
provide an excellent treatment of the structural
modeling aspects for constructing profitability
models. This treatment goes well beyond the
more heuristic structural models provided in
the direct marketing literature (Dwyer, 1989;
Keane and Wang, 1995). Storbacka (1998) de-
scribes customer profitability as a central aspect
in relationship marketing, and provides some
measures for evaluating the distribution of prof-
itability across customers. Papers by Schmit-
tlein, Morrison, and Colombo (1987) and
Schmittlein and Peterson (1987) provide sto-
chastic modeling procedures for determining
two of the micro-level inputs to a profitability
analysis—whether a customer is still “active,”
and what future purchase behavior can be ex-
pected. While these studies provide important
elements for customer profitability, there is no
systematic treatment in the literature of the
measurement issues involved in customer prof-
itability. The purpose of this paper is to formally
set forth the issues that are involved in (1)
measuring customer profitability and (2) evalu-
ating the concentration of profitability among
customers. We go on to discuss how customer
profitability measures can be used for strategic
marketing practice and what research is needed
to develop customer profitability as a useful
research area. To help demonstrate the impli-
cations of the measurement issues raised here,
we provide an empirical analysis in a business-
to-business marketing context.
MEASURING CUSTOMER PROFITABILITY
While measuring customer profitability might
appear to be a straightforward process, it is
actually quite complex. The exact specification
of a profitability analysis has important implica-
tions for marketing decisions based on profit-
ability measures. Accordingly, it is crucial to
consider the many specification issues that per-
tain to a profitability analysis. The appropriate
JOURNAL OF INTERACTIVE MARKETING
specification of a profitability analysis should be
made in the context of the strategic situation,
and will vary for different applications. For ex-
ample, a profitability analysis done for the pur-
pose of allocating a sales force might use cor-
porate customer locations as the customer unit,
whereas an analysis for direct marketing might
use individuals as the customer unit. Below we
identify the key measurement components and
the issues involved in specifying a profitability
measure.
Profitability Measurement Components
Specification of Customers. Definition of Cus-
tomer Unit. The customer unit is the entity for
which profitability is computed. Firms often dis-
tinguish different types of customers (e.g., con-
sumer versus corporate customers for an air-
line, store versus catalog shoppers for a
retailer). Depending on the application, a prof-
itability analysis could be performed for all cus-
tomers, or some specified customer unit. Spec-
ification of the customer unit delineates the
scope of a profitability analysis.
Aggregation of Customer Units. Ideally, a profit-
ability analysis is performed for the individual
customer units; however, in some cases it is
preferable to compute profitability at a higher
level of aggregation. Higher levels of aggrega-
tion are practical when individual customer
purchase data are not available or individual-
level marketing is not feasible. For example,
consumer packaged goods manufacturers
might not find it economically practical to mar-
ket to individual customers because of the low
dollar amount of individual purchases. A higher
level of aggregation could represent a market
segment consisting of customers that should
receive the same communication.
In consumer marketing, individual custom-
ers are often studied at the household level. In
business marketing, the customer unit issue is
more complex. Customer units can be defined
in many different ways: an entire corporation
with several holdings, strategic business units
(SBUs), divisions of SBUs, departments within
divisions, or specific corporate locations. What-
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 JOURNAL OF INTERACTIVE MARKETING
ever the chosen unit of analysis, consideration
must be given to the comparability of the cus-
tomers. Profitability results can be distorted
when there are major size differences in cus-
tomer units.
Existing or Prospective Customers. A profitability
model may be constructed for both existing
customers and prospective customers. While
measures of profit for both customers and pros-
pects are important, it is much easier to build
models for existing customers because detailed
information on their purchases is often avail-
able in marketing databases. Information on
prospects can be extremely difficult to obtain.
The potential profit of prospects can be mea-
sured by matching them to existing customers
with data mining and clustering techniques that
identify similarities among observations.
Determining Which Customers Are “Active.” Cus-
tomers in a database vary dramatically in their
purchase activity. Most customer databases con-
tains names of customers who are no longer
active. Should a customer who made extensive
purchases a year ago, but has made no pur-
chases in the current year be included? The
determination of what qualifies a customer as
active is critical because the profit of each cus-
tomer is assessed relative to the profit of other
customers. The question of delineating the sta-
tus of customer has been addressed in detail by
Schmittlein et al. (1987) and Schmittlein and
Peterson (1994). Those papers compute the
probability that a customer is active given the
number and timing of purchase transactions.
Such an analysis is an important precursor to
profitability measurement. Schmittlein et al.
(1993) show that the evaluation of the concen-
tration of purchases among customers can be
dramatically affected by whether nonusers are
included in an analysis.
Specification of Products/Services Level of
Products/Services. Separate profitability analysis
can be performed for individual product lines
or brands. For example, a computer manufac-
turer could do separate analyses for main-
frames, workstations, and desktop systems. Con-
JOURNAL OF INTERACTIVE MARKETING
versely, profitability analysis can be performed
at an aggregate level such that every element of
the relationship between an organization and a
customer is included in a single profitability
measure. From a relationship marketing per-
spective, all of the brands or products pur-
chased should be included. In practice, how-
ever, lesser levels of aggregation may be
appropriate for certain marketing decisions.
Organizational Level.
Depending on data availability, profitability
analysis can be performed at a variety of orga-
nizational levels. For example, a computer soft-
ware company could compute the profitability
of customers at the level of its own sales territo-
ries, local sales offices, regional sales offices, or
the national level.
Customer Profitability Measure Core Profit El-
ement. A profitability model centers on a core
profit component, typically dollar contribution.
Other measures could be used, depending on
the purpose of the analysis. For example, cus-
tomers who are opinion leaders or market ma-
vens, avid proponents of a product or brand to
others (Feick and Price, 1987), may be valued at
a level above what is represented by their own
profit contribution.
Present or Future Profit.
Customers can be evaluated based on present
purchase behavior or of the anticipated future
stream of purchases. One aspect of customer
lifetime value models that is not often discussed
is the need to forecast individual customer pur-
chase behavior over the specified lifetime. This
can be performed with well-established forecast-
ing techniques (e.g., exponential smoothing or
ARIMA models), or by using an analog ap-
proach where customer purchases are pre-
dicted by evaluating the purchase behavior of
similar customers in the past. However, models
incorporating predicted future purchases are
subject to a great deal of forecasting error.
The appropriateness of future-oriented life-
time profitability analysis varies by industry.
Lifetime analysis is natural for industries such as
financial services and some business-to-business
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 CUSTOMER PROFITABILITY ANALYSIS
supplier relationships in which customers natu-
rally are bound to an organization for a long
time period because of high switching costs.
However, in many industries, customer lifetimes
are difficult to specify because the length of a
“relationship” maybe very short. More impor-
tantly, the difficulty in projecting purchase be-
havior at the individual level makes lifetime
models difficult to estimate. Hence, we advocate
profitability analysis of past purchase behavior
initially, with subsequent analysis of projected
future purchases for more sophisticated appli-
cations. When future purchases are included in
a profitability model, dollars must be adjusted
to present profit using a standard net present
profit procedure, as discussed in research on
customer lifetime value (Berger and Nasr, 1998;
Keane and Wang, 1995).
Brand or Category Profit.
Models can be constructed to measure the
realized profit from a customer’s purchases
from one company (brand), or the category
level profit represented by the sum of a custom-
er’s purchases from all companies selling in a
category. Typically, one would first measure
brand profit, and then attempt to estimate cat-
egory-level profit. The most complete picture is
obtained by measuring both brand and cate-
gory-level profit. This allows for the computa-
tion of share of requirements—the portion of a
customer’s profit that one company possesses.
Marketing resources can then be allocated ac-
cording to the available potential profit that can
be obtained by attracting a larger portion of
customer category expenditures.
Length of Time Period.
For both the analysis of projected future or
actual past purchases, a decision must be made
regarding the length of time that a profitability
analysis should encompass. Longer time peri-
ods incorporate more purchase cycles and
therefore are less subject to behavioral anomo-
lies. However, longer time periods involve the
diminished relevance of more historical data
(in the case of analysis of past data) or the
increasing inaccuracy of projected future pur-
chases as time into the future increases (for
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lifetime models). Schmittlein, Cooper, and
Morrison (1993) show that the length of the
time affects the measured concentration of pur-
chases among customers. Typically the length-
of-time-period decision should be made based
on the time-related aspects of customer life-
time, interpurchase times, and an organiza-
tion’s planning cycle.
Cost Allocations Assignment of Variable
Costs. A fully developed profitability model
features the assignment of variable costs to cus-
tomers. Variable costing shifts a revenue analy-
sis to a contribution margin analysis. When vari-
able costs cannot be allocated, less complete
formulations can be used that assign costs to
market segments, or collapse variable costs into
fixed costs. More sophisticated customer data-
bases contain data on the costs for marketing
communications and other customer-specific
variable costs. In fact, the mere matching of
variable marketing costs to revenue streams of
customers is valuable information for market-
ing decisions. In most cases, fixed costs are not
allocated to customers (Berger and Nasr, 1998;
Dwyer, 1989). Foster, Gupta, and Sjoblom
(1996) provide a more detailed description of
the cost accounting issues that should be con-
sidered when computing customer profitability.
Assignment of Acquisition Costs.
In some industries there are specific and de-
finable acquisition costs, such as prospecting
sales calls, product specifications, and price dis-
counts. More typically, acquisition costs cannot
be directly assigned to individual customers. For
example, consumer packaged goods manufac-
turers spend a great deal of money in media
advertising, much of which is intended to ac-
quire new customers. However, there is no way
to match media expenditures with the custom-
ers that are attracted. Thus the only possible
allocation would be to apply an average cost to
all customers—a practice that simple lowers
each customer’s computed profitability by a
constant, leaving the relative profitability of
each customer unchanged. In such instances,
acquisition costs are best left out of a profitabil-
ity analysis.
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 JOURNAL OF INTERACTIVE MARKETING
A final aspect we note is the possible inclu-
sion of customer responsiveness to marketing
efforts. Typically, profitability models are
“closed” in that the value of a customer is as-
sumed to exist independently of marketing ac-
tions. However, the value of a customer is partly
a function of the marketing efforts directed at
that customer. Deighton, Peppers, and Rogers
(1994) note the profitability of a customer de-
pends in part on a firm’s ability to leverage its
access to the customer. A firm can increase a
customer’s actual or potential profit by improv-
ing product or service performance, changing
prices or conducting effective communications.
Accordingly, a more advanced form of profit-
ability analysis would include response coeffi-
cients that account for the effects of marketing
efforts on customer profit. This is a recursive
model, and is analogous to diffusion of innova-
tion models that represent the diffusion rate
and saturation levels as a function of marketing
effort (Mahajan, Muller, and Bass, 1990).
Structural Profitability Model. Once the mea-
surement specifications discussed above have
been established, a structural measurement
model can be constructed. Since Berger and
Nasr (1998) provide an excellent overview of
alternative model specifications, we refrain
from a detailed discussion of modeling issues
here. We describe two basic profitability mod-
els. The first applies to situations in which fu-
ture purchases are forecasted and profitability is
estimated by discounting future cash flows and
variable costs to a present value. This is the
standard customer lifetime value approach.
More detailed formulations for various pur-
chase scenarios are described by Berger and
Nasr (1998). A general formulation for cus-
tomer lifetime value is:
O ~p O mc
Ji Ki
ijt 2 c ijt! 2 ikt
O
T
j51 k51
CP i 5
t51
~1 1 r! t
where
CPi 5 the profit of customer i to a firm,
JOURNAL OF INTERACTIVE MARKETING
pijt 5 the price of purchase j made by customer
i in period t,
cijt 5 the unit cost of purchase j made by cus-
tomer i in period t,
mcikt5 variable marketing cost, k, for customer i
in period t,
r 5 the discount rate for money established
to reflect the riskiness of cash flow.
Customer lifetime models are appropriate
when customers have ongoing relationships
with organizations and future purchase and cost
streams can be accurately forecast at the indi-
vidual level. In marketing situations where life-
time analysis is not relevant or when accurate
projections of purchase cannot made, be a his-
torical profitability analysis can be performed.
The following model applies for historical prof-
itability models:
FO SO DG
O mc
T Ji Ki
CPi 5 ~ pijt 2 cijt! 2 ikt ~1 1 I!t ~2!
t51 j51 k51
where the elements are defined as in equation 1
except that I represents an adjustment factor to
eliminate the time value of money (e.g., annual
inflation rate).
Equations 1 and 2 incorporate customer
profit over a series of discrete time periods. For
each time period, the dollar contribution mar-
gin (price minus costs of good sold) for all
purchases is computed, and the variable mar-
keting costs are identified. The margins and
variable costs for all time periods are adjusted to
remove time value of money effects, and to-
taled. Note that this formulation does not imply
that variable marketing costs in time period t
necessarily apply to purchases in time period t.
Since this is a simple additive model, it makes
no difference if net contribution margin (price
(1)
minus cost of good sold minus variable market-
ing costs) is computed separately for each time
period, or computed singly after margin and
variable costs are discounted to present time
separately.
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 CUSTOMER PROFITABILITY ANALYSIS

TABLE 1
Specification of Customer Profitability Measure for Empirical Analysis

Measurement Issue Chosen Specification

Specification of Customers
Customer Unit Physicians
Aggregation level Individuals
Existing or Prospective Customers Existing
Active Condition All physicians writing one or more prescriptions
Specification of Products
Aggregation of products All products sold by firm
Organizational level Three sales territories
Customer Profitability Measure
Core profit element Dollar contribution
Present of Future Profit Present
Brand or Category Profit Brand (company)
Length of time period 1.5 years
Cost Allocations
Assignment of variable costs Sales calls, product samples, direct mail
Acquisition costs None

EMPIRICAL DEMONSTRATION included in the analysis. Since we only deal with

We provide a demonstration of customer profit-
ability in a business-to-business marketing situa-
tion involving pharmaceutical sales. Pharmaceuti-
cal manufacturers have sales forces that call on
physicians to influence prescription writing be-
havior. The measurement problem involves deter-
mining the profitability of individual physicians so
that marketing communications and personal sell-
ing efforts can be allocated accordingly. We describe
a profitability analysis performed on three sales ter-
ritories of a pharmaceutical manufacturer over a
six-quarter period from July 1995 to December
1996. A total of 834 individual physicians are located
in the three territories. Data on prescription writing
behavior were obtained from a large data vendor
that sells syndicated data on prescriptions written by
physicians to pharmaceutical manufacturers. Data
on the variable costs for marketing efforts were ob-
tained from internal company records on sales calls,
marketing communications, and free samples dis-
tributed as promotions.
Customer profit is computed by aggregating
total prescription dollar volume and subtracting
variable marketing costs, as shown in equation 2.
Acquisition costs were not specified and are not
historical purchases, we have no need for a dis-
count factor for money. To incorporate inflation-
ary effects, dollars were adjusted using the average
price increase for all the drugs sold by the phar-
maceutical manufacturer being studied. The spec-
ifications for the profitability measure are pro-
vided in Table 1. Descriptive statistics for
customer profitability are shown in Table 2. The
mean profitability per physician was just over
$7,000 for the two-year period. Profitability per
physician varies quite dramatically as it ranges
from below negative $12,000 to over $62,000. The
wide variability in profitability per customer can
be attributed to physician specialties, differences
TABLE 2
Descriptive Statistics on Customer Profitability for
Physicians
Number of Obs. 834
Maximum $ 62,407.20
Minimum $212,814.12
Mean $ 7,026.04
Median $ 3,536.68

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 JOURNAL OF INTERACTIVE MARKETING
FIGURE 1
Hypothetical Customer Profit Orderings
in size of patient loads, differences in physician
preferences for pharmaceutical brands, and vari-
ability in physician behavior with respect to effi-
cacy and appropriateness of pharmaceuticals. We
discuss the analytic interpretation of the customer
profit measure for this empirical setting in the
next section.
THE CONCENTRATION OF CUSTOMER
PROFITABILITY
One of the primary uses of customer profitabil-
ity analysis is the evaluation of the how profit-
ability varies across customers. Assessing the dis-
tribution of profitability is extremely important
because it reveals the extent to which an orga-
nization depends on a small set of customers for
its profits. Information on the distribution or
concentration of profits can also be used for
targeting marketing decisions. While much at-
tention is placed on the concentration of profits
among customers (the so-called 80/20 rule),
FIGURE 2
Customer Profit Ordering for Physicians: Highest to Lowest
JOURNAL OF INTERACTIVE MARKETING
very little research in the marketing literature
has addressed the measurement and meaning
of such profit concentration. One exception is a
paper by Schmittlein et al. (1993) that provides
a statistical basis for evaluating purchase con-
centration with the negative binomial model.
Their empirical analysis deals strictly with pur-
chase volumes, not profitability.
At the simplest level, an assessment of the
distribution of customer profit can be made by
observing a ranking of computed profits from
highest to lowest. Consider a two-dimensional
plot in which the vertical axis represents cus-
tomer profit and the horizontal axis represents
customers—in decreasing order from highest to
lowest profit. The straight line in Figure 1 de-
picts the special case of all customers having
exactly the same profit. While this is not a typ-
ical distribution of customer profit, it may apply
in some situations such as a single purchase
event where a flat price is charged to all custom-
ers and marketing costs do not vary across indi-
vidual customers (e.g., admission to a parking
garage on a single day).
A more likely ordering of customer profit is
represented by the curve Figure 1. In such a
situation a relatively small number of customers
have a very high level of profit, while the bal-
ance of customers have a low, and in some
cases, negative, profit. This type of distribution
appears to be prevalent and business and con-
sumer marketing contexts based on anecdotal
evidence. In Figure 2, we show the ordering of
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 CUSTOMER PROFITABILITY ANALYSIS
FIGURE 3
Frequency Distribution of Customer Profit for Physicians
customer profit for the physicians in our empir-
ical demonstration. Note that there are a few
extremely high-profit customers (about 100 cus-
tomers generate over $20,000 in profit each)
and a large number of very low-profit custom-
ers. This figure clearly shows that a large por-
tion of profits comes from a relatively small set
of customers.
Another tool for assessing the distribution of
customer profit is a frequency distribution as
shown in Figure 3. Importantly, one should be
careful not to confuse the customer profit plots
in Figure 2 with a frequency distribution in
Figure 3. In Figure 2, the vertical axis is repre-
sents profit while the horizontal axis represents
customers, in descending order of profit from
left to right. In the frequency distribution
shown in Figure 3, the vertical axis represents a
frequency and the horizontal axis represents
customer profit dollar ranges.
FIGURE 4
Lorenz Curve for Customer Profit
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Viewing the distribution of customer profits
becomes cumbersome when a large number of
customers exist. Therefore, it is useful to con-
vert the raw data into percentiles, and plot the
cumulative percentile of customer profit against
the cumulative percentile of the number of cus-
tomers. (A common practice in direct market-
ing is to classify customers into 10 deciles. While
deciles have the advantage of being easily com-
municated to managers, percentiles allow for a
much more precise level of analysis.) A graphi-
cal representation of percentiles is known as a
Lorenz curve in economics, where it is used to
represent the concentration of incomes (Sen,
1997). The convention in economics is to rep-
resent the cumulative percentiles on the hori-
zontal axis such that the first percentile corre-
sponds to the lowest-income consumers while
the highest percentile corresponds to the high-
est-income consumers. We use this convention
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 JOURNAL OF INTERACTIVE MARKETING
FIGURE 5
Inverted Lorenz Curve for Physicians
in Figure 4, which shows a hypothetical Lorenz
curve. The horizontal axis represents cumula-
tive percentiles of customers ordered from the
least to the most profitable. The straight 45-
degree line represents points where the cumu-
lative percentile of customers is equivalent to
the cumulative percentile of customer (e.g.,
40% of the customers provide 40% of the total
profit). This condition is analogous to the flat
customer profit curve in Figure 1. When cus-
tomer profit is distributed unevenly across the
percentiles, the Lorenz curve bows downward.
The extent of this bow represents the degree of
unevenness in customer profit. The most ex-
treme form of profit concentration would be if
one customer represented 100% of all profits
while all other customers provided zero profit.
This situation can be represented by a Lorenz
curve that goes along the horizontal axis until
the 100th percentile, at which point it goes
vertically up to the 45-degree line.
An important observation is that a sharply
descending curve for the ordering of customer
profit, as in Figure 2, corresponds to a skewed
frequency distribution (see Figure 3) and a
highly bowed Lorenz cure (see Figure 4).
A shortcoming of using the Lorenz curve for
profitability analysis is that it cannot portray
percentiles of customers who represent a finan-
cial loss to a firm. Customer profitability will be
JOURNAL OF INTERACTIVE MARKETING
negative when variable marketing costs exceed
unit contribution. Conceptually, when some of
the percentiles generate losses, the bow would
drop below the horizontal axis. However, this is
not numerically attractive because there is no
sensible interpretations for negative values of
the vertical axis. A suitable remedy to this prob-
lem is to flip the Lorenz curve above the 45-
degree line as advocated by Schmittlein et al.
(1992) and Storbacka (1997). By flipping the
curve above the 45-degree line, we avoid the
presence of the lower bound present in a tradi-
tional Lorenz curve. The lower bound elimi-
nates the possibility that a portion of the cus-
tomer base constitutes more than 100% of the
profit. Also, the inverted Lorenz curve is more
amenable for marketing purposes, since mar-
keters are often concerned with the highest
profit market segment. Also, with the inverted
Lorenz curve, the placement of customers
along the horizontal axis is consistent with the
highest-to-lowest ordering used in Figures 1 and
2. Flipping the curve above the axis is achieved
by reversing the percentiles on the horizontal
axis such that the first percentile represents the
most profitable one percent of customers. Fig-
ure 5 shows the inverted Lorenz curve for the
physicians in our empirical analysis. Note that
the curve is quite bowed and surpasses the
100% line. The apex of the curve represents the
● VOLUME 13 / NUMBER 1 / WINTER 1999
34
 CUSTOMER PROFITABILITY ANALYSIS
portion of customers who are profitable. Each
percentile to the right of the apex (represent-
ing about 15% of the customers) reduces the
overall profitability of the customer base. Profits
are quite concentrated, as 20% of the customers
account for 65.5% of the profits and half the
customers account for 95.5% of the profits.
The disparity of customer profit evident in
Figure 5 can also be depicted mathematically.
Many measures of disparity can be applied to
customer profitability. These include the range,
the standard deviation, the mean absolute devi-
ation and the coefficient of variation. Here we
describe two more popular measures of income
disparity that can equivalently be applied to a
Lorenz curve for customer profit. For a stan-
dard Lorenz curve (Figure 4), the Schultz coef-
ficient is a measure of the longest vertical dis-
tance between the 45-degree line and the
Lorenz curve (Cowell, 1977). The Schultz coef-
ficient is represented geometrically by the line
in Figure 4. The Schultz coefficient has a min-
imum of zero and a maximum of 100, and is
measured in the units of the vertical axis (cu-
mulative percent of customer profit). For the
inverted Lorenz curve in Figure 5, the Schultz
coefficient can exceed 1.0, as there is no up-
ward bound in profit concentration (since some
consumers could theoretically contribute infi-
nite losses). Higher Schultz coefficients corre-
spond to greater concentration of customer
profit.
A second measure of profit concentration is
the Gini coefficient, which is the geometric area
between the 45-degree line and the Lorenz
curve divided by the total area under the 45-
degree line (Sen, 1997). Mathematically, the
Gini coefficient is one half of the relative mean
difference — the mean of the absolute values of
the differences of all pairs of profit levels. For
the inverted Lorenz curve in Figure 5, we can
define a modified Gini coefficient as the area
between the curve and the 45-degree line di-
vided by the area under the 45-degree line
(Storbacka, 1998). Compared with more sim-
plistic formulations (range, standard deviation,
etc.), the modified Gini coefficient is attractive
because it is based on the differences in profit
of all pairs of customers as opposed to the over-
JOURNAL OF INTERACTIVE MARKETING
all mean or extreme values that determine
other disparity measure. Sen (1997) and Cowell
(1977) provide comparisons of measures of dis-
parity used in economics. The Gini coefficient
for a Lorenz curve is defined as:
A
Modified GINI 5 (3)
A1B
where A is the area above the 45-degree line in
Figure 5 and B is the area below the 45-degree
line. For a standard Lorenz curve, the Gini co-
efficient ranges from zero (even distribution of
profit) to one (all profits from one customer).
For the inverted Lorenz curve, the modified
Gini coefficient, like the Schultz coefficient, has
a minimum of zero but no upward bound. In
our empirical example, the modified Gini coef-
ficient is 0.666. The Schultz coefficient is 50.02.
Each of these numbers represents a very high
level of disparity in customer profit. Their inter-
pretation of these measures becomes more
meaningful in the context of comparing mea-
sure of disparity of profits across firms, product,
sales territories or time.
One other measure of disparity (concentra-
tion) of customer purchases is proposed by
Schmittlein et al. (1993). They show that if pur-
chasing rates are distributed gamma across the
population of customers, one parameter of the
gamma distribution, r, can act as an inverse
measure of purchase concentration. Mathemat-
ically, 1/r is the squared coefficient of variation
in purchase rates across customers. While this is
to a useful measure of concentration, it is not as
easily computed or communicated as the more
geometric-based measures described above.
STRATEGIC USES OF CUSTOMER
PROFITABILITY MEASURES
Customer profitability measures can be used for
many marketing decisions at both a strategic
and a tactical level. Here we discuss uses of
customer profitability for market segmentation
and resource allocation decisions.
● VOLUME 13 / NUMBER 1 / WINTER 1999
35
 JOURNAL OF INTERACTIVE MARKETING
Market Segmentation
Most discussions in the marketing literature and
textbooks describe behavioral segmentation in
terms of usage volume such as heavy users, me-
dium users, and light users (Kotler, 1997) or
brand-buying behavior such as brand loyals,
other brand loyals, and brand switchers (Ros-
siter and Percy, 1997). Customer profitability
can serve as another important basis for behav-
ioral segmentation because of the central im-
portance of profits.
Profitability measures can help organizations
target marketing efforts to the most lucrative
market segments. At the simplest level, two seg-
ments may be formed— customers worth keep-
ing (retention segment), and those that are not
worth the effort. If customers are targeted in a
one-to-one fashion purely in terms of measured
profit, then the optimal target market, in a mi-
croeconomic sense, consists of those customers
whose marginal return exceeds the marginal
costs of marketing to them (Baumol, 1977).
This is equivalent to selecting all customers
whose expected profit score exceeds zero. That
is, ignoring the time value of money for the
moment, all customers would be targeted who
meet the condition:
O ~p O mc
J K
ijt 2 c ijt! 2 ikt .0 (4)
j51 k51
At a more advanced level, several segments
maybe formed based on customer profit. For
example, one may identify a best customers seg-
ment consisting of the highest-profit customers
for whom extensive retention programs could
be developed. Another valuable segment is less
profitable customers who are similar to the best
customers in purchasing pattern of general
characteristics. Programs can be developed to
migrate these customers to higher levels of prof-
itability.
Segmentation analysis performed with stan-
dard basis, exclusive of an economic measure of
profit, often yield segments that are not eco-
nomically viable to the firm. Thus customer
profit adds information to existing segmenta-
JOURNAL OF INTERACTIVE MARKETING
tion approaches that ascertains the economic
attractiveness of a segment, and guides deci-
sion-making concerning the amount of market-
ing effort that can be profitably expended on a
segment. This approach represents a multivari-
ate basis for segmentation, which is more prac-
ticable with large-scale databases that with sur-
vey-based which if often too spares to use for
multiple basis segmentation.
Resource Allocation
Marketing mix decisions involve the allocation
of marketing budgets across customers or mar-
ket segments. When a valid profitability mea-
sure is available, resource allocations can be
made in a manner that maximizes the return on
the marketing investment. This is accomplished
by matching customer profitability with mea-
sure of customer responsiveness to marketing
efforts. Mantrala, Sinha, and Zoltners (1992)
discuss the use of such customer response infor-
mation, in combination with customer profit
(in their case potential profit). They show that
resources should not simply be allocated to cus-
tomers or market segments in direct proportion
to profit. Rather, resources should be allocated
according to both profit and responsiveness.
For example, one would not make high expen-
ditures in personal sales calls to a high-profit
customer if it were known that sales calls to that
customer were completely unrelated to pur-
chase behavior. Table 3 shows how profitability
and responsiveness can be combined to form
target segments that can facilitate resource allo-
cation. Knowledge of both profitability and re-
sponsiveness of customers can help a firm lever-
age its marketing efforts in a more profit-
maximizing manner that analytic approaches
based solely on market-level responsiveness that
prevail in the literature (Hanssens, Parsons, and
Schultz, 1990).
We note one additional measure that per-
tains to resource allocation with respect to the
value of a customer of an organization. Custom-
ers sometimes vary in terms of the degree to
which they can be replaced. Customers who are
easily replaced, even if they have very high
profit levels, are not as attractive for marketing
efforts as high-profit customers who are difficult
● VOLUME 13 / NUMBER 1 / WINTER 1999
36
 CUSTOMER PROFITABILITY ANALYSIS
TABLE 3
Combining Customer Profitability and Responsiveness for Market Segmentation
to replace. To incorporate replacement cost
into a profitability analysis, the measure known
as Tobin’s q can be applied. Tobin’s q is the
ratio of the market profit of an investment to
the replacement cost (Hayashi, 1982). Convert-
ing absolute profitability measures to Tobin’s q
can direct resource allocations to customers
based both on their profitability and replace-
ability.
DISCUSSION AND FUTURE RESEARCH
This paper establishes a foundation for measur-
ing customer profitability and assessing dispar-
ity of profitability across customers. As de-
scribed above, customer profitability is an
important component for marketing practices
that involve communicating with individual cus-
tomers, particularly with interactive media. A
great deal of additional research is required to
develop a knowledge base in three important
areas: (1) what factors act as determinants of
customer profitability (as in a scoring model in
direct marketing [Shepard, 1990]), (2) what
factors determine the degree of disparity of
profits across customers, and (3) how customer
profitability measures should be incorporated
into marketing planning.
While profitability is obviously an outcome of
prices, unit costs, unit volume, purchase fre-
JOURNAL OF INTERACTIVE MARKETING
quency, and variable costs, there are other, non-
economic factors that are likely to relate to
profitability. For example, Reichheld (1996)
claims that the profitability of a customer in-
creases over the tenure of a customer relation-
ship because variable costs decline and pur-
chases may become more concentrated with a
single seller. Another factor that may relate to
customer profitability is customer satisfaction.
Anderson et al. (1994) find a relationship be-
tween customer satisfaction, measured at the
individual customer level, and firm profitability,
measured at the firm level. Implicit in this find-
ing is that satisfaction at the individual cus-
tomer level is correlated with individual cus-
tomer profitability. This relationship exists
because more satisfied customers are likely to
be more profitable because they may be less
price sensitive, and less prone to purchase from
competitors. This relationship is also likely to
exist at the individual customer level. In the
context of a customer orientation, customer
profitability is likely to be greatest for customers
whose needs are best satisfied by the product
offering. In fact, early proponents of the mar-
keting concept emphasized that a profit focus as
opposed to a sales volume focus as one of the
elements of the marketing concept (Bell and
Emory, 1970). However, only now, with the
availability of customer databases, can customer
● VOLUME 13 / NUMBER 1 / WINTER 1999
37
 JOURNAL OF INTERACTIVE MARKETING

TABLE 4
Suggested Research Propositions

Customer profitability is positively related to customer satisfaction.

Customer profitability is positively related to brand loyalty.
Customer profitability is positively related to the length of a customer relationship.
Customer profitability is positively related to the match between a product’s benefits with the customer’s needs.
Customer profitability is positively related to the quantity and quality of marketing communications to the customer.
Customer profitability is inversely related to price sensitivity.
Customer profit is directly related to the degree of favorableness of customers’ attitudes toward a company or brand.
Customer profit is directly related to the portion of a customer’s business that a company owns (share of
requirements).
The concentration of customer profitability is positively related to the breadth of brands and product lines offered.
The concentration of customer profitability is positively related to the variability in prices offered.

profitability be easily measured and included in
consumer-oriented marketing strategies.
Customer profitability is also likely to be de-
termined by several other behavioral factors in-
cluding price sensitivity, brand loyalty, and pur-
chase timing, as well as perceptual factors such
as perceived value, brand attitude, and attitude
toward advertisements. Empirical research in
needed to determine if, and under what condi-
tions, factors such as these relate to customer
profitability.
Research is also needed to explore the distri-
bution of customer profitability across customers.
The distribution of profitability is likely to vary
dramatically for different brands, products and
industries. For example, Schmittlein et al. (1993)
find that profit concentration levels differ across a
variety of consumer packaged goods. Identifica-
tion of what determining factors relate to the
degree of disparity in profitability can help man-
agers understand how marketing efforts relate to
profitability at the customer level. The degree of
disparity is likely to be influenced by factors such
as the breadth of assortment and prices offered
and the heterogeneity of customers needs and
buying behaviors. Further research in needed to
identify how such factors influence the disparity
of profitability across customers.
A great deal of research in marketing has
explored how sales levels and market share re-
spond to marketing efforts. What is needed is a
similar stream of research for how customer
profitability relates to marketing efforts. This
would elevate customer profitability models to a
recursive level and would allow organizations to
develop a systematic approach to managing re-
lationships with customers in a profit maximiz-
ing fashion. Table 4 provides a list of research
propositions drawn from this section that can
guide empirical research on customer profit-
ability.
One methodological area in need of research
concerns the prediction of individual customer
purchasing behavior so that lifetime models can
be calibrated. While the direct marketing liter-
ature has explored many aspects of lifetime
profitability models, there is little research that
develops methods for accurately forecasting in-
dividual customer purchase behavior. Such
forecasting is subject to a great deal of error
because of the stochastic nature of individual
purchase decisions. Research building on the
work by Schmittlein and Peterson (1994)
should help address this problem.
CONCLUSION
Customer profitability analysis has important
implications for marketing decision-making.
Knowledge of the profitability of individual cus-
tomers can help organizations segment mar-
kets, allocate marketing resources and specify
marketing mix elements in a way that returns
high levels of profits. In the previous section we
noted two straightforward uses of customer
profitability measures—market segmentation

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 13 / NUMBER 1 / WINTER 1999

38
 CUSTOMER PROFITABILITY ANALYSIS
and marketing resource allocation. Further re-
search is needed to build theories and models
of marketing practice that incorporate cus-
tomer profitability.
The inclusion of customer profitability in mod-
els for segmentation and other marketing prac-
tices can focus attention more on the manage-
ment of customers. This perspective represents a
substantial change in the way organizations think
about their markets. Much of marketing today is
defined by, and acted on, in terms of the market-
ing mix variables. In practice, the marketing man-
ager’s function to manage the variables repre-
sented by the 4 Ps. The use of customer databases
to measure individual customer profitability helps
shift the emphasis from managing marketing mix
variables to managing customers. This shift facili-
tates the implementation of the marketing con-
cept which, despite its central presence in market-
ing theory, is not actively practiced by many
organizations. As an operational tool, customer
profitability analysis fits well into the customer/
relationship perspective of marketing practice as a
framework for marketing management (Gron-
roos, 1991; Morgan and Hunt, 1994). In this man-
ner, customer profitability analysis plays a central
role in data-driven relationship marketing and
individual customer-based marketing communi-
cations.
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