Real World Customer Profitability Management
"Real World"
Customer Profitability Management
Gordon Koury
Foris Consulting
"We've seen our volume go up by 15% over last year, we have more customers than ever. I don't understand why our net profit hasn't increased"
--Anonymous Wholesale Distributor VP of Sales
Ok, so not many of us have seen sales go up in the past year or two, but it brings up a great question. We control our costs, try to grow sales, yet all too frequently don't get the bottom line results we hoped for. Kaplan and Narayanan, of Harvard Business School, argue in their white paper Customer Profitability Measurement and Management that for many companies, the most profitable 20% of the customers produce over 200% of the net profit, with the remaining 80% contributing little and actually consuming profits.
Customer Profitability Management is a concept that can help with this. It starts out with a financial model that can tell you the profitability of any existing customer or new piece of business. The model should use Activity-Based Costing (ABC) allocations and feature both full-cost and variable cost assessments, and allow you to easily look at options for improving profitability. It should tell you the Net Profit and Return on Investment (ROI) percentage for a customer, considering both variable and fixed costs. It must have the capability to allow cost allocations to be easily modified to reflect special customer requirements and unique product economics. Don't be discouraged if you do not have the in-house capability to develop the financial model. There are many people who can do that for you. There are also some easy to use models that have been refined while in use for several years which are available to you. My Profit Master? tool is one of those.
Once you have the model, the hard work starts; you need to figure out what to do with this information and implement a process of continual improvement. What do you do about existing customers that appear to be unprofitable? How profitable should new customer opportunities be? Who is responsible for all this?
Fortunately, the implementation of this process can be done in several stages.
It's important to recognize that new customers are the life blood of any business, so start by using the model to evaluate major new opportunities. In evaluating new business and/or new customers you want to be sure that the new sales will generate incremental net profit and cover cost of capital. New opportunities, especially larger ones, are often price competitive. It is important to set a minimum hurdle for profitability for new business to assure that any opportunity covers all variable costs and makes contributions to fixed costs.
Customers that have higher credit risks or are not strategic to your business (they don't fall into one of your primary target markets) should have higher hurdles. This helps to keep you growing with financially sound companies that match your core capabilities. As your managers use the model on new business, they'll understand the factors (I call them "Profit Levers") that can improve the profitability of business-for wholesalers, these include margin, order size, payment habits, inventory days, lines per order and others.
After you've got some experience with evaluating new business profitability, it's time to tackle the existing customers. You should stratify customers into one of four categories based on their potential sales volume and their present profitability. Each one of these strata has different strategies that are appropriate. The Chart above illustrates this concept and the strategies that are appropriate.
Your obvious starting point with this process is your largest customers, who will be in one of the right-hand quadrants. Since they're large, you can devote time and energy to just a few of these and have a significant impact. A great way to start is to evaluate the top 5 accounts in each sales representative's territory, and come up with an action plan on just one or two of their accounts. The action plan can be to increase total volume, add drop-ship business, improve order size, etc. Some very large, price-competitive customers may require special cost-reduction efforts to get an acceptable ROI. In some cases, you may decide to exit a particularly difficult and unprofitable customer to free up resources for more promising opportunities.
The next order of business is to identify the customers in the bottom left quadrant (Low-ROI, Low-Potential). There are going to be a lot of these accounts. You'll want to automate this process by dumping a download of all accounts into your ABC model and then just sorting the low profit, low volume accounts to the top. These are not usually "house" accounts, as most wholesalers have implemented pricing and order size rules for such customers (although one company I worked with recently had implemented order minimums so low that they had hundreds of customers who averaged less than $30 gross profit per order!) These are typically customers who have a sales rep calling on them, but don't have the stringent rules for price and order size. What you do with this group of accounts depends on the total volume and business practices. You don't want a wholesale "firing" of customers who appear unprofitable, as there are very likely some hidden gems in this grouping (accounts that really belong in the Low-ROI, High-Potential quadrant). I advocate rapid action on a limited number of the worst of these accounts (order size and pricing guidelines) and a thoughtful strategy for the rest to grow the volume and improve profitability. While it's tempting to try to tackle the whole grouping at once, my experience has been that several smaller moves are more effective than a single large one.
Finally, spend some time evaluating the customers in the top quadrant-High ROI, Low-Volume. There are likely to be a lot of these customers in number. Look for natural customer segments and consider how to cost-effectively attract more customers in these segments and expand product opportunities. Again, there are going to be hidden gems in this grouping that offer significant additional volume potential if targeted.
Before you know it, you'll have an ongoing process of evaluating and continually improving customer profitability. There are several major tools you can use in conjunction with this process, these include:
- "Business Reviews" with large (current or potential), low profit accounts - You want to detail all the great things you've done for them and ask for more volume and opportunities. This is amazingly successful if done professionally. Your organization should absolutely have a template PowerPoint presentation ready to load with data for such customers.
- Pricing "Lift" tools - These are programs that do sophisticated evaluations on price/volume ratios on all your customers to find where pricing on specific customers is lower than other customers with similar volumes. They recommend price changes for specific customers on specific products. This is not a quick fix, but there are numerous companies out there offering such service, some at no upfront cost to you. We work with the Next Horizon? pricing lift product offered by Zyman group, and have implemented it dozens of times with great results.
- Sales training - Your sales force may lack the sophistication or skills to close larger opportunities or negotiate better terms with customers. They may be primarily "price" or "relationship" sellers. If you can train them to look to provide solutions to customers, and give them some basic skills and commit to some "batting practice" to assure that they really develop the new skills, you can get them in front of more and larger opportunities.
The combination of the profitability evaluation tool, a bias for getting new business in the door, and an ongoing process of looking at the least profitable customers will help assure your company continued sales growth and continuous profitability improvement. I do have a couple of notes of caution on the process, though. First, I encourage you to avoid "qualitative" labeling of customers (e.g., low-profit customers are "bad"). From my perspective, anyone wanting to give my company business is "good", so I prefer quantitative labels like "Low ROI" accounts. Second, be sure that you are being smart about decisions that could drive volume away; it's important to be clear on what the true incremental impact of volume changes will be. You can't shrink your way to profitability. Third, I counsel that you avoid the temptation to try to make every order profitable. You have certain customer strata where you'll likely want to make every transaction profitable, but you need to be strategic about where to focus on order profitability and where to focus on relationship profitability. Finally, take several small steps rather than one giant one. It's all too easy to see the giant initiative fail, as it's too overwhelming for a staff that already has more than enough to do.
Gordon Koury is a Partner with Foris Consulting. He has spent 20 years in the wholesale distribution business in diverse roles including information technology, division management, strategic planning, operations, finance, turnarounds, business startups, and acquisitions/mergers. He has taught Finance & Strategy in formal management development programs. He has Bachelor's and Master's Degrees in Business Administration. His work has been published in industry magazines, turnaround management publications and is featured in the "Distance Learning Program" sponsored by Accenture's Supply Chain Academy. He can be contacted at www.forisconsult.com.
Gordon Koury is a Partner with Foris Consulting. He has spent 20 years in the wholesale distribution business in diverse roles including information technology, division management, strategic planning, operations, finance, turnarounds, business startups, and acquisitions/mergers. He has taught Finance & Strategy in formal management development programs. He has Bachelor's and Master's Degrees in Business Administration. His work has been published in industry magazines, turnaround management publications and numerous webinars. He can be contacted at www.forisconsult.com.
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