The ROI of an Activity Based Costing (ABC) project

This is the most common question that is asked to all the vendors that propose any concept, solution to any organization. I, as a management consultant have answered this question a lot of times. Surprisingly, when I am at the client’s place and see various internal projects (managed totally by the employees of the organization) launched, almost none of them are proved (or may be asked) on their positive ROI. They are run as a necessity and the outcome is ‘expected’ to be good but does not guarantee anything. Especially the marketing campaigns and sales improvement related projects.

Today I am going to talk about the return on investment (ROI) of an ABC project. As you know from my earlier post that ABC has already completed 20 years of its existence. Over those 20 years various experts have explained the ROI of ABC project in different ways. I will try to put most of them as well as my own view.

ABC methodology came into existence, as the US markets were facing tough competition from the Japanese market on the costs. The earliest use of the concept was to take costs to the products with a more logical way. The method that was used to take overheads to the product, before ABC was based on ‘Labor hours’. After this it has been used for various purposes like Product profitability, Customer profitability, Process improvements, Cost reduction, Resource planning, Activity based budgeting, customer segmentation, marketing campaigns, customer life-cycle value (CLV) etc.

Now we will look at the components to calculate ROI, i.e. Cost and benefit. On the cost side it is easier to compute as you know the costs for the components like software solution (from spreadsheets to enterprise wide integrated solution. Now you can get ‘pay per use’ type of option also), hardware cost to host this application (not an investment in case of ‘pay per use’ option) and the consultancy costs for initial modeling and training of the team. The ongoing costs are those for the software licenses and hardware maintenance. The internal costs, are related to the time spent by various personnel in collecting, uploading the data; creating and circulating reports. This is comparatively simpler to calculate.

Now comes the difficult part that is calculating the ‘value’ of the benefits in monetary terms. I remember the days when various ERPs were introduced in that market and the ROI was calculated on the benefit that ERPs can improve your business processes hence; the organization can improve the inventories and less number of people would be require to run the business. In case of ABC, the experts have various views on the calculation of benefit. Some say that the use of the ABC information is for taking better business decisions. Hence, it is very difficult to calculate the benefit of ABC. Some say, as it is used for talking better business decisions, the benefit due to the business decision taken can be attributed to ABC. In other words the benefit can also be calculated as the ‘Loss avoided’, if we had not got the information given by ABC project.

Let us take an example here. An organization is looking at increasing a market share. This is aimed at acquiring more number of customers in a particular segment. The reason behind acquiring such type of customer was they were giving more and more revenue to the organization. The logic presented was more number of customers will more revenue and definitely more profit to the organization. A marketing campaign was run and the organization got more customers with increased revenue. To cater to the increased requirement of the products/services the organization has invested in infrastructure and facilities. But the financial statements statement showed that the profitability was unchanged (sometimes it is even worse as the profitability decreases).

If ABC had been implemented in this organization to calculate the customer profitability and product/service profitability (sometimes region wise also), then the organization could have known that which products/services to be offered to which customer segments and which regions, based on the profitability information of the existing customers coupled with their demographic and psychographic information. This would have made the marketing campaign more effective towards the ultimate aim of increasing market share with profitability. In this example the benefit of ABC project can be calculated as the increase in the revenue and profits of the organization. Alternatively it can be also calculated as the loss of expenses on the campaign that did not increase the profitability of the organization.

I am sure it can be also applied to the other uses of ABC projects, but would not be always so simple to calculate the benefit which could be more implicit than this. The experience of implementing ABC over 20 years has shown that at a gross level the benefit can be stated as reduction of installed overheads by 3-5 % or improvement of the profitability by 200% percent.
When we talk about the reduction of overhead costs, people in various types of industries tell that our overheads are very less. For example in manufacturing, they say 65-90 % of our costs are material costs. So why take so much of efforts and try to rock the boat (by change management) for 10% of the overheads? To answer this, we take an example of an organization with INR 5 billion (approx USD 100 million) of revenue. We will assume that the profitability is 10% i.e. INR 0.5 bn. This leaves us with a cost of INR 4.5 bn. The material cost is 90% of this, i.e. INR 4 bn approx. So we are talking about 3-5 % of INR 500 mn (approx USD 10mn), which comes to INR 15 mn (approx USD 300,000). In Indian context this would give less than a year’s ‘pay back’ period for this organization. If we couple the improvement of the profitability it would look like the payback period is in few weeks. This is explained in more detail in my earlier blog http://activitybasedmgmt.blogspot.com/2009/03/activity-based-management-in-company.html

Actually a blog post by Dr Peter Turney, founder of Cost Technology Inc., has given me a stimulus to write on this subject in detail. It will also help all the readers, especially those who are thinking of implementing ABC (even more for those who have postponed or cancelled the ABC implementation). In this article of Dr Turney, has mentioned three reasons for implementing ABC, viz. a compelling business need, recognition that ABC is superior to whatever you currently have or don’t have, and a positive return on the required investment. I also present the ABC case as to answer three challenges,

• Making strategic decisions based on a true understanding of which business segments are profitable




• Determining the business processes that drive cost and how to control them




• Predicting future resource needs, and costs in dynamic organizations, and the impact they will have on future financial performance
  

In 'Sanskrit' (an old Indian language), we used to have small riddles. In this, there used to be three questions in first three lines and the fourth line used to be the answer of those three questions. The amazing part was the answer used to be in 'single word'. This single word had three different meanings, which used to be the answers to the three questions. I want extend the same idea here. I would say whatever the reason for implementing is; the results give you an 'INSIGHT'. You use this insight to find answers to different questions.

We will now focus on the 'ROI' part, for a long time experts have mentioned that the ROI comes from either improving costs or profitability. The percentage would vary from organization to organization. It is dependent on how good and how bad you are. Actually it would 'how bad' and 'how good' you are, if we want to look at it sequentially.

Let us take the ‘How bad’ part of this. This is nothing but haw bad are the internal processes today. How much is the ‘non value added’ part in these processes. This non value added part can come because of doing activities that are not at all required or doing activities again and again or to do them because the information or material is not of proper quality or any other reason. This tells us the ‘Potential to improve’ in an organization. The same logic can be applied to the profitability information also. The 2x2 diagram with customer profit plotted against customer revenue will tell how good is our understanding about the customer profitability and how well we know the requirements of our customers to add or manage or retain our best customers.

Now comes the most difficult part. The 'how good' part. This is nothing but the ability of the organization to implement the action plans to achieve the benefits. This actually talks about the ‘potential to change’ in the organization. So the ABC project may have identified various opportunities to improve (may be worth 5% of the overheads), but the actual benefit achieved will depend on the willingness of the people at various levels in the organization. To help the organization to reap maximum benefit, I suggest plotting a 2x2 diagram of potential improve v/s potential to change.

The quadrant that talks about the highest potential to improve and also highest potential to change is the priority area. I also call this as the ‘low hanging fruit’. Once you start implementing these actions and show the results of the same. These people or actions can be shown as the ‘islands of excellence’. This actually can propagate the chain of actions in your organization to achieve maximum of the ‘potential to improve’.

Finally the ROI of the ABC project can be calculated, though difficult. It can be as high as 300-400%. It can be seen as a payback period of less than a year. It actually is different for each organization as the potential to improve and potential to change does differ from organization to organization.

The best time to plant a tree was 20 years ago. The second best time is now.....

I passed my management accountancy exam in 1992. This was the same time when Activity Based Costing, was at its peak (may be first peak). Although I was not aware that such a concept exists then. I heard about this concept for the first time, when I was asked during one of the employment interviews in 1993, “What do you know about Activity Based Costing?” I was zapped, as I had never heard about such a thing in my life. Life took me back to Activity Based Costing again in 2000, when I started reading about anything and everything about it on Internet. Since then I have been hooked on to this concept till date. The only reason why I telling all this is, when I look back, I see Activity Based Costing and my alliance with Costing have crossed 20 years of mark. In those twenty years I have changed a lot, as well as the concept of Activity Based Costing. Let me put the life of the Activity Based Costing for last 20 years as I know it. Correct me, wherever I am wrong, by posting your comments.

In the late eighties, the western organizations were facing competition from the Japanese organizations. These Japanese organizations (especially in electronics and automotive) had a distinct advantage of cost over the western organizations. This was due to the various management techniques used by Japanese (SPC, JIT, Continuous improvements etc.). At the same time some of the western organizations were looking at their decreasing margins, without knowing the real reasons behind it. During that time costing was used for completing the financial reporting by calculating the inventory costs. The same information was used to calculate the product cost. This was obviously leading to ‘not-so-correct’ product costs and decreasing margins.

This is when people built their first ABC models. These models provided them the information that helped them to understand that the basic reason for the wrong business decisions was the cross subsidizing product costs. Organizations then started ABC results for pricing and product mixes as well. With this came the flood of ABC implementations. Both the consultants and organizations went overboard. The models were designed with in detail (sometimes in too detail). The corresponding technological solutions could not cope with such detailed models and this led to the early reactions. ABC is very much time consuming. ABC takes too much time to build. ABC was also used for product costing only, then. So it has to face the criticism of not being customer focused or process oriented. Also the followers of ‘theory of constraint’, also criticized that ABC can only be used for long term decisions and not for short term decisions.

A lot of changes have happened to the modeling concepts, technology, uses of the concepts etc. The irony is that, people criticize the ABC concept even today, based on the state that ABC had 20 years back. It could be so because they do not know about the changes that have happened to the concept of ABC. Let me give a try to provide this information.
The concept of costing was relevant to manufacturing industry, because costing was always synonymous to ‘Product Costing”. With this understanding the modeling was such that each and every ‘penny’ spent was taken to the product. Over the years people have understood the ‘cause-and-effect’ relationship of costs and now the ABC models separates the costs that are caused by Products, Customers, Capacity and costs not related to any of these (business sustaining costs). Due to this segregation of costs organizations are able to calculate and understand the product as well as the Customer profitability also. As the costs are separated for the resources provided and resources used, organizations are able to calculate and understand the resource utilization of the various functions. Earlier capacity was always synonymous to machine capacity. When you know the capacity utilization you can use the concept to plan your resources. Hence, ABC can be used for resource planning.

In the early days of ABC modeling it was a single stage modeling. This means costs from resources taken to activities and from activities to the cost objects (products). The current ABC models can have multiple level assignments. You can assign resources to resources (Cost of HR function assigned to various other functions), activity to activity assignments (secondary activities supporting primary activities), reciprocating assignments (HR providing services to IT and IT providing services to HR in turn). By using various attributes one can view the cost of process at various stages. For example we can see the cost of procurement process at various stages as requisition, purchase order, QC, returns, payment etc. This analysis helps the organization to directly attack the areas that are inefficient. All this is possible because of the technological solution as well as changes that have happened in modeling.

The changes in technology have also happened in parallel. From the early days PC based solutions to the current enterprise wide application, is one way. Various functionalities like multi-stage assignments, reciprocating assignments, attribute etc. For me the most important is the ability to do the multi-dimensional modeling and viewing the results as OLAP views (for those who not so technical OALP are very similar to the ‘pivot tables’ in MS Excel). With the use of this feature we can not only see the product or customer profitability, but this can be seen as product wise – customer wise profitability (or vice-a-versa). This combination can possibly lead to understand profitability of a customer – for a product – sold in a region – thru’ a channel. Alternatively one can see profitability of a customer can be seen for a telecom company as a set of customers falling as private customer – acquired thru’ retail outlet – with a prepay plan – having very low technology aptitude – with a life stage as matured family – age group of 44 to 55.

As I said the costing as well ABC was initially used in manufacturing industry. It has had such an effect on people’s mind that people still think that ABC is useful for manufacturing industry only. In the early nineties came the CAM-I cross.

This diagram helped organizations to understand that ‘Activity’ was the most important part of the ABC model. Process in nothing but set of activities performed in sequence by one or more functions. Analysis of cost drives as the ‘cause of the cost’ helped organizations to use ABC results to improve their processes. Here was the answer to the people who criticized that ABC is useful only for product costing (and hence for the strategic use and not for operational improvements). This modeling concept led to the use of ABC in various service industries because the ‘products’ of those service industries were their ‘services’ and nothing but various processes. Initially the service industry used this concept to calculate the customer segment level profitability. In case of Retail it was used to calculate the category level or product group level profitability. The technological challenge was, it could not handle the millions of assignments. Today the commercial software solutions are available that can handle 100s of millions of assignments, which can be used to calculate profitability at subscription level in telecom, account level in banking or SKU level in retail. The time driven activity based costing equations have helped to model these millions of assignments very easily.

The latest technological evolution is the integration among the various software solutions. Because of this, the data required for the ABC model to update the model can be directly pulled from the ERP or any OLTP application running in the organization. For the ‘non-ERP’ data we can develop a small web-based solution, so that employees can enter the empirical data for the ABC model. The results of the ABC model can be integrated with various Customer Intelligence (CI) solutions like segmentation, retention, campaign management etc. ABC model can feed up-to 20% of the KPI data in a scorecard. This has increased the usability of the ABC information.

The use of ABC has also changed over the years. It started with calculating product costs, to customer, channel, Business unit profitability etc. This has been used to calculate the resource planning and activity based budgeting. After creating the activity based budgets, organizations can start reporting activity based variances. Route optimization in supply chain for various organizations like Retail or CPG, can be supported with more accurate costs of various activities at multiple places. This cost information coupled with optimization techniques can help them to find the optimal route for various vendor-item category-location combinations. ABC information can support any other process improvement program that is running in the organization, by providing accurate costs of various processes and help to prioritize the program. For this we can use the ‘2 x 2 diagrams’ methodology. We can use cost v/s potential to improve (the potential to improve will depend on how badly you are performing the process or activity). From here we can choose the quadrant that is ‘high cost and high potential to improve’. For the activities in this quadrant we add another attribute ‘potential to change’ (that is how easy it is in the organization to change the way in which we perform the activities). The first set of activities would be then ‘high cost – high potential to improve – high potential to change’. This seems to be the low hanging fruit.

It is no longer that the organization would start looking at business as a portfolio of customers. Then managing business is managing these portfolios of customers. To form the customer portfolios, customer profitability would be one of the most important information. Soon the board of directors would start demanding the customer profitability information and will challenge management to act on it. Who knows, shareholders would also start asking for this information. While mergers and acquisitions people will start running ABC project to understand the customer profitability, because in the acquisition, organizations are acquiring a portfolio of customers. The bid would also depend on the portion of the customers that match the profile but also portion of the customers that are profitable and matching profile.

During all this discussion, I wanted to explain that since the introduction of the concept of ABC till today and in future, it has gone through various cycles. Some people have used it, some have criticized it. It has taken its path of crests and troughs. Looking at the maturity of the use of the concept, technology available, consulting resources and competitive market situation, I feel the right time to start using ABC is TODAY. I will modify my title little bit and say “The best time implement ABC was 20 years back. The second best time is now….’

Profit plus Cost is Revenue

We have seen the business planning happening majorly as ‘Sales Planning’. In other words we can say that it is the ‘Revenue’ planning. Based on the planned revenue and returns expected the ‘Cost Budget’ is targeted. With the equation ‘Revenue – Profit = Cost’. The pressures are majorly on the costs. With this pressure the management as well as the line managers try to cut costs which is nothing but cutting expenses (read as ‘resources’). Activity Based Management (ABM) helps to understand the ‘non-value added’ activities and those can be scrapped with reducing the expenses and resources can be freed to perform the customer facing activities. This would in turn help to maintain the ‘Customer Value’.

Instead of starting with revenue if we can start with the profit expected by the management, then understand the market situation to bring that profit. With this study we can understand our product offering, their pricing, our customer segments, their requirements, competition etc. With this understanding we would be able to build our business strategy comprising of ‘what to sell’, ‘whom to sell’ and ‘how to sell’. This will help the organization to understand their current business processes and the plan the future one. This planning would define the activities to be performed and the resources requirement for the same. This information can be converted into cost budgets. What we know now is profits plus the costs, and the sum of this should be the revenue that needs to be brought in. Based on this information we can break down the revenue into various products, customers, channels, prices, geographies etc. Based on this a detail sales plan can be defined and monitored further.

In recent past various organizations are using ‘Balanced Scorecard’ as their performance planning and managing methodology. In this methodology organizations define their ‘strategy map’. Based on this map and the strategic objectives various KPIs are defined. Among those are the cost related and profit related KPIs. While defining this strategy map and the KPIs, if we can use the ABM models where in we can create various ‘what-if’ scenarios based on various options that the organization may have to achieve their ultimate goal, then the organization can choose the strategic path that is matching with their ROI targets. This is based on the assumption that the strategy map (by itself) does not give the numbers that can be achieved. But the ABM scenarios can help the organization to understand the impact of various actions on the profitability. Before choosing a path the organization can understand the effects of their future action converted into bottom line.

I have posted this with few assumptions and I would be interested in getting the feedback from readers on at least following questions (more than that is always welcome);

1) Is this concept already used by the organization?

2) If yes,
a. What type of industry is using?
b. In which geography this organization is?
c. How useful is this?
d. What are the challenges faced?

3) If no,
a. Does this sound practical?
b. In which type of industry this would be helpful?
c. What are the lacunae?
d. What type of alternatives can be used?

4) Any other comments (for or against), as this will make us the concept understand better.

You can post here or send me an email at rajenpatil12@gmail.com

Workshop on Profitability and Cost Management

Indian industry, notwithstanding its growth projection, continues to face an uphill battle to identify the ‘real’ opportunities for growth amidst reduced consumer confidence and a customer population that is prone to churn and attrition. Many Indian enterprises, having invested heavily in good times are now finding it very difficult to sustain the cost structures with reduced margins. While the economic crisis will have serious impact on the growth and profitability of the companies, the crisis offers an excellent opportunity for companies to transform themselves towards long term profitable growth and increased stakeholder value. Not surprisingly several leading firms in India have started comprehensive transformation programs. The question though is – what should be the goal of such transformation programs? Should they focus on growth or profitability? Wouldn’t cutting costs offer immediate return of profits? Should more customers be acquired? Do more customer means more revenue and importantly more profits? While these are very common questions that the executives driving these transformation programs address, the reality behind these transformation programs is that often companies undertake these programs on “Gut feel” rather than basing them on “complete and consistent facts”.

To improve financial performance is a high priority in most organizations today. But to find accurate information on costs and profits for decision-making can be difficult. The problem is that traditional accounting systems were developed mainly for external reporting purposes. As a result, these systems often provide inaccurate and misleading information about costs and profitability. What you need is a system that will enable you to accurately measure costs and profitability for products, services, customers, and processes. It should also reveal the root causes of a certain cost or profitability level, enabling you to make the right decisions and take action to improve financial performance. What you need is Activity-Based Costing and Management. An unmatched concept that enables you to make better strategic and operational decisions to increase profitability, manage costs, and improve operational efficiency.

With ABC/M you can:
– Identify the most and least profitable products, services, customers, or sales Channels
– Accurately determine true costs for products and services

We are pleased to invite nominations from your organization for our One Day's Workshop on "Profitability & Cost Management". The details of the same are as under:

Date of The Workshop - Friday, 22nd January, 2010

Time - From 9:00 a.m. to 5.30 p.m.

Venue of the Workshop:
B.V. Rao Hall , 1st Floor
Deccan Gymkhana Recreation Building
Deccan Gymkhana Club
Opp Hotel Ait / Near Chitale Sweet Mart
Pune - 411 030

Faculty:
Mr. Rajendra Patil is B.E. - Polymer Engineering from Pune Univ. & a Cost Accountant (AICWA). He is a technocrat with 17 years of proven experience in Business Analysis, Providing Consultancy in Strategic Cost Management, Profitability Analytics, Organisational Performance Management and Business Process Management. He was working with SAS Institute R&D India Pvt. Ltd., Pune, a US based Enterprise, as a Specialist – Performance Management Solutions for Indian Customers. In 2008 he ventured into consulting and started APPS Consulting.The major objective of APPS is to provide consulting services to organizations in Banking, Insurance,Retail, Communication, Manufacturing, IT and KPO sector. The unique proposition of APPS is to prove and earn. Mr. Patil has undergone Training on Activity Based Costing & Profitability Management as well as on Expert Modeling and OLAP analysis at SAS, U.S.A. He has handled various projects related to (ABC/M) various Business Organisations from Manufacturing, Telecom, Retail and Banking Sector. His clients are Kirloskar Group, Suzlon Energy,Thermax,JK Files and Tools,Merck India,Syngenta India,Waterville TG, ING Vysya Life Insurance, SAS R&D India, Systems America Inc.,Mercedes Benz India,Finolex Cables.

Who Should Attend the Workshop:
• CEOs, Senior as well as Middle Level professionals from Finance, Marketing, Costing, Operations, Sourcing who are keen to take their functional expertise to the next level.
• Note: This is not just a workshop but this can lead to Consultancy on ABM Projects. Systimatic Implementation of ABM will add to your bottom line in Lacs!!
• Workshop Charges / Fees - (Includes Course Material, Break-fast, Tea-Coffee & Lunch & Certificate)

Rs.4800/- for 1 participant.
Rs 4500/- per participant for 2 participants from the same organization.
Rs.4200 /- per participant for 3 or more participants from the same organization.

Payment to be made by cheque in the name of "Human Capital Consultants".

With Best Regards,

Ajay Walimbe
Director
Human Capital Consultants
A/16, Pradnyangad Apartment
Opp. Haripriya Hall
Navsha Maruti Mandir Lane
Off Tanaji Malusare Marg
Pune - 411 030
Tel: 020-66203576
Mobile: +91-9881060190
We Turn People into Asset!

ajaywalimbe@vsnl.net

Customer Analytics with Profitability Solution

In the last post ‘Revenue is means and not end’, we saw that it is important to understand the customer profitability for taking business decisions around customer acquisition and retention strategy. I had made a point that once we know the profitability of various customers; we can understand who is creating profit and who is creating a loss. When we get this information we should not directly jump to the conclusion that we have to ‘chuck’ all those loss making customers. Initially we may concentrate on the other customers and define the strategy to acquire and make deliberate attempts to retain the profit making customers. We may not take any action on ‘loss making’ customers, if we wish to, as there could be various reasons to do so.

We have seen the ‘whale curve’ diagram, which tells us the information about potential to reach a profitability level that our organization has. The same information can utilized to understand the behavior of the customers and how to use the same to maximize the profits for our organization. I am going to talk about one of the techniques, which I call as a ‘2x 2 diagrams’. It has many other names also. This is nothing but a scatter diagram using two characteristics of customers. Imaginary thresholds are created to distribute the scatter diagram into four quadrants. I found it useful for the reason that once we start using these diagrams, we can understand the reasons for the behavior of the customers and hence, we can have our strategy to tackle those customers for our better performance. I have used possible actions in those diagrams and would like to mention that these could be some actions that you can take but are not limited to those only.

1) Customer deciles

Before going to the 2 x 2 diagram I am going to talk about another way in which the whale curve can be projected. Here we have created deciles of the customers based on their profitability. Once we have created such groups, we can understand who is falling in which group. This is a kind of segmentation based on the profitability. Once this segmentation is done then we can start analyzing the behavior of those customers that are making high profits as well as that are making high losses. The reasons could be buying profitable products, less cost to serve, good payment terms, less special requests, using better channels etc. Using these various reasons we can further segment the deciles in behavior patterns. This kind of detail analysis is useful to relate the behavior of a customer to the profitability that is brought in.

2) 2 x 2 - Customer Revenue and Profit

This is based on the information available on the revenue and profit that is brought in by the customers. We start with the top-right corner (HH). Here the customer buying is high and the profits are also high. This means the customers are not only bringing revenue they are possibly buying the most profitable products or less cost to serve. This type of customers should be retained at any cost. As well analyze their other demographic characteristics and try to acquire similar type of customers in future. The L-H quadrant is where the revenue is low but profits are high. Obviously we should sell more and more with cross sell, up sell efforts, so that we get maximum of the ‘wallet share’ from the customers. The H-L quadrant shows high revenue but not such a great profit. This could be possibly because of the product mix, cost to serve, payment terms etc. We can offer them alternate products that can serve customer’s requirements and are more profitable, we can offer ‘menu based pricing’ for few of the services. We may also remove some the services that are not adding value to the customer. The lat quadrant L-L, is low revenue and low profitability. We should try to move them horizontally to increase the revenue or vertically to increase profits.

3) 2 x 2 – Cost to serve and revenue

From the earlier analysis if we find that the basic reason for difference in profitability is the behavior of the customer and particularly the ‘cost to serve (CTS)’, then we can analyze this behavior and can understand the reasons, which could be the buying patterns, special requests, channels used, changes in schedules, changes in requirements after ordering, knowledge about the product etc. Let us look at the quadrants. The L-L quadrant is where the CTS is low but the revenue is also low. We should try to sell more by cross sell, up sell strategy and keeping the services levels same. The H-L quadrant shows high CTS and low revenue. So the customer is too demanding. Here we can discuss the real requirements of the services that are needed by the customer. First of all remove all the services that are not needed by the customer. We can make our customer understand the more number of orders, frequent changes in the orders and products, special packing needs are adding costs and could be reconsidered. Then from the required one decide which can be offered by default and the other can be pushed to ‘pay per use’. The L-H quadrant is the best quadrant here and we should try to sell more and more to the customers in this quadrant with the similar level of service.

4) 2 x 2 – Loyalty and Profitability

The 2 x 2 diagram of loyalty and customer profitability can be used to allocate and program the marketing campaigns. Here the H-H quadrant shows that the customers are with you for a sufficient amount of time and they are profitable too. You can use these customers as your brand ambassadors. Understand their requirements and keep them happy. The H-L quadrant is happy with your service o products, but they may not be buying with a full potential from you. So you may spend more on cross selling or up selling to them. They may not be buying the most profitable products from you, so you can try to sell alternate products to them. The L-H quadrant is there the customers are profitable but they are not with you for a long time. This could be the customers are new or they like your products but may not like the service. Understand the requirement of those customers and improve the service or try to retain the new customers that are adding to your portfolio. The L-L quadrant may not be looked into initially, unless there is large number of customers lying there or a major portion of revenue is coming from those customers. If this is true then it really a cause of concern for the organization and should be given priority.

In some industries like telecom, the value of ‘probability to churn’ is used instead of loyalty. This is the probability that the customer is likely to terminate using your services. There we can use the similar graph with an attribute ‘churn’ instead of loyalty.

Till now we have seen various attributes for analysis which are objective and historic. But we can also use the attributes which are analytical and predictive. Probability to churn is one of such attributes. We can use similar attribute that is related to profitability and is called as ‘Future profitability’. The profitability we were talking of was the ‘current profitability’. Not all the decisions can be taken based on the current profitability or the historic profitability of the customer. We also have to see the future profitability potential in the customer. The future profitability is actually made up of two parts viz. a) predictive profitability b) potential profitability. Predictive profitability is if you extrapolate the profitability because of the products or the services that the customers are using in future. Potential profitability is the profitability that is brought in because of the customers propensity to buy other products and if they do buy, the profitability band they would fall in.

5) 2 x 2 – Current and future profitability

Here we are putting the current profit v/s the future profit (combination of predictive and potential profit). Profitability solutions provide the information about the current profitability for the customers. If the organization has calculated such ‘current’ profitability for a long period they would have history about the profit. Using this information and other variables statistical models can be created to calculate the future potential of profit. This is important to understand as the customers that are unprofitable today may have potential to be profitable in future and vice-a-versa. The text book example for this is the young doctor who has started his practice recently may not look profitable today but she can have potential to bring profits in future. Also a doctor who is potentially retiring in few years may look profitable today and had provided good results in past may not be a good future potential.

If we look at the L-L quadrant where the current and future profit looks low, you may not want act on them immediately (unless this is a large portion of customers). The L-H quadrant where the current profit is low but there is good potential in future. Here you would like sell more to them by understanding there requirements. For example for the young doctor in the earlier example it may start with the credit products for the clinic and may have potential to buy house and bigger or luxurious cars etc. H-L quadrant is where the current profit is high but does not look great in future. You can maintain the current relationship with them and the marketing spend may not allocated much to them. The best is the H-H quadrant where the current and the future profit look good. The strategy could be to retain these customers at any cost and acquire customers with similar profile.

6) 2 x 2 – Predictive and potential profitability

We can also go deeper in future profitability and see the analysis of predictive profitability against the potential profitability. If we look at L-L quadrant then we can see that if both predictive and potential profitability is going to be low then the overall future profitability is going to be low and we may not wish take immediate action (as always if this is not true for the major section of customer). In the L-H section we can see that the customer would be profitable in future with the same type of products but the behavior shows that the propensity to but other product is good. This may bring future profits for the organization and you may choose them for cross selling other products. H-L section is opposite to this and shows that these customers are unlike to buy other products but they can be profitable with the current products they are having. So the organization may look at up selling. For the H-H section where they would be profitable with current products have great potential for buying new products and could be profitable with those new also. The best segment of customers to have and you can try and spend more on selling them.

We have looked at various types of analysis that we can perform using the profitability information. These attributes could be objective as revenue, loyalty etc. or could be predictive (and hence subjective) like propensity to churn, future profitability. The future historic, current and future profitability information can be used to calculate Customer Lifecycle Value (CLV) and it can also be used for analysis. For this you need correct calculation of Customer profitability and the best way to get is using Activity Based Management Concept.

Finally wish you happy holidays. Hope you have done well in 2009 and best wishes for 2010.

Revenue is means and not end

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.