Gary Cokins, the founder of advisory firm Analytics-Based Performance Management, explains how techniques for profit-margin management can help move your less-profitable customers to richer ground.
This is the story of two types of customers: good and bad. You know them well.
The good customers are those that place standard orders with little fuss. They often just buy a company’s product or service line and are hardly heard from. When they are heard from, they communicate in a way that is productive, not tedious, and perhaps even helpful.
The bad customers demand nonstandard everything — special delivery requirements, special packaging, changing schedules and the like. They’re the ones that purchase low-margin products and then spend hours tying up the customer-support staff before deciding to return the products. The cost of providing these products — plus the effort and resulting cost of service to the customer — may actually result in a financial loss, and perhaps a question: Is the bad customer being paid to purchase the product?
Managers are increasingly seeking more granular data on the costs related to serving a customer, as well as information about intangibles such as customer loyalty and social media messaging of the company and its competitors — all for the purpose of identifying, fostering, retaining and increasing customers.
Unfortunately, many companies’ accounting systems are unable to calculate and report customer profitability and value information to support an analysis. But by using profit-margin-management techniques — solutions that don’t necessarily require sophisticated software — a company can properly measure customer profitability and, in turn, move less-profitable customers to richer ground.
BENEATH THE ICEBERG: UNREALISED PROFITS
Activity-based cost management (ABC/M) is the accepted method to economically and accurately trace the consumption of an organisation’s resource expenses, such as salaries and supplies, to products and services to the types of channels and customer segments that place varying degrees of workload demand on a supplier. It is no longer acceptable to not have a rational accounting method of assigning so-called non-traceable costs to their sources of origin. ABC/M is that method.
Yet some companies are not properly linking and tracing their customers to expenses for distribution channels, selling, marketing and customer-related activities (eg, invoicing) and services.
Using ABC/M, a seller can create valid profit-and-loss (P&L) statements based on incurred costs related to individual customers. For instance, a manufacturer can take the revenues derived from sales to an individual customer and then further subtract costs the manufacturer incurs for activities such as processing orders, shipping, returns and customer support. To simplify the accounting effort, the same calculation can be done for logical segments or groupings of similar types of customers. If the process is carried out across a body of customers, a company can more easily identify the most profitable customers, the least profitable customers and those in between. The sum total of these customer profits will exactly reconcile with the manufacturer’s income statement profit.
With valid cost modelling, Figure 1 displays a graph line referred to as the “profit cliff”. This graph line is the cumulative build-up of each customer’s profit to the supplier. The customers are ranked from the most profitable to the least (ie, customers with a financial loss where their costs exceed their revenues). The last data point exactly reconciles with the company’s total P&L statement.
The graph illustrates how certain profits can be hidden due to inadequate cost-allocation methods based on broadbrush averaged factors without causal relationships (eg, amount of sales) and incomplete costing below the product gross-profit-margin line.
The shape of this graph is typical for many companies. From left to right the graph reveals the company earns a substantial amount of profit from its relatively more profitable customers, roughly breaks even on some, and then loses profit on the remainder.
ABC/M information can be surprising to executives and managers the first time they see it. They have typically presumed that almost all but a few of their customers are profitable. They may also presume the largest sales customers are also the most profitable ones. The facts usually reveal these flawed beliefs. With a clearer and more accurate view, however, they can make better decisions about improving internal operations and customer strategies.
MIGRATING CUSTOMERS TO HIGHER PROFITABILITY
Indeed, the crucial challenge is to not just use ABC/M to calculate valid customer profitability data. The benefit comes from identifying the profit-lift potential and then realising it and fulfilling it with smart decisions and actions.
Customer P&L information quantifies what everyone may already have suspected: Customers who purchase roughly the same volume and mix at similar prices are not nearly the same when it comes to profit. Some customers may be more or less profitable based strictly on how demanding their behaviour is. The information also provides cost visibility and transparency when it comes to the business processes and work activities that cause the higher or lower costs.
Although customer satisfaction and loyalty are important, a longer-term goal is to increase customer and corporate profitability. There must always be a balance between managing the level of customer service to earn customer loyalty and the impact it will have on increasing owner and shareholder wealth.
In a company’s P&L there are two major “layers” of profit margin:
1. The mix of products and service lines purchased.
2. The non-product “costs-to-serve” apart from the unique mix of products and service lines purchased.
Figure 2 combines these two layers in a two-axis grid — the “composite margin” of the product mix each customer purchases (reflecting net prices to the customer) and their costs-to-serve. Any individual customer (or grouped cluster) can be located as an intersection where the circle’s diameter reflects each customer’s revenues. The figure debunks the myth that customers with the highest sales volume are also generating the highest profits.
The objective is to drive customers with profit-increase potential to the upper-left corner of the grid through a host of actions such as surcharge pricing, up-selling and cross-selling.
The data could also help suppliers identify customers that are substantially unprofitable — those that reside deep in the bottom-right of the grid. These relationships can be terminated through actions such as increased pricing or reduced service-level tactics — actions that might encourage customers to “de-select” themselves.
Note that migrating customers to the upper-left corner is equivalent to moving individual data points in the “profit cliff” profile in Figure 1 from right to left. Knowing where customers are located on the matrix requires ABC/M data.
One critical reason for knowing where each customer is located on the profit matrix is to protect the most profitable customers from competitors.
OPTIONS TO RAISE THE PROFIT CLIFF CURVE
What actions can an organisation take to increase profits? This is all about the “M” in ABC/M — the managing of costs and profits.
Although this is a partial list, increasing profitability can be accomplished by doing the following:
- Be aware of the service cost for each customer and reduce it;
- Establish a surcharge for or reprice expensive costs-to-serve activities;
- Reduce services;
- Introduce new products and service lines;
- Raise prices;
- Abandon unprofitable or less lucrative products, services or customers;
- Improve processes to drive up service line or product profitability;
- Offer the customer profit-positive service level options at varying prices;
- Increase activities that a customer shows a preference for;
- Up-sell and cross-sell the customer’s purchase mix toward richer, higher-margin products and service lines; or
- Discount to gain more volume with low “costs-to-serve” customers.
Before doing anything, it is important for anyone interpreting the profit distribution diagram to understand the following key issues about the diagram:
- This snapshot view of a time period’s cost does not reflect the life-cycle costs of the products, service lines or customers that have consumed the resource and activity costs for that particular time span. For example, a new product may be in its shake-out period with future cost reductions on the horizon. In the next snapshot it will move to the left of the “profit cliff ”.
- The information represented in the graph should not be prematurely or spontaneously acted upon until it is properly analysed.
Increasing profits is no longer about increasing market share and growing sales. It is about growing profitable sales and ideally to the types of customers with traits that are conducive to beneficial, long-term relationships. Managerial accounting information like this does not answer all questions. Its benefit is that it generates questions that lead to better questions where further analysis produces higher profits.
Gary Cokins (firstname.lastname@example.org) is the founder of Analytics-Based Performance Management, an advisory firm in Cary, North Carolina. He was a consultant with Deloitte and KPMG and the former head of the National Cost Management Consulting Services for Electronic Data Systems (EDS). He also worked in business development with SAS, a leading provider of enterprise performance management and business analytics and intelligence software.
FUTURE PROFIT POTENTIAL VIA CUSTOMER LIFETIME VALUE
For business-to-consumer companies in sectors such as banking and telecommunications, customers pass through life cycles. This means there is a difference between a currently profitable customer and a valuable customer.
This difference shifts attention from the current run rate of their consumer profits to their future potential profit level. Business-to-business companies can calculate customer lifetime value before and after various marketing campaigns and targeted offers and deals. This provides sales and marketing with the ability to apply return on investment measures to evaluate which customers can achieve the highest profit lift.