Arizona State University



CUSTOMER PROFITABILITY

As Critical as Product Profitability

Assign the revenues, expenses, assets, and liabilities to the customers

An Article published in Management Accounting October 1990

BY ROBERT A. HOWELL, CMA, AND STEPHEN R. SOUCY

A key strategic objective for many companies has been to find ways to enhance customer satisfaction. In the 1990s, companies also are going to need to know how well customers satisfy them-that is, how profitable is the customer for the company? In increasingly competitive markets, it is critical to know customer, market, and channel of distribution profitability as well as product profitability.

While much of the current literature on advanced cost management and activity-based costing has focused accountants on alternative cost methodologies, most of the attention has remained on product cost development The advanced costing techniques used to develop product costs are equally applicable to other cost elements, especially customers.

Advanced product cost systems often show highly volatile products with low volume and high scrap and rework to be undercosted significantly. When the costs are compared to the product's revenue stream, product profitability may be negative. The first step is to identify ways to eliminate the product's nonvalue-added expenses. The second step is to evaluate the strategic benefit of the product in the product line. The decision to drop a product, however, is not made solely on the cost input Strategic, product life cycle and customer issues must be taken into consideration. In fact, the most frequently asked question after the development of new product costs is: Who purchases the product?

If a large, high-profit customer purchases a product that is sold below manufacturing cost, the company will not necessarily discontinue the product because the decision-making process is focused on customer profitability, not product profitability. An effective cost management system provides information relevant to the decision made. While accurate product cost information provides the foundation for customer profitability, as companies analyze the purchasing patterns, shipping policies, inventory carrying requirements, and other issues associated with different customers, opportunities become apparent. Many resources of the company are used in different ways by different customers, markets, and channels of distribution. Examples include:

• Volume discounts,

• Commissions,

• Sales support,

• Inventory and distribution support,

• Inventory holding requirements,

• Freight policies,

• Credit and collection support,

• Accounts receivable (days),

• Order entry and customer support, and

• Field service.

Current cost management practice is to classify these costs as period expenses that are managed in total and not assigned to any cost element. In fact, what little customer profitability analysis is done typically uses gross margin excluding sales, general, and administrative (S, G, & A) expenses. The costing activity for most management systems is to assign manufacturing costs to products excluding S, G, & A.

A second issue is that past cost accounting practices have focused on redeveloping product costs, not customer or activity costs. Although GARP does not preclude the assignment of sales, general, and administrative expenses to products, such expenses are rarely assigned to products or customers. Even manufacturing-driven expenses such as cost accounting and senior manufacturing personnel often are treated as administrative expenses and are not assigned to products or product lines. Past practices do not motivate management accountants to determine the cost drivers for S, G, & A expenses.

OBJECTIVE AND APPLICATIONS

The objective of a customer profitability analysis is to assign the revenues, expenses. assets, and liabilities of an organization to the customers who cause them. This analysis is developed by first assigning the costs to products. Customers who purchase high-cost products are charged properly by applying the costs against the customer's mix. The second step is to assign to customers expenses and assets that are driven by the marketing and sales process. The result will be a total cost associated with a customer. This cost is compared with the customer's revenue stream to establish profitability.

As companies attempt to differentiate themselves from their competitors on a service level as well as a product level, it becomes critical for them to understand the customer/cost relationship for two applications: customer management and cost control. In a competitive environment, a business must manage its resources effectively. This may mean investing in a customer that generates high profits or dropping a customer that does not generate enough revenues to justify the expenses required to support it.

In order to make those decisions, companies must understand each customer's profitability. Many companies think their highest-volume customers are their most profitable. Our experience and analysis indicate, however, that it is probably not true. The most profitable more often are those customers just below the "top tier" that have high sales volumes but do not require significant levels of support.

Understanding the cost and value of service activities is a requirement of the 1990s. Markets demand services that often drive business expenses up without a corresponding increase in revenue. Businesses that understand and that can quantify these costs are in the best position to control them. The objective is not to minimize the service, just the cost, through the elimination of nonvalue-added activities.

ANALYSIS TECHNIQUES

The analytic tool used to develop customer and product profitability analysis is Resource Costing. Resource costing simply combines activity analysis and direct costing techniques to assign resources in a logical way to customers or to products.

Companies often overlook the tremendous databases of information within their organization from order entry and freight to customer service systems. For those areas without such information, activity-based costing typically yields a reasonable assignment of costs to the end element The objective is a cost-effective approach that provides the right information on a timely basis to drive action.

A primary reason for the attention to S, G, & A expenses is their growth over the past decade, a reflection of the changing business environment The emphasis on total customer service has driven the basis of competition to services. S, G, & A expenses today represent 2040% of the sales costs in some Fortune 500 companies, and they are growing. One company, for example, from 1985 to 1989 experienced an annual increase in S, G, & A expenses of 26%, versus 7% for manufacturing.

NINE BOX PROFILE

A "nine box profile" is an analytical tool used to gain understanding about a company's customer diversity. As shown in Figures 1 and 2, the nine box analysis applies the principles of GE's strategic business "growth, hold, and harvest" analysis to a company's customer database. The analyses compare sales volume against margin. The opportunity is to shift customers from a low sales/low margin to a high sales/high margin position. To do so requires an understanding of the overall revenue and cost structure of the company and the specific customers to be targeted.

Figure 1 identifies the profile of the number of customers that fall into each category for one company. Ninety-eight (6%) customers fell under the high sales/high margin profile. Two hundred eighty and 824 were defined as medium sales/high margin and low sales/high margin respectively. One hundred eighteen customers were low gross margin companies.

This analysis was constructed using the company's new product costs applied against the customer's sales volume. The questions become focused on the probability that a diverse customer base will draw resources from the vendor consistent with some volume measures (such as units, sales dollars).

Recognizing that the majority of S, G & A costs are not driven by volume Figure 2, which presents the customer sales and gross margin information by profile segment, reinforces the question of customer profitability. If 824 customers in the high margin/low sales category generate $838,000 of gross margin, it needs to be ascertained whether the costs supporting these low-volume customers exceed $1,000 (their average gross margin).

While management is often aware of the 20/80 rule—that is, the top 2096 of customers generate 80% of the volume and the lower 20% of customers generate 80% of the cost—the analysis in Figure 2 quantifies the issues and identifies the area of opportunity. Questions to ask include:

• What resources are dedicated to supporting high-volume customers?

• What does it cost to support low-volume customers?

• Do customers drive different level of activities and cost?

• How do you control the growth in S, G, & A expenses?

• Is the company structured (costs and services) to support a changing and diverse customer base?

COST ASSIGNMENT TECHNIQUES

The first step in implementing a Resource Costing model is to define the company's value chain and determine whether the resource is driven by the research and development, manufacturing, distribution, or sales and marketing process (Figure 3). The next step is to define which re sources are driven by activities designed to support the customer. Those resources then are analyzed and assigned to customers, markets, channels of distribution or activities.

The first option is to assign costs directly to customers. It is always preferable to avoid any allocations if systems are in place to identify the resources consumed by each customer. One company was able to identify more than 60% of the S, G, & A expenses directly with customers. Freights commissions, discounts, and other distribution expenses often are available from the sales and distribution systems. It is also important to a sign assets to customers, such as the average receivable balance and day. by customer.

A company with a large and diver customer base probably will find large differences in the rate at which resources are consumed by different customers. It is very rare that the consumption is a function of sales dollars.

If resources cannot be identified directly with a customer, it is often possible to identify the resource either with different markets to which a company sells or with different channel. distribution used to sell products to markets.

Typically companies provide products to more than one market For ample, an electronics manufacture] may provide products to the automotive, consumer products, military, and electronic games/leisure products markets. Each of these markets requires a different level of support, which often relates to the competitive pressures applied by other companies. The key is to evaluate any resources (personnel especially) that support primarily a specific market.

Many marketing and sales departments are organized by market category. Identifying resources to appropriate markets provides management with much better information regarding market profitability.

A third assignment basis is to establish resources supporting different channels of distribution. A company that sells through many different channels, such as distributors, representatives/agents, direct sales, national account sales, retail outlets/catalogs, or private label will have material differences in the level of resources required to support each channel's sales volume.

Distributors typically require little support from a company. They have established territories in which the company carries on advertising and promotion, but for the most part few staff personnel support distributors, aside from a coordinator or liaison. In exchange, the distributor gets a discounted price indirectly reflecting the services assumed. The other extreme is the direct sales force, which requires manpower, administrative and supervisory support, expenses, and assets (sales offices).

At one manufacturer, a distributor and direct sales channel each had sales of $80 million. The company had a staff of three to support the distributor channel versus 300 to support the direct sales force. Of course, the salesmen were able to bypass the distributor discount by selling at the market price. They provided a return that justified their cost but was not higher than the distributor channel's.

Once costs have been assigned to customers, markets, or channels of distribution, the final step is to assign costs on the basis of activities. Costs assigned to markets or channels of distribution as described above may be assigned to customers based on the activities that drive the cost. For example, salespeople identified to a specific market or region may be assigned to customers based on their sales calls. Many companies keep logs but do not determine the cost of a sales call and therefore do not know whether the resource is being applied effectively. Sales prospects will show up as high sales expense with low or no sales volume, but each situation must be evaluated separately. For some companies, the proper response is to track time spent on sales maintenance calls (existing customers) compared to sales generation calls (new customers).

There may also be some activities that cannot be assigned to a further level of disaggregation (customers, markets, or channels) but that can be identified with specific cost drivers. An example is the order entry department. All orders are received, entered and processed through the order entry system, which supports all markets and channels of distribution. To assign such cost properly, one must establish the "best/most reasonable" cost driver. In many cases this will be either the order itself or the number of line items on the order. This cost then can be re assigned to customers based on their buying patterns.

Cost per order becomes significant when management considers that some markets or channels of distribution (distributors especially) purchase in high-volume lots as contrasted to re tail purchases. In one example, the average order size for a distributor was $50,000 versus $500 for a retail purchaser. The cost to handle an order was approximately $100.

Once resources have been assigned directly to the most appropriate cost category, the next step is to repeat the process of direct and activity-based assignment, reassigning to customers the costs identified by market, channel of distribution, or activity. The assignment approach selected will be a function of three primary issues: information value, cost of collection, and accuracy/reasonableness.

In some cases, it may be possible to break down a department's functions and activities into detailed steps. These resources then may be assigned directly to customers or markets for the purpose of evaluating customer profitability. Such detailed information may give an accurate picture of the variety of activities and which customers and markets consume them, but the cost of obtaining and maintaining the information may be excessive.

MARKETING CONTRIBUTION STATEMENT

A vestige from the manufacturing-dominated era is the classic profit and loss (P&L) statement. The P&L statement subtracts cost of goods sold from revenues to calculate gross profit Sales, general, and administrative expenses (period expenses) then are subtracted to arrive at an operating profit.

Two issues caused one company to reevaluate the traditional P&L. First, the P&L placed most of the emphasis and visibility on cost of sales and gross profit. A marketing organization has very little control over the cost of sales. The expenses that had the greatest impact on operating profit variation were S, G & A, so the first objective was to improve the visibility of these expenses. The second issue was that the flow was inconsistent with the value chain concept. As seen in Figure 3, the flow of resources in the business cycle starts with marketing and product development and continues with manufacturing, distribution, and sales. It was determined that a profit and loss statement structured along the value chain would be more useful to management.

Table 1 shows an example of a marketing profit and loss statement, also referred to as the "value chain P&L." Its objective is to heighten the visibility of customer-driven resources and to recognize their timing in a company's value chain.

The statement starts with list revenue: unit sales times list price. Markets and channels of distribution receive varying discounts off list price because of volume and the services (distribution, inventory) they provide. Most companies review the comparative return on sales using gross sales: unit sales times invoiced price. This practice distorts the return information in favor of those markets and channels that receive larger discount but consume fewer sales, general, and administrative expenses. The lower sales base naturally provides a higher return for a given profit level.

The second issue for list revenue the materiality of the discounts. List revenue is set at an arbitrary level, but the discounts are hidden costs. Managing this expense can yield a bottom line impact greater than any other single line item.

Other discounts (sales) and customer, market, and channel of distribution costs then are subtracted from gross revenue to calculate a market contribution. The total market or channel costs reflect the cost to market, sell, and deliver the products. The market contribution reports the profit available to cover the cost of the products.

Finally, the cost of products and other manufacturing expenses are subtracted from the marketing contribution to calculate a net margin for each market and channel of distribution.

Because the information is built at the customer level, the marketing P&L is a compilation of each market's customer profitability statement. An example of a customer profitability statement is shown in Figure 4. The statement presents the major sales, general. and administrative expenses and highlights the amount of resources consumed by each customer.

The value of any information system ultimately is determined by how it is used. While the use of resource- and activity-based costing techniques revolutionizes the quality of management information, the key is that it drives positive management actions. A customer profitability study will highlight the customers and markets that make and fail to make money. The most important piece of information is understanding where a company is profitable and vulnerable to competition and unprofitable and vulnerable to shareholder dissatisfaction.

MICRO VERSUS MACRO STRATEGIES

The customer profitability analysis allows management to prepare a micro strategy to increase the profitability of each customer. For instance. Joe's Warehouse (Figure 4) is marginally profitable. One of the major expense items is the freight costs. In this case, the customer purchases inconsistently and often requires special handling through the distribution system. This characteristic also drives customer service expenses. The solution is to work with the customer to reduce expenses. The company promised the customer 24-hour emergency delivery on any product In return, the customer agreed to provide a weekly requirements list that allowed the company to take advantage of its distribution system's cost efficiency and reduce overall costs.

On a macro level, a company can evaluate channel of distribution and market profitability. Table 1 breaks down the company's profit statement by channel of distribution (direct, dealers, and distributors) and market (construction, auto, wood products, and packaging). It shows that one significant opportunity would be to improve the profitability of the packaging market The cost issue appears to be in the channel and market costs. The underlying activity analysis will provide the management with the information to identify what activities the packaging market is consuming and what costs are required to support those activities. This information is a basis for cost reduction and improved market and company profitability.

CUSTOMER SATISFACTION YIELDS PROFITS

Companies need to place a premium on every sales dollar coming into the business. Companies too often react to information regarding product or market profitability by dropping unprofitable business. Instead, management should seize the opportunity to understand why a customer or market is unprofitable. By analyzing costs directly assigned to a customer and the activities a customer drives (orders, sales credits, customer support), a company should be able to understand the reason a customer is unprofitable and take corrective measures.

In many companies, there is an almost gravitational pull of resources to the largest customers. Instead, management needs to reassign resources to activities and customers that will yield more sales, greater customer service, and, ultimately, higher profits. The aim is to enhance customer value without increasing costs. Customers will pay only for product and services that provide an increased benefit to them. In many cases, resources directed at some customers exceed that point of diminishing returns.

Few companies have management information that provides managers with a clear understanding of which customers and markets are profitable. As services (sales, general, and administrative costs) become a more significant part of companies' competitive advantage and cost structure, the management tools must respond. The effective use of customer profitability information will greatly enhance a company's ability to direct the right services to the right customer. The goal is to increase customer satisfaction so as to obtain greater returns.

Robert A. Howell, DBA; CMA, is clinical professor of management and accounting, New York University, and president of Howell Management Corp. Stephen R Soucy, MBA, CPA, is a senior consultant at Howell Management Corp.

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