Understanding Customer Profitability for profit optimization

In an economic environment where downsizing, reduced funding, and budget cuts have become a necessity for many organizations, so has the consequential need to identify where non value-add activities really exist and where unnecessary costs in operational activities can be eliminated in order to effectively reduce operating expenditures. Today’s economy has also spurred many businesses to place a greater focus on their customers and on increasing overall product profitability, yet many are finding that their largest customers or best-selling products are not necessarily the most profitable ones until they perform activity-based costing analysis.

Whenever I have asked the question in an open workshop or during a client presentation, ‘are your all customers profitable?’, all the time I have got the same answer ‘YES’. People see that products are profitable or unprofitable, but customers are always profitable. We have seen the ‘whale curve’ for the customer profitability in my last posting. You can see here similar diagram for a retail bank, wherein the top 40% of the customers bring 327% of the current profitability, but unfortunately the next 60% of the customers eat out the 227% of the profit to bring the profit to the current level of 100%.

Then I ask a similar question but probably simpler to answer, ‘are all of your customers equal?’ The answer here is ‘NO’. And this ‘no’ is primarily because the revenue brought by the customer is not the same. But revenue is not the only factor that distinguishes the customer. There are various other reasons like the products that they buy, the # of orders, the locations for delivery, discounts, # of special requests that they make etc. Generally the customers that bring more revenue are treated like king in any organization. On the other hand when the customer knows that it a ‘valued’ customer for the organization they the customer starts making various special requests.

I liked the concept that is mentioned in the book ‘Angel Customers & Demon Customers’ by Larry Selden and Geoffrey Colvin. They have mentioned that the organizations should look at their business not only as group of products or functions or regional territories but as portfolio of customers. These portfolios of customers should constantly bring superior shareholder value to the organization. Organization can enhance customer profitability by creating, communicating, and executing competitively dominant customer value propositions.

It is not far away that the Boards of directors will begin to demand customer-- profitability data and will challenge management to act on it; investors will demand that companies report it. This is going to be one of key information that the organizations would use to run their business, define business strategy and enhance the value to the stakeholders. Technological advancements are also going to help the organizations to achieve this. Earlier it was very difficult to calculate the profitability at customer level or even at customer segment level. But today we can not only calculate the profitability at customer level but even at account level for banks or subscription level for telecom industry.

Once we have calculated the customer level profitability, it can be used in various ways. If we plot a scatter diagram based on the customer profitability information of customer revenue v/s customer profit, we can segregate the customers in four quadrants.

Once we plot the diagram and segregate the customers in four quadrants, we can also see who is falling in which quadrant. We can also see the various reasons that are making them remain in those quadrants. We can get the actions to be taken for various customers of our organization.
APQC has come out with many best practices after conducting a study on the same. I am mentioning some of them here.

1) Best-practice organizations secure buy-in from the users and upper-level support for customer profitability initiatives.
2) Best-practice organizations use customer profitability and segmentation to appropriately align sales and marketing resources.
3) Best-practice organizations have specific programs/sales efforts geared to their more valuable customers.
4) Best-practice organizations successfully convert unprofitable customers to profitable customers.
5) Best-practice organizations hold employees accountable for customer profitability.

In the end, I would add a portion of the newsletter that I got from Douglas T. Hicks recently;

“Whether you believe that activity-based concepts are the solution or not, the fact remains that the misinformation (or non-information) accountants perpetuate about process, product, service, and customer costs has been a significant contributor to the underachievement of our organizations and sometimes a major cause of their failure. It’s not just the numbers – it’s the dysfunctional behavior and inappropriate decisions invalid economic cost models cause that make business success so elusive. Management uses information generated by their accountants to judge their performance and direct their actions. When that information is based on invalid models of the business, financial performance suffers.”

Cost reduction only or Profit optimization too?

Now days wherever we are, with friends or colleagues or customers or conferences we are sure to hear about the downturn and the various ways people are trying to sustain in this kind of scenario. People are talking about the postponement of projects, reduction in people, reduction in expenses like from travel, communication up to printing stationery. Quite a few organizations are also looking for the programs to improve the costs in the organization using productivity improvements, process management and waste removal in processes. Some organizations are asking their vendors to reduce the prices, accept longer payment schedules. At some places there is only a directive from the top management to reduce ‘x’ percentage from the operational expenses and then the department heads are chopping expenses like anything.

All these steps are being taken to maintain or maximize the retained money with the organization when there is a reduction in the revenue. This retained money is nothing but the net profitability of the organization. This is even more important for the publicly listed companies where the ‘quarterly results’ pressures are even bigger.

On this background when I go for making people understand the benefits of Activity Based Management (ABM) to their organization, they are still in the same mind set. I mean they are thinking of the same ways of reduction of cost and then try to see how your concept or solution is going to help them. The solution providers are also in the race to show them the ‘cost benefit analyses’ of their solutions. I am not saying this is a wrong way to look at the situation or even handle the situation, but there is another angle to this also and people are less attentive to.
My position is that understanding profitability is always important for any organization and it is even more important in the current economic scenario. This profitability is about product profitability as well as customer profitability of the organizations. It not true that, the organizations do not know their product or customer profitability, but is not the ‘true profitability’. This is because the way in which the traditional costing calculates the profitability of the products and it calculates the cost of product by taking all the expenses to the product.

When we calculate the customer profitability using ABM we are segregating products costs from cost of selling those products to various customers and hence it gives accurate customer profitability. In the diagram where customer profitability is plotted we can see that the first 10-12 % of the customer bring the 100% profit that you are getting. So if we speak theoretically, we can say, we will deal with only these customers and still get the same profit for the organization. But is that the potential of the organization? I would say no. A big ‘NO’. Because there are next 30-40% of the customer that take you to the 300-400% of current profit levels. The next 30% of the customer that are almost ‘no profit-no loss’ type of customers and the last 20% of the customer bring you to the current level of profitability.

Organizations should understand this potential in their organization and get the visibility of the real ‘culprits’ for the situation. By understanding who those customers are, that are eating the profits earned from the organization and also finding the behavior pattern would help the organization retain profit at a higher level than today.

Using Activity Based Management can help organization to find out the true profitability of the products and customers and build a graph like this. The efforts that the organizations are putting in the improvement of costs with various methods will definitely help them in the current situation, but unearthing this huge ‘profit potential’ in the organization and acting on that will make the organization to remain healthy in the current economic scenario.

Activity Based Management in a company where 90% cost is Raw Material only

Whenever I go for pre-sales presentation to organizations, there are various questions that they ask. When it is a service organization like a bank or insurance company, they say Activity Based Management is useful for manufacturing companies. The manufacturing people say, most of our costs are material costs (anything between 65% to 90%), then do we need Activity Based Management efforts for the rest of the expenses? Recently I was asked following questions;

“I am working in one of the better known aluminium extrusion company in India. We primarily buy virgin aluminium ingots from primary aluminium manufacturers. Afterwards we melt the aluminium, alloy it with different alloying elements and extrude it into thousands of different forms.

Our costing method is very primitive. One of the reasons is that, almost 90% of the total cost is accounted by Raw Material. Then there are various other variable costs which can be directly associated with a particular cost center. The % of fixed cost rarely exceeds 5%. Though not satisfied with my present costing methods, I want your opinion that to control only 5% cost, whether so much efforts is necessary to change our costing system to ABC. Kindly correct me if I am wrong. “

I will try to answer this question from various angles.

Answer # 1)

First of all we will see typically which type of organizations that need Activity Based Management. It is needed by all those organizations that;

a) Are striving for improvement.
b) Need accurate costs.
c) Are interested in bottom line results
d) Desire improved decision-making.
e) Wish to be competitive in the new millennium.

Now you would say that means ‘everybody’. You are correct. The reason being who does not want to achieve one of more of the points mentioned above. So the primary answer for, who needs ABM is, ‘everybody’.

Answer # 2)

Let us go into more details and try to understand more about the organization. For that we need to know;

a) How many different products do you make?
b) How many customers do you have?
c) How many different types of customer do you have?
d) How many different plants do you have?
e) How many channels do you use to sell your products?

In the old days organizations used to have few products and were selling to a limited geographical area. In the today’s world customer is asking various options in the products. They also want the product to be available at the nearest point. The complexity of the business is increased when it has multiple products, multiple types of customers, serving different geographical locations, using various different channels to sell and serve. As the complexity of doing business increases it requires more resources to manage the complexity. This increases the overheads in the organization. Activity Based Management helps the organization to calculate the ‘cost of this complexity’. Actually it helps to reduce the complexity of the business by understanding which are the ‘non value adding’ products, customers, channels etc.

Answer # 3)

Let us look at the benefits of Activity Based Management

a) Information for effective decision-making
b) Information to continuously improve processes and reduce costs
c) A focus on significant costs
d) A relationship between organizational cost and organizational value
e) Methods to measure performance with accountability

Activity Based Management tool provides you the costs for products, customers, process etc. Once you calculate those costs with various dimensions you can use the OLAP (Online Analytical Processing) tools to ‘slice-and-dice’ the data. For example we can analyze customer profitability v/s customer revenue, Current profitability v/s future profitability, importance of a process (activity) v/s performance of the process (activity). We can use various subjective attributes together with objective cost data to take various business decisions or improvement action plans.

Answer # 4)

Let us now take the example of this particular organization and use the financial data that is publically available.

When I saw the company's website, it tells that they have sales of Rs. 8000 mn in 2006-07. It also shows they have 15% of profit which is Rs. 1200 mn. It leaves a cost of Rs. 6800 mn. 90% of this cost is material cost i.e. Rs. 6120 mn.

So the other costs are Rs. 680 mn. We will primarily assume that we cannot use the material cost and we have to work only on the non-material costs. If you use Activity Based Management to manage those costs, typically one can save 3-5% of these costs. With about 3% of savings you are making almost Rs. 21 mn. To achieve this profit, one will have to increase the revenue by Rs.143 mn.

There are examples where organizations have reduced the number of items they handle as raw material or non-raw materials by using the Activity Based Management concepts. Activity Based Management does not only calculate the costs, it unearths the drivers of the cost. When we analyze this and take actions on the non-value adding work, we go on improving our processes and reduce costs.