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.”