How Many of Your Customers Are Profitable?
How Many of Your Customers Are Profitable?
The provision of value should be a two way street. If providing value to your customers is essential for long-term prosperity, then so is accurately measuring the value you receive in return. This article explains how to calculate the profitability of one’s customers, and offers some thoughts on how to treat the profitable and unprofitable.
Customer Value as a Strategic Advantage
A clear understanding of the net profitability of each customer, or group of customers, should give any business a clear strategic, as well as tactical advantage over competitors who lack such information. We all know that customers purchase a mix of high and low margin products and demand services that erode those margins, the net effect of which produces a population of profitable, loss making or break-even customers.
Most organisations only have a gut-feel about relative customer profitability. Indeed those feelings are frequently deeply suppressed, since managers are usually reluctant to discard customers they suspect may be unprofitable, especially if those customers do large volumes of business. They tend to refer to them as ”strategic”, “providing base load”, or “covering overheads”. The extent and depth however, of the unprofitability of certain customers, after a profitability analysis, often comes as a shock. This is critical in markets where mergers and acquisitions have resulted in a massive aggregation of buying power, in a diminishing pool of large customers who leverage their buying power and demand high levels of service and support. At the same time, these suppliers have retained a myriad of smaller customers, many of whom have become unprofitable to them. (See diagram below).
It is also true that the population at the other end of the customer profitability scale comprises those most profitable customers, the loss of whom to a competitor would damage the business. That information is as strategically important as knowing which customers are unprofitable.
Wholesale discards of unprofitable customers are not recommended. Making good use of customer profitability information is all about developing differentiated systems and processes for serving the various types of customers, with the comfort of knowing the real impact each will make to the bottom line. Indeed, it is sometimes more important to address the issue of retaining profitable customers than shedding unprofitable ones.
Profitability Varies Across the Customer Base
The graph below shows what happens if one accumulates revenues net of all costs, validly allocated to individual customers or groups of customers. The data supporting the graph represents an accumulation of net profits per customer, ranking them from the most to the least profitable. The example shows that R4 million was made on the most profitable 75% of the customers and then R2 million was lost on the remaining 25% of customers, reducing net profit back to R2 million. This pattern is not unusual. Indeed, in some businesses the “profit mountain” can be as high as five to six times the ultimate net profit.
How Do Businesses Calculate Which Customers Are Profitable and Which Aren’t?
Applying the all-up costs of serving customers in a valid and acceptably accurate manner would obviously start with the gross profit on the products sold to each customer. These gross profit figures are comparatively readily available to the management of most businesses, most familiar management reports give sales and gross profits by brand, pack, sales region etc., all of which are essentially internally focused and none of which give management much idea of which customers they should be nurturing.
There is a huge difference between gross profit and net profit, even if your definition of net profit is calculated before costs such as interest, depreciation etc. Traditional management information and accounting systems group indirect, or fixed costs, according to the structure of the organisation chart, and state them on a calendar basis. This presentation ignores the end-to-end view of the value chain that starts and finishes with customers.
The allocation of costs on a valid basis to the businesses’ products, sales regions and channels, and ultimately customers, requires the application of Activity Based Costing (ABC). ABC allocates costs to activities based on their cost drivers (for example man-hours, in the case of employee costs). The second stage of the process allocates these activity costs to final cost objects in terms of their respective utilisation of the activities.
In the past, ABC was generally regarded as something of an academic exercise, or undertaken as a once-off study to gain a better understanding of the dynamics of businesses or departments. More recently, however the development of advanced ERM software systems and data warehouses has brought “ABC on Demand” within the economic reach of many organisations. There is a case to be made for using purpose designed software, that pulls raw data from the accounting database, performs a series of structured costing allocations, then generates ABC reports on anything from product to customer net profitability.
Thanks to being able to understand true ABC calculated profitability, many companies, particularly where service intensive products are involved, are able to modify prices, and generate profitable service offerings, which more precisely match customer requirements and propensity to pay.
Example 1. A Supplier to the SA Mining Industry
A supplier of consumables to the mining industry undertook a customer profitability pilot study, covering their business with certain mines. The study used ABC principles to allocate overhead, distribution, sales, service and marketing costs to serve the respective mines. The study was carried out in tandem with detailed and scientific market research into the value delivered to the same mines. When the ABC costs were deducted from the gross profits, an interesting pattern began to emerge. The mines that were receiving high levels of service and were correspondingly less profitable, showed much higher perceived value scores than those customers who received little or no support service and were consequently much more profitable. The supplier therefore took steps to increase levels of satisfaction in the profitable mines to ensure that dissatisfaction did not result in defection. At the same time it re-examined its service provision to the less profitable mines, whilst maintaining high levels of satisfaction.
Example 2. A Chemical Specialty Company
A South African business specialising in supplying cleaning chemicals to catering establishments and food plants had adopted a “systems” approach. This involved supplying automated dosing and control systems to ensure that their chemicals were utilised correctly as well as service and maintenance calls. All the equipment was supplied free, as long as the customer used their chemicals. After an ABC analysis of customer profitability, they discovered that smaller customers ran at a loss for 2 – 3 years before recovering the costs of the investment in the equipment, as well as installing and maintaining it. This industry segment is notoriously fickle, and customers frequently switch suppliers, or go out of business. Once properly costed, it became evident that the small customers were responsible for substantial losses, severely eroding overall company profitability.
If you are interested in learning more about customer profitability analysis e-mail Peter Gilbert on pgilbert@icon.co.za.
Focusing on Profitable Customers – A case study
Many companies have had supplier certification programmes for years, but today’s market leaders are creating customer certification programmes. These leaders have learned that it is easier to optimise the value of customer relationship assets, if those assets have high value in the first place. This realisation has led companies to develop criteria that select – up front – only their most valuable (i.e. profitable) prospects.
CRI is a national market research firm with annual revenues of around $30 million. A high percentage of this comes from 36 strategic accounts. However, this was not always the case. In 1989 CRI was generating $10 million in revenues from 157 customers and the owners were concerned about profitability. With the help of a consultant, management divided customers into 4 groups.
1. High volume and low margin. About half these customers were new ones that CRI felt would become profitable. The other half was on the verge of the high volume/high profit quadrant.
2. High volume and high margin. These were customers who had a supplier reduction programme and who valued an ongoing relationship with CRI. They accounted for roughly 30% of sales.
3. Low volume and low margin. CRI once believed it could make this group loyal, but they proved fickle, unreliable and price sensitive.
4. Low volume and high margin. These were small customers who were very profitable. But the key issue for account managers was whether there was more potential for sales.
After this analysis, CRI realised that only ten of its customers fell in the high/high quadrant and over 100 customers made little, if any profit! CRI realised it had been paying so much attention to its top thirty customers (by revenue) that it had never really prioritised its remaining customers – some of which were Fortune 100 firms, but many of whom were draining value from CRI.
There are many firms which suspect that they are serving unprofitable customers. However, few companies are willing to analyse customers on a case-by-case basis, looking at each accounts revenue, direct costs, indirect costs and profits. Even fewer have had the courage to shed their unprofitable customers.
After serious soul searching and a period of huge stress and anxiety, CRI began to shed its unprofitable customers and established a rigorous qualification process for new customers. CRI’s selectivity has paid off and the customer base has been cut by 50% while revenues have tripled and profits have doubled. 90% of CRI’s business is from referrals and CRI manages these referrals carefully. They regularly quantify and present the value they deliver to their “core” partners. They invest heavily in the upkeep and maintenance of these relationships and have learned that they can gain significant competitive advantage by determining relationship asset value, prior to investing the major resources that strategic accounts require.
Strategic Account Management Association
How Many of Your Customers Are Profitable - To learn more about this author, visit Peter Gilbert's Website.
Like this article? Share it with your friends
How Many Of Your Customers Are Profitable?
The provision of value should be a two way street. If providing value to your customers is essential for long-term prosperity, then so is accurately measuring the value you receive in return. This article explains how to calculate the profitability of one’s customers, and offers some thoughts on how to treat the profitable and unprofitable.
Customer Value as a Strategic Advantage
A clear understanding of the net profitability of each customer, or group of customers, should give any business a clear strategic, as well as tactical advantage over competitors who lack such information. We all know that customers purchase a mix of high and low margin products and demand services that erode those margins, the net effect of which produces a population of profitable, loss making or break-even customers.
Most organisations only have a gut-feel about relative customer profitability. Indeed those feelings are frequently deeply suppressed, since managers are usually reluctant to discard customers they suspect may be unprofitable, especially if those customers do large volumes of business. They tend to refer to them as ”strategic”, “providing base load”, or “covering overheads”. The extent and depth however, of the unprofitability of certain customers, after a profitability analysis, often comes as a shock. This is critical in markets where mergers and acquisitions have resulted in a massive aggregation of buying power, in a diminishing pool of large customers who leverage their buying power and demand high levels of service and support. At the same time, these suppliers have retained a myriad of smaller customers, many of whom have become unprofitable to them. (See diagram below).
It is also true that the population at the other end of the customer profitability scale comprises those most profitable customers, the loss of whom to a competitor would damage the business. That information is as strategically important as knowing which customers are unprofitable.
Wholesale discards of unprofitable customers are not recommended. Making good use of customer profitability information is all about developing differentiated systems and processes for serving the various types of customers, with the comfort of knowing the real impact each will make to the bottom line. Indeed, it is sometimes more important to address the issue of retaining profitable customers than shedding unprofitable ones.
Profitability Varies Across the Customer Base
The graph below shows what happens if one accumulates revenues net of all costs, validly allocated to individual customers or groups of customers. The data supporting the graph represents an accumulation of net profits per customer, ranking them from the most to the least profitable. The example shows that R4 million was made on the most profitable 75% of the customers and then R2 million was lost on the remaining 25% of customers, reducing net profit back to R2 million. This pattern is not unusual. Indeed, in some businesses the “profit mountain” can be as high as five to six times the ultimate net profit.
How Do Businesses Calculate Which Customers Are Profitable and Which Aren’t?
Applying the all-up costs of serving customers in a valid and acceptably accurate manner would obviously start with the gross profit on the products sold to each customer. These gross profit figures are comparatively readily available to the management of most businesses, most familiar management reports give sales and gross profits by brand, pack, sales region etc., all of which are essentially internally focused and none of which give management much idea of which customers they should be nurturing.
There is a huge difference between gross profit and net profit, even if your definition of net profit is calculated before costs such as interest, depreciation etc. Traditional management information and accounting systems group indirect, or fixed costs, according to the structure of the organisation chart, and state them on a calendar basis. This presentation ignores the end-to-end view of the value chain that starts and finishes with customers.
The allocation of costs on a valid basis to the businesses’ products, sales regions and channels, and ultimately customers, requires the application of Activity Based Costing (ABC). ABC allocates costs to activities based on their cost drivers (for example man-hours, in the case of employee costs). The second stage of the process allocates these activity costs to final cost objects in terms of their respective utilisation of the activities.
In the past, ABC was generally regarded as something of an academic exercise, or undertaken as a once-off study to gain a better understanding of the dynamics of businesses or departments. More recently, however the development of advanced ERM software systems and data warehouses has brought “ABC on Demand” within the economic reach of many organisations. There is a case to be made for using purpose designed software, that pulls raw data from the accounting database, performs a series of structured costing allocations, then generates ABC reports on anything from product to customer net profitability.
Thanks to being able to understand true ABC calculated profitability, many companies, particularly where service intensive products are involved, are able to modify prices, and generate profitable service offerings, which more precisely match customer requirements and propensity to pay.
Example 1. A Supplier to the SA Mining Industry
A supplier of consumables to the mining industry undertook a customer profitability pilot study, covering their business with certain mines. The study used ABC principles to allocate overhead, distribution, sales, service and marketing costs to serve the respective mines. The study was carried out in tandem with detailed and scientific market research into the value delivered to the same mines. When the ABC costs were deducted from the gross profits, an interesting pattern began to emerge. The mines that were receiving high levels of service and were correspondingly less profitable, showed much higher perceived value scores than those customers who received little or no support service and were consequently much more profitable. The supplier therefore took steps to increase levels of satisfaction in the profitable mines to ensure that dissatisfaction did not result in defection. At the same time it re-examined its service provision to the less profitable mines, whilst maintaining high levels of satisfaction.
Example 2. A Chemical Specialty Company
A South African business specialising in supplying cleaning chemicals to catering establishments and food plants had adopted a “systems” approach. This involved supplying automated dosing and control systems to ensure that their chemicals were utilised correctly as well as service and maintenance calls. All the equipment was supplied free, as long as the customer used their chemicals. After an ABC analysis of customer profitability, they discovered that smaller customers ran at a loss for 2 – 3 years before recovering the costs of the investment in the equipment, as well as installing and maintaining it. This industry segment is notoriously fickle, and customers frequently switch suppliers, or go out of business. Once properly costed, it became evident that the small customers were responsible for substantial losses, severely eroding overall company profitability.
If you are interested in learning more about customer profitability analysis e-mail Peter Gilbert on pgilbert@icon.co.za.
Focusing on Profitable Customers – A case study
Many companies have had supplier certification programmes for years, but today’s market leaders are creating customer certification programmes. These leaders have learned that it is easier to optimise the value of customer relationship assets, if those assets have high value in the first place. This realisation has led companies to develop criteria that select – up front – only their most valuable (i.e. profitable) prospects.
CRI is a national market research firm with annual revenues of around $30 million. A high percentage of this comes from 36 strategic accounts. However, this was not always the case. In 1989 CRI was generating $10 million in revenues from 157 customers and the owners were concerned about profitability. With the help of a consultant, management divided customers into 4 groups.
1. High volume and low margin. About half these customers were new ones that CRI felt would become profitable. The other half was on the verge of the high volume/high profit quadrant.
2. High volume and high margin. These were customers who had a supplier reduction programme and who valued an ongoing relationship with CRI. They accounted for roughly 30% of sales.
3. Low volume and low margin. CRI once believed it could make this group loyal, but they proved fickle, unreliable and price sensitive.
4. Low volume and high margin. These were small customers who were very profitable. But the key issue for account managers was whether there was more potential for sales.
After this analysis, CRI realised that only ten of its customers fell in the high/high quadrant and over 100 customers made little, if any profit! CRI realised it had been paying so much attention to its top thirty customers (by revenue) that it had never really prioritised its remaining customers – some of which were Fortune 100 firms, but many of whom were draining value from CRI.
There are many firms which suspect that they are serving unprofitable customers. However, few companies are willing to analyse customers on a case-by-case basis, looking at each accounts revenue, direct costs, indirect costs and profits. Even fewer have had the courage to shed their unprofitable customers.
After serious soul searching and a period of huge stress and anxiety, CRI began to shed its unprofitable customers and established a rigorous qualification process for new customers. CRI’s selectivity has paid off and the customer base has been cut by 50% while revenues have tripled and profits have doubled. 90% of CRI’s business is from referrals and CRI manages these referrals carefully. They regularly quantify and present the value they deliver to their “core” partners. They invest heavily in the upkeep and maintenance of these relationships and have learned that they can gain significant competitive advantage by determining relationship asset value, prior to investing the major resources that strategic accounts require.
Strategic Account Management Association
How Many of Your Customers Are Profitable - To learn more about this author, visit Peter Gilbert's Website.
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