The three major challenges that Activity based Management (ABM) concept helps to get insight into are
• Understanding profitability of products and customers
• Understanding the process costs and the drivers of those costs
• Understanding the resource utilization and planning resources for the future
Let us take the first challenge of understanding the Customer profitability. I have mentioned in my earlier posts also that whenever we use the word ‘costing’ it is always assumed that we are talking about ‘product costing’. This assumption has always led us to take all the costs to the product (whichever methodology of costing you use). The obvious effect of this thinking is that we always calculate and talk about the profitability of products. And we almost ignore the fact that a product sold to different customers can bring different profits (even if the selling price is the same).
As a follower of ABM concept when I try to explain the prospects that the customer profitability is not the revenue less the ‘total product cost’, most of the time they fail to understand (at least initially). Customer profitability is ‘revenue less cost to produce the product less cost to serve’.
As the product cost is assumed the same for all the customers, those customers who buy in more quantity and hence bring more revenue are supposed to be the more profitable customers. In this way revenue has become the most important ‘Performance Indicator (PI)” for any sales person in most of the organizations. The performance incentive or commission is also based on the revenue not only for the sales employees but the partners for sales also.
On this background I would like to present the information that the ABM project can display with respect to customer profitability.
a)
This is graph which plots the customers on the x-axis and the cumulative profitability on the y-axis. The typical scenario shows that, the top 12-15 % of the customers provide you the 100% of the profits you are getting today. Theoretically if you cater only these customers you will the same profit that you are getting today. The next observation is the first 35-40% of the customers take the profits to 350% of the profit. The middle 40% of the customers are almost ‘no profit – no loss’ and the last 20% of the customers who are practically loss making bring the 350% of the profits back to the 100% i.e. your current profits.
This graphical presentation helps the organization to understand their own profit potential and also who are their top 20% of the customers as well as who are bottom 20% of the customers.
b) 2x2 diagram for customer profitability
Once the organization has understood the ‘who-is-where’ from the whale curve, it is natural for the organization is to think of taking actions. The graph shown above is one of the useful graphs for the same. In this graph, the information about the customers is plotted revenue v/s the profit. This type of analysis not only segregates the customers, but gives a possible action plan. To retain the customers in the ‘high revenue-high profit’ quadrant at any cost and moving in some other quadrant the customers from ‘low revenue-low profit’ area.
The typical reaction from the people is that if we cannot do anything about the last 20% of the customers or the customers in the ‘low revenue-low profit’ quadrant, what the use of the information is. You do not have to guess that these are people from the Finance function.
This is information is not only for understanding who the worst are and the action is to be taken only for them. The other 80% of the customers in the first graph and the customers in the other 3 quadrants in the second graph are also important.
It is important to understand who your profitable or unprofitable customers are but also important to know why they are profitable or unprofitable. This helps the organization to focus on the type of customers to be acquired in future or retained. If you want move the customers from unprofitable to profitable zone what is that you have to do. Even in case of the unprofitable customers it is not always taking them away. You can try to move them to move horizontally to ‘high revenue’ zone or vertically to ‘high profitability’ zone by taking various actions. If all the actions do not lead to the better performance it could be still good for your organizations to lose those customers as this will improve your profitability and possibly reduce the profitability of your competitors.
This view is not only taken by the Finance person but by the Sales person as well and the main reason is that there is revenue coming from those customers. The Finance person can afford to say that if she cannot do anything with the unprofitable customers, there is not use of the information, but the CEO cannot say this. The purpose of a commercial enterprise is to earn a return on investment, not to generate sales. Any sales person that refuses to try to make his account a more profitable customer for the company should be made to walk the plank.
ABM can really give insight into the workings of organizations and that's why may be some sales folks may not appreciate it - who would like to disclose that most of their accounts are not profitable at all :-) At the same time, the business situations are complex and some low profitable accounts are kept that way intentionally for business benefits - reaping fruits of their brand-names, a perpetual friendly beta site, partners in business, etc
ReplyDeleteGood article Rajendra.
ReplyDeleteThis was exactly what I have used to demonstrate the need to build the Time-Driven Activity-Based Costing project with Damco. Looking forward to read your next post and if you have the time I would love if you could post your topic in our time-driven abc forum
Best regards,
Miguel
The typical reaction from the people is that if we cannot do anything about the last 20% of the customers or the customers in the ‘low revenue-low profit’ quadrant, what the use of the information is. You do not have to guess that these are people from the Finance function.
ReplyDeleteIt's slightly more complicated than that.
Anyone who understands ABM knows that it is concerned with fully burdened costs. Therefore the customers in the last 20% of the profit cliff graph pay a share of fixed costs. It is no surprise then that if we just simplistically drop the last 20% of customers then we only save the variable component of their cost. The balance is now carried by the 80% of customers that remain. Unsurprisingly the profit cliff is redrawn. Customers in the 70-80 sector who were previously breaking even, will now be losing money.
That is the cause of cynicism. The solution is retain output levels but switch sales focus.
Very good article Rajendra. ABM gives us an insight wherein we can plan our strategy keeping long term perspective in mind. At times we may decide to retain a customer from where we are only able to recover our variable costs provided the future prospects are bright. It also gives us insight to look at our servicing costs and take effective measures to mange the same.
ReplyDeleteThis issue became very apparent, when we were working with a diary company. The company was selling to very big departmental stores, shopping malles and also to small shops their dairy products. The "Cost to serve" clarly establsihed the very low prodits being earned from the big departmental stores / shopping malls vis a vis the other customers. The discounts, shelf rent etc. took away most of the profits.
ReplyDeleteBased on the inputs of customer profitability from their ABC reports, the company worked out an excellent pricing / discount strategy and improved their bottom line.
"If all the actions do not lead to the better performance it could be still good for your organizations to lose those customers as this will improve your profitability and possibly reduce the profitability of your competitors."
ReplyDeleteIt is a good point. When customers in the low profitability band are lost to competitors the competitors bottomline may weaken. but the counterpoint would be when you drop a customer, market share gets shrunk to that extent.
However getting rid of the bottom 20% customers is a double edged weapon. As JohnM has pointed out, when you lose revenue you lose contribution also and thus transfer extra wiught of fixed cost to the other profitable customers. Suddenlt they look less profitable! This is because the flaw in logic. At any given point there will be a bottom 20% customers and getting rid of them will prove counter productive!
I recall a CIMA article (satirical) over 15 years back where the new 'bean counter' employed this logic and turned a profitable restaurant into an unprofitable one!
Customer profitability is much more complex than just revenue minus cost to produce AND serve. A holistic approach of what happens when yoy drop a not so profitable customer must be considered before dropping one.
I wd imagine a more pragmatic long term approach would be to consider striking a balance between top line and bottom line.