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Chapter 6 - Customer Profitability Analysis

Companies not only incur the production costs of its products, but also incur the
marketing, selling, distribution, and administrative (MSDA) costs. These expenses are
usually not dependent on the product mix and volume produced, thus it is not traceable to
the production cost. Most of the expenses are incurred to market and sell products to the
customers through multiple channels of distribution. MSDA expenses depend on the
demands from customers by products for factory resources, customers, and channels.
Financial and nonfinancial measurement are needed by the management to determine the
profitability of the customers (revenue generated from a customer less the cost to serve
the customer) through managing the customers as using only financial measurement may
sometimes improving the short-term performance but will harm the long-term
performance.
As each customer of a company will incur different MSDA cost for example different
type and quantity order and sometimes customized orders with different delivery
agreement, company should assign the MSDA expenses to each customer differently.
There are some characteristics that will differ the high cost-to-serve customers with the
low cost-to-serve customers. High cost-to-serve customers usually order custom products
in small quantities any time they need the products, the delivery will be customized and
the requirement will be changed, manual processing is needed which means that the order
error rates is high, needs a large amount of pre-sales support (marketing, sales resources,
and technical) as well as large amount of post-sales support (installation, warranty,
training, service), and pay slowly (high accounts receivable). While the low cost-to-serve
customers are usually ordering the standard products in big quantities regularly, using the
standard delivery procedure so there is no change in the requirement, using electronic
processing (EDI) so there is no defect, incurring little to no pre-sales support and no post-
sales support, and the customers usually pay on time (have low accounts receivable).
When companies classify their customers and products from highest to lowest
selling, they commonly found that the top-selling
20% of products or customers make up the 80%
of the total sales. The lowest volume 40% of
customers and products are also usually
contribute 1% of the total sales. Yet, the findings
are not applicable to the profits. Whale curve, a
graph of cumulative profits versus customers
based on the ABC customer profitability analysis,
is used to analyze the profit. The most profitable
20% of customers produce 180% of total profits;
the peak or hump of the whale above the sea
level. The middle 60% of customers are around Figure 1. Whale Curve
the break-even point and the rest 20% of least profitable customers lose 80% of total
profits.
Service companies have to be more focused to customers cost and profitability than
the manufacturing ones because the service companies demand for the resources is more
customer driven. Manufacturing companies costs are more customer independent as they
can easily calculate the production cost without taking into account how the customers
use the products, and only the MSDA expenses will be dependent on the customers. In
service companies, the behavior of the customers will establish the quantity and type of
demand for the resources to produce and deliver the service. Measuring the revenues and
costs at the customer level will provide more relevant and useful information than the
product level costing.
There are some options for the companies to change the breakeven or loss
customers into profitable customers: improve the production, selling, delivering, and
servicing process to the customers, use menu-based pricing to provide options for
customers to use and pay the selected services, upgrade the customer relationship to
increase margin and lower the cost to serve customers, apply more control to grant
discount and allowances. Managers should analyze the internal operations to know the
area to be improved to minimize the cost to serve customers. When customers are
preferring small order sizes, companies should decrease the costs of setup and order
handling processes, but when the customers like to order high variety products,
companies can use technology to improve the linkages from design to production so more
variety and customization is possible without additional cost. Using activity-based pricing,
companies will set a base price for producing and delivering a standard quantity for every
standard product. The companies will then charge more price to the customers for every
additional service demanded by each customer. This system will benefit both suppliers and
customers because it will lower the total supply chain costs as it prices orders not
products. Companies can also utilize the customer relationships to persuade the
customers to use wider range of the companies products and services so that the margins
will also increase. Setting a minimum order sizes for unprofitable customers can be used
as well to minimize the loss from unprofitable customers. Moreover, some customers may
be unprofitable since it is only the beginning of the relationship with the company as the
company may incur high acquisition cost for the customers while the order is not enough
to cover the cost. Yet, the customers might turn into profitable ones in the future.
Big discounts and special allowances given to the customers may lead into
breakeven or unprofitable customers. The pricing waterfall chart will illustrate the multiple
revenue leaks from the list price caused by special allowances and discounts granted to
get the order and build customer loyalty. The quantity of discounts given to customers in
the prior years have no relations with the volume or the cost-to-serve individual
customers. Company will be able to create better discount policy to give more discount to
low-cost-to-serve customers and give less discount to high-cost-to-serve customers
through activity-based costing systems (tracing all revenue deductions, promotional costs
and allowances to individual customers and orders to calculate actual profit or loss).
Company can categorize its customers into fur quadrants: high profit and low cost-to-
serve, high profit and high cost-to-serve, low profit and low cost-to-serve, low profit and
high cost-to-serve; thus, company can develop more specific way to improve the
profitability (menu-based pricing, product mix rationalization, elimination of discounts and
allowances, and moving to larger orders and more standard packaging and distribution).
Salespersons incentives are usually linked to revenues as it is a simple measure,
easy to calculate, align with the mission to generate sales, therefore the salespersons tend
to neglect the cost incurred to make the sales such as the MSDA expenses. With the time-
driven ABC system, company can trace the MSDA costs and actual product margins to
individual customers to analyze the customer-specific profit and loss statements.
Customer profits should be the base to establish the salespeoples incentives. Salespeople
can receive breakeven or even loss order if the transactions provide opportunity for profits
in the future transactions. Recognizing the characteristics of profitable customers, can
help the company to focus the marketing on the profitable customer segments. The life-
cycle profitability will help in recognizing the cross-sectional variation of demands and the
longitudinal variation, it tracks the acquiring cost and profits earned each year for every
customer. Critical parameters to calculate customer lifetime strategy are initial acquisition
cost, profits and losses earned each year, any additional costs incurred to retain
customers every year, and the duration of the relationship. To calculate the customer
lifetime value:
t=n t=n
(M t c t ) o (M c )
CLV = t
Initial acquisition cost CLV = Acquisition cost
t =1 (1+i) t =1 i+(1r)
Companies can use nonfinancial metrics such as customer satisfaction, customer
loyalty, and the willingness of the customer to promote to measure the customer
profitability. Customer satisfaction can be achieved when the product or service provided
has met the customers expectation. But it does not mean that the customer will be loyal
(keep repurchasing the products, persuading others to buy the products, or willing to pay
more). Therefore, the most important metric is how willing the customer to promote the
products (measured by net promoter score = % of promoters less % of detractors).
Reference:
A.A. Atkinson, R.S. Kaplan, E.M. Matsumura, and S.M. Young. 2012. Management
Accounting: Information for Decision-Making and Strategy Execution. Upper Saddle River:
Pearson Prentice Hall