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Measuring and Managing Customer Profitability

The only value a company will ever create for its shareholders and owners is the value that comes from its customers—current ones and new ones acquired in the future. To remain competitive, companies must determine how to keep customers longer, grow them into bigger customers, make them more profitable, serve them more efficiently, and acquire more profitable customers.

But there’s a problem with pursuing these ideals. Customers increasingly view suppliers’ products and standard service lines as commodities. This means that suppliers must shift their actions toward differentiating their services, offers, discounts, and deals to different types of existing customers to retain and grow them. Further, they should concentrate their marketing and sales efforts on acquiring new customers who have traits comparable to those of their more profitable customers.

As companies shift from a product-centric focus to a customer-centric focus, a myth that almost all current customers are profitable needs to be replaced with the truth. Some high-demanding customers may indeed be unprofitable! Unfortunately, many companies’ managerial accounting systems aren’t able to report customer profitability information to support analysis for how to rationalize which types of customers to retain, grow, or win back, and which types of new customers to acquire. With this shift in attention from products to customers, managers are increasingly seeking granular non-product-associated costs to serve customer-related information, as well as information about intangibles, such as customer loyalty and social media messaging about their company and its competitors. Today in many companies there’s a wide gap between the CFO’s function and the marketing and sales function. That gap needs to be closed.

Here’s the basic problem. With accounting’s traditional product gross profit margin reporting, managers cannot see the more important and relevant “bottom half” of the total income statement picture—all the profit margin layers that exist and should be reported from customer-related expenses, such as distribution channel, selling, customer service, credit, and marketing expenses.

The marketing and sales functions already intuitively suspect that there are highly profitable and highly unprofitable customers, but management accountants have been slow to reform their measurement practices and systems to support marketing and sales by providing the evidence. To complicate matters, the compensation incentives for a sales force (e.g., commissions) typically are based exclusively on revenues. Companies need to not just increase market share and grow sales but to grow profitable sales. Compensation incentives should be a blend of both customer sales volume and profits.

Who are the troublesome customers, and how much do they drag down profit margins? Who are the more profitable customers and why? More important, once these questions are answered, what corrective actions should managers and employees take to increase the profit from a customer? Measurements are the key.

Good vs. Bad Customers

Some customers purchase a mix of mainly low-profit-margin products. After adding the non-product-related costs to serve for those customers, apart from the costs of the mix of products and standard service lines they purchase, these customers may be unprofitable to a supplier. But customers who purchase a mix of relatively high-profit-margin products may demand so much in extra services that they also could be unprofitable. How does a company measure customer profitability properly? In extreme cases, how does it deselect or “fire” a customer that shows no promise of ever being profitable?

Every supplier has what I call good and bad customers. Low-maintenance “good” customers place standard orders with no fuss, whereas high-maintenance “bad” customers always demand nonstandard offers and services, such as special delivery requirements. For example, the latter constantly returns goods or contacts the supplier’s help desk. In contrast, the former just purchases a company’s products or service lines and is rarely bothersome to the supplier. The extra expenses for high-maintenance customers add up. What can be done? After the level of profitability for all customers is measured, they all can be migrated toward higher profits using “profit margin management” techniques, which I’ll discuss later.

Pursuit of Truth about Profits

To be competitive, a company must know its sources of profit and understand its own expenses and cost structure. For outright unprofitable customers, a company can explore passive options of gradually raising prices or surcharging for extra work, hoping the customer will go elsewhere. For profitable customers, a company may want to reduce customer-related causes of extra work for its employees (e.g., unneeded extra product packaging), streamline its delivery process, or alter the customers’ behavior with pricing incentives so those customers place fewer workload demands on the company.

Activity-based costing (ABC) is the method that will economically and accurately trace the consumption of an organization’s resource expenses (e.g., salaries, supplies) to products and to the types and kinds of channels and customer segments that place varying degrees of workload demand on the company. It should no longer be acceptable not to have a management accounting system where so-called non-traceable costs are assigned to their sources of origin. ABC is that system. Yet many companies still don’t use it.

ABC Is a Multilevel Cost Reassignment Network

ABC uses multiple stages to trace and segment all the resource expenses as calculated costs through a network of cost assignments into the final cost objects: products, service lines, channels, and customers. It facilitates more accurate reporting because it honors costing’s causality principle (i.e., the relationship between cause and effect) for expense consumption relationships.

In complex, support-intensive organizations, there can be a substantial chain of indirect work activities that occur prior to the direct ones that eventually trace into the final cost objects. These chains result in activity-to-activity cost assignments, and they rely on intermediate activity cost drivers traced to consuming activities in the same way that final cost objects rely on activity cost drivers to reassign costs into final cost objects based on their diversity and variation.

Turning indirect costs into direct costs is no longer as insurmountable a problem as it was in the past. Integrated ABC software allows intermediate direct costing to a local process or to an internal customer or required component that is causing the demand for work. It further allows tracing costs among the final cost objects. Resource and activity cost drivers reassign expenses into costs with a more local, granular work activity level than in traditional systems. An example would be the accountant’s rigid cost center stepdown cost allocation method that reduces costing accuracy by relying on a single cost allocation factor for an entire support department.

Figure 1 displays the design of an ABC cost assignment network. ABC software is arterial in design, so it flows costs flexibly and proportionately. ABC consists of three modules connected by cost assignment paths. Eventually via this expense assignment and tracing network, ABC reassigns 100% of the resource expenses into the final accumulated costs of products, service lines, channels, customers, and business sustaining work. Visibility of costs is provided everywhere throughout the cost assignment network, including for how costs are “driven” by the activity cost drivers that comply with the cause-and-effect relationships. This visibility aids in identifying where to focus improvement efforts.

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Figure 1

For those interested in understanding the mechanics of this design, here is a link to a PDF file of a Statement of Management Accounting (SMA) that I authored on ABC for the Institute of Management Accountants: http://www.garycokins.com/images/pdfs/Cokins%20IMA%20SMA%20Implementing%20ABC.pdf

Beneath the Iceberg: Unrealized Profits

With a valid ABC cost model, Figure 2 displays a graph line referred to as the “profit cliff” (and sometimes the “humpback whale” curve). This line is the cumulative buildup of each customer’s profit. Customers are rank-ordered from the most profitable to the least profitable, including those who are unprofitable (i.e., customers with a financial loss where their costs exceed their revenues). The last data point reconciles exactly with the company’s total profit and loss (P&L) statement.

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Figure 2

The graph illustrates how a substantial amount of unrealized profits can be hidden because of inadequate existing cost allocation methods, and because of incomplete costing below the product gross profit margin line. Managers usually believe that the curve will be relatively flat. The broad averaging of traditional non-causal overhead cost allocations is crushing the cost accuracy and results in this flat-curve belief. ABC detects the unique variations of the final cost objects’ consumption of the work activities and their related capacity-providing resource expenses. ABC information usually shocks executives and managers the first time they see it because they have typically presumed that almost all of their customers are profitable. Instead, they have large profit-makers and profit-takers.

By using ABC, there can now be a valid P&L statement for each customer as well as for logical segments or groupings of similar types of customers. The shape of this graph is typical for most companies. From left to right, the graph line reveals the company earns a substantial amount of profit from a minority of customers, roughly breaks even on some, and then loses profits on the remainder. Figure 3 is an example of an individual customer profitability statement.

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Figure 3

Migrating Customers to Higher Profitability

The crucial challenge is not to use ABC just to calculate valid customer profitability information from transactional data, but to really use the information—and use it wisely. The benefit comes from identifying the profit-lift potential from customers and then realizing that potential with smart decisions and actions.

Although customer satisfaction and loyalty are important, a longer-term goal is to increase corporate profitability for the shareholders derived from increasing profits from customers as if each customer were an investment in a stock portfolio. Think that the purpose of actions taken is to increase the financial “return on customer” (ROC). There should always be a balance between managing the level of customer service to earn customer loyalty and the spending impact that doing that will have on shareholder wealth.

In any company’s P&L, there are two major “layers” of profit margin:

  1. By the mix of products and service lines purchased
  2. By the “costs to serve” apart from the unique mix of products and service lines (This is that “bottom half of the picture” I referred to earlier.)

Figure 4 combines these two layers as a two-axis grid: (1) the “composite product mix profit margin” of what each customer purchases (reflecting net prices to the customer), and (2) their costs to serve. Individual customers (or grouped clusters of customers with similar traits) are located at intersections where the size of the circle diameters reflects each customer’s revenues. Note that migrating customers to the grid’s upper-left corner is equivalent to moving individual data points in the “profit cliff” profile in Figure 2 from right to left. Knowing where customers are located on the matrix requires ABC data.

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Figure 4

Figure 4 debunks the myth that customers with the highest sales volume are also generating the highest profits. The objective is to generate more profits from all customers regardless of their intersection location. This is represented by driving customers to the upper-left corner of the grid. Examples of actions that will do this are surcharge fee pricing, up-selling, and cross-selling. Those actions come from the sales and marketing function. The point here is the CFO’s accounting function needs to provide them the information.

A critical reason for knowing where each customer is located on the profit matrix is to protect the most profitable customers from competitors. Because so few customers typically account for a significant portion of the profits, the risk exposure from losing them is substantial. In Figure 2, the farther to the left side of the “profit cliff” profile distribution curve that the curve’s peak is located, the more sensitive and vulnerable the bottom line corporate profit is to competitor attacks from winning a company’s key customers.

Expand the Function

Much has been written about the increasing role of CFOs as strategic advisors and their shift from bean counter to bean grower. Now is the time for the CFO’s accounting and finance function to expand beyond financial accounting, reporting, governance responsibilities, and cost control. They can support sales and marketing by helping them (1) target the more attractive customers to retain, grow, and win back, and (2) acquire the relatively more profitable and valuable customers.

 

Gary Cokins will be presenting a free webinar with ITMPI on April 13! Sign up here: Measuring and Managing Customer Profitability

About Gary Cokins

Gary Cokins (Cornell University BS IE/OR, 1971; Northwestern University Kellogg MBA 1974) is an internationally recognized expert, speaker, and author in advanced cost management and enterprise performance and risk management (EPM/ERM) systems. He is the founder of Analytics-Based Performance Management LLC, an advisory firm located in Cary, North Carolina. He began his career in industry with a Fortune 100 company in CFO and operations roles. He then worked 15 years in consulting with Deloitte, KPMG, and EDS (now part of HP). From 1997 until 2013 Gary was a Principal Consultant with SAS, a leading provider of enterprise performance management and business analytics and intelligence software. His two most recent books are Performance Management: Integrating Strategy Execution, Methodologies, Risk, and Analytics and Predictive Business Analytics. Mr. Cokins can be contacted at gcokins@garycokins.com.

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