MEASURE CUSTOMER PROFITABILITY AND ACT
Consider all of your customers as a portfolio of investments into which you have been pouring your organization's resources in hopes of an optimal return. You know that some accounts are quite profitable and others are losers, because they cost more to serve than they contribute in margin dollars.
1. The good ones were fewer, but dramatically more profitable than you expected?
2. The losers were far greater in number and some far more severe a drain on your resources?
Would you want to: secure the loyalty of the best; shape-up-or-out some of the losers to redeploy your resources towards more profitable business; and take preventative measures to keep new or old losers from sneaking back into your customer portfolio?
If you don't take such actions, then aren't you vulnerable to a clever competitor who might be quietly pushing losing accounts your way. More losing accounts would not only erode profits, but their activity demands would reduce your ability to pay special attention to your best accounts that your competitor would be targeting with his freed resources. Better to hit the competition with this double-pronged tactic first.
But how do you exactly rank all of your accounts by profit contribution? Because of the problems of allocating fixed, semi-variable, and even variable costs, we can never perfectly rank accounts from best to worst. Don't let this lack of finality keep you from acting. Good managers must act wisely with imperfect information; do initial analysis crudely and quickly; then, refine further rounds of analysis as needed.
As a first cut, use the following equation for each customer:
Gross Profit(12) - [Invoices(12) x Avg. Cost per Invoice] = Est. Operating Profit Contribution
- You take the gross profit for an account for 12 months or however many months of trailing history you might have.
- Subtract from it the product of the number of invoices billed to the account for the same time period - 12 months in this case - times (x) the average costof an invoice.
- The cost per invoice is simplistically calculated by taking the entire operating cost of running the business for the year and dividing it by the grand total of invoices for the same period.
- Before you start to criticize this equation and its underlying assumptions read on. The next step is to have the computer rank all of the accounts from high to low by their estimated profit contribution while also putting in cumulative percentage columns for customers and profit. Then we can quickly see what percent of the customers account for what percent of the profits. In one case study, a distributor had the following breakdown:
top 10% customers ...95% of the profits
top 20% " ...145% " " "
top 40% " ...155% " " "
bottom 60% " ...(55%) " "
This crude analysis suggested that the top 40% of the accounts generated 155% of the profits to offset the losses of 55% caused by the other 60%. Assume now, that we will never know exactly which account should have been number one on the list, but that the top 20% of the accounts are most probably profitable; they should be further protected and secured as most precious assets. We could also assume that the 60% in the middle of the ranking report are not of immediate importance; most are about break-even and carry their fair share of overhead allocation. The bottom 20%, however, starting with the last place accounts are to be individually analyzed and most likely acted upon in some corrective way. There is only one way to be at the bottom of such a report - little margin activity and lots of transactional expense which always causes a loss. Run this profit ranking report for each profit center, each service division, and each sales territory. Suggest that each area investigate and shape-up, ship-out, or fully explain their worst accounts. If as a result, these accounts: order twice as much, half as often; pay up-charges for their small orders; or leave to paralyze your competition with their losing mix of business; resources are freed. You will be able to take on new, presumably profitable business without adding extra people.
If you want to then pursue further levels of customer profitability analysis, a few further suggestions:
- Rank all accounts by their ratio of credits issued divided by the number of invoices billed for 12 months trailing. The top 50 accounts will have an abnormally high rate of credits which are expensive for both you and them. Investigate why the rate is high and you will find some structural, costly problems that can be changed. You will also find some "rascal" accounts who have been playing one of several different exploitive games.
- Another approach to determining rascals is to ask your inside sales, customer service, and credit department people to name accounts off the top of their heads who are chronic headaches. Check their past performance numbers and their upside potential. You will discover some accounts that are longtime, small operators who not only abuse your organization, but also their employees and customers - not a growth formula; cut your losses and tell them to behave and pay more or move their business to a competitor.
- Exception ranking reports for slow pay accounts are another extra-cost dimension way to look for losing accounts. A good, longtime credit manager can tell you off the top of their head which accounts are the chronic, abusive players to further investigate. A more exact and automated approach would be for the computer to calculate the month-end total receivables and days outstanding for each account and store this information in the customer master-file for twelve months or more. Then every six months you can run a ranking report for the accounts with the longest-outstanding-days average to the fewest; investigate further; and take appropriate action. Don't pretend that the deadbeats are paying all of their late charges. Most firms write most of these off.
In closing, a few key guidelines:
- If you have been volume-driven without measuring customer profitability regularly, then greater cross-subsidization of losing accounts by winning accounts exists in your customer portfolio than you expect. Cure it to boost profitability and productivity before a sharper competitor exploits it.
- Once you measurably discover how vital your best accounts are, take extra steps and services to further secure, penetrate and proactively anticipate their changing needs.
- When analyzing any aspect of your business - inventory, services, customers, people- design ranking reports to sort losers from winners. Feed the winners and starve the losers. Ranking reports are action reports.
- In business analysis, approach problems like peels of an onion. Do a quick and dirty first cut to see what is revealed; it is an inexpensive experiment. Then with more insight do another layer of analysis. If you format results in an exception, ranking report, you can address the extreme, high-leverage opportunities.
- Redefine your competitive strategy to be focused on qualitative growth of profitable customers instead of quantitative growth of product sales which leads to a lot of unprofitable customers in your portfolio.
Merrifield Consulting Group, Inc., Article # 2.3