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Customer Profitability Analysis GPG 37 March 02 PDF
Customer Profitability Analysis GPG 37 March 02 PDF
Customer
profitability
analysis
MARCH 2002
Introduction
First Union recognises that not all customers ■ understanding and analysing customer
are the same. Though customer satisfaction is profitability;
important, the goal is to increase customer ■ maintaining and increasing customer prof-
and corporate profitability. Customer prof- itability; and
itability analysis is evolving as a basis for ■ turning unprofitable customers into prof-
determining the level of service that cus- itable ones.
tomers receive and the level of their fees.
First Union estimates that its ‘Einstein’ sys- The guideline does not present a detailed
tem will add at least $100 million to its examination of an all-inclusive analytical
annual revenue. tool for determining customer profitability. It
does, however, provide the tools that permit
About half of that will come from extra fees the analysis of customer profitability and the
and other revenue from unprofitable cus- implementation of programs to improve
tomers, while the rest will flow from pamper- these profits.
ing preferred customers who might otherwise
leave the bank. First Union is not alone in Over the last 10 years, strategic cost manage-
this effort; an increasing number of compa- ment and activity-based costing (ABC) have
nies employ the same procedures to deter- created a framework for companies to exam-
mine profitable and unprofitable customers ine more closely the drivers (or causes) of
and manage customer relationships to their costs in order to improve management
improve corporate profits. decisions and corporate profitability.
Companies initially focused on product prof-
The example above is one of many that itability are now using ABC and other models
demonstrate the increased corporate focus on to examine further the profitability of distrib-
customers and their profitability. This guide- ution channels and customers.
Simultaneously, many companies are explor- tools, can direct managerial attention to
ing the drivers of profit and success through areas of improvement that can lead to greater
the use of the balanced scorecard. Whichever customer and corporate profits. An ABC sys-
model is used initially, determining customer tem is not the only means to measure cus-
profitability requires a clearer understanding tomer profitability, but merely one of several
of the causes of the revenues and the costs. tools that can be used.1
This guideline provides details of company
experiences in examining the causal relation- Since ABC provides a better understanding of
ships between the drivers of customer satis- the profitability of products and services,
faction and customer revenues as well as in companies have started to use the same
measuring the profitability and costs of ser- approach to understand the profitability of
vicing existing customers. Comprehensive customers. Following an ABC analysis, com-
systems that identify, measure, analyse and panies can examine the customer profitabili-
manage customer profitability and its drivers ty information and determine how to man-
are only now being developed (Epstein, age customer relationships in order to
Kumar, and Westbrook 1999). increase customer satisfaction and the prof-
itability of both individual customers and
Expanding global competition is one reason customer segments. The ABC analysis often
behind the increased concern for customer provides information leading to such
profitability. Companies worldwide are being improved relationships that the profitability
pressured to become more customer focused of both the company and its customers is
and to increase shareholder value. Customer increased.
profitability analysis is a useful tool in both
areas. Companies have been using improved infor-
mation technology and large databases to
Increasing customer focus help refine marketing efforts. Marketing tools
Many companies are convinced that improv- and IT systems now permit companies to tar-
ing corporate profitability requires more cus- get individual customers and customer
tomer contact and closer customer relation- groups with pinpoint accuracy and to deter-
ships. Further, many marketing professionals mine whether or not a customer spends
have directed recent attention to increasing enough to warrant the marketing effort. At
customer satisfaction, primarily examining Federal Express, for example, customers who
the links between overall satisfaction and spend a lot of money but demand little cus-
tomer service and marketing investment are
treated differently than those who spend just
as much but cost more to maintain. In addi-
tion, the company no longer markets aggres-
Expanding global competition is sively to those customers who spend little
one reason behind the increased and show few signs of spending more in the
future. This change in strategy has substan-
concern for customer profitability tially reduced costs.
losing customers. Thirty thousand of them, ed to lose another 325,000 customers before
about 3% of the bank’s total clients, closed the end of 1998. The company determined
their accounts. Some customers became more that the cost to service these customers was
profitable by increasing their account balances greater than the revenue being generated and
to avoid the fee or by visiting ATMs instead of decided to cut its losses.2
the tellers. While First Chicago lost some
3
customers, it was also able to improve the Customer satisfaction, loyalty, and value
profitability of most. Understanding customer Recently, many companies have looked to
profitability requires an understanding of the the service profit chain model (see Figure 1
costs of customer service. below) to help them understand the causal
relationships between employees and cus-
Paging Network, Inc., a paging service tomers and the impact on revenue growth
provider located in Dallas, initially gave away and firm profitability. Among the relation-
its pagers to increase market share. After ships that have been documented and mea-
analysing data on individual customers the sured in this model are:
company determined that many customers
were too costly to service profitably. It sent ■ customer satisfaction and loyalty;
letters to marginal customers increasing the ■ the value of services and goods delivered to
rates and subsequently lost 138,000 cus- customers;
tomers in the third quarter of 1998. Of the ■ employee satisfaction, loyalty, and produc-
remaining 10.2 million subscribers, it expect- tivity; and
Internal External
Loyalty
Revenue
Satisfaction growth
Productivity
and Service
Satisfaction Loyalty
Employees Output value
quality Profitability
Capability
Service
quality
Adapted and reprinted by permission of Harvard Business Review. An exhibit from ‘Putting the Service Profit Chain to Work’ by James L.
Heskett, Thomas O. Jones, Gary W. Loveman, W. Earl Sasser, Jr., and Leonard A. Schlesinger, March –April 1994, p.166. Copyright © 1994
by the President and Fellows of Harvard College, all rights reserved.
■ employee capabilities that aid in delivering ny’s products and services are influential.
outstanding results to customers. (Heskett, Organisations place great value on their cus-
Sasser, and Schlesinger 1997:18). tomers and depend on them for long-term
viability. Five fundamental customer value
Finance and accounting professionals must axioms apply to most companies and help
understand these relationships to be able to explain a customer’s value to the firm:
develop links between:
■ the customer defines the product quality,
■ the human resource focus on employees; service quality and acceptable price;
■ the production focus on operations; ■ customers form their expectations relative
■ the marketing focus on revenues; and to competitive alternatives;
■ the traditional accounting focus on costs. ■ customer expectations change, usually
upward;
The integration provides significant value to ■ product and service quality must extend
marketing and general management execu- throughout the value chain; and
tives as they try to improve customer and ■ maximising customer value requires that
corporate profitability. Some of the relation- the whole organisation be involved.
ships between customers and employees are (SMAC 1995:7-8).
self-reinforcing, satisfied employees contribute
to customer satisfaction, and satisfied cus- Customer satisfaction
tomers contribute to employee satisfaction. Customer satisfaction is the perception that
the products or services received meet or
To a customer, value involves the expected exceed the expectation of the product or ser-
benefits and costs of a product or service, vice. This is not an isolated phenomenon
and the customer’s perception is of signifi- and is often considered within the context
cant relevance. The expected benefits are of loyalty, retention, and profitability.
derived from the product and service attrib- Researchers have shown that a causal rela-
utes and the expected costs include the trans- tionship exists between customer satisfac-
action costs, the life-cycle costs, and the risk. tion and customer loyalty and that this rela-
Transaction costs are typically the immediate tionship often leads to increases in prof-
financial outlay, which includes the price, itability.
delivery, and instal-
lation costs. The life-
cycle costs are the FIGURE 2 WHY CUSTOMERS ARE MORE PROFITABLE OVER TIME
additional expected
costs that the cus-
tomer will incur over Profit from price premium
the life of the prod-
uct. The risk is asso-
Profit from referrals
Company profit*
Many companies have long held the view Ford Motor Company recently estimated the
that customer satisfaction is a prerequisite for value of customer retention (ie, the percent-
long-term profitability. Increased competition age of the firm’s customers buying a Ford as
and maturing markets have made the issue of the next car). Ford’s stated goal was to
customer satisfaction more significant. increase customer retention from 60% to 80%
Further, the focus of sales and marketing has as the company was convinced that each
often shifted from an offensive strategy of additional percentage point of customer
finding new customers to a defensive strategy retention was worth $100 million in profits.
of retaining current customers and increasing
the volume of their purchases (Fornell, Ryan, Software producer Intuit found the worth of a
and Westbrook 1990:14). customer to be far greater than the customer’s
original purchase of Quicken software. The
A study by American Express Travel demon- revenue is $30 initially, but increases to sever-
strated the relationship between customer al hundred dollars or more as satisfied cus-
satisfaction and profitability. After establish- tomers buy additional products. The revenues
ing that business travellers from large compa- continue over time while the costs of cus-
nies were the most profitable customers, tomer service decrease.
The model in Figure 3 (below) shows the rela- then develop key performance indicators to
tionships between satisfaction and loyalty for link to corporate, business unit, and func-
these four groups in different competitive tional strategies. The balanced scorecard
environments. includes financial and non-financial metrics
that incorporate both lagging and leading
This model also suggests strategies for invest- indicators of performance. The four perspec-
ing in customer satisfaction improvements tives of the balanced scorecard are:
for the greatest amount of profit improve-
ment. The ‘apostle’ group of customers and ■ financial – to succeed financially, how
those who are close to being ‘apostles’ should should the organisation appear to its share-
be cultivated and maintained as a valuable holders?
resource. This group includes satisfied cus- ■ customer – to achieve its vision, how
tomers who also tell others about the prod- should the organisation appear to its cus-
uct or service, and can be considered a part tomers?
of the sales force and a valuable marketing ■ internal business process – to satisfy share-
tool. On the other end, the ‘terrorist’ group holders and customers, at what business
can have a detrimental effect on the compa- processes must the organisation excel? and
ny, since they are vocal in their dissatisfac- ■ learning and growth – to achieve the vision,
tion. Efforts to turn this type of customer how will the organisation sustain its ability
around often prove very beneficial. to change and improve? (Kaplan and
Norton.1996: 9).
Balanced scorecard and the value
proposition In the customer perspective (see Figure 4 on
The balanced scorecard is a strategic manage- page 10), the organisation identifies the cus-
ment system that focuses on the drivers of tomer and market segments that will deliver
profit, success, and value in organisations. It the revenue component of the company’s
looks at four organisational perspectives and financial objectives. The customer perspec-
the causal links among them. In the balanced tive enables the firm to fine-tune its core cus-
scorecard, companies identify and measure tomer outcome measures – satisfaction, loyal-
the drivers of future performance through ty, retention, acquisition, and profitability –
the identification of key success factors, and to targeted customers and market segments.
"Hostages" "Apostles"
Non-competitive zone Highly competitive zone
high
Regular monopoly local telephone Commoditisation or
or few substitutes low differentiation
Dominant brand equity Consumer indifference
High cost of switching airlines Many substitutes
Powerful loyalty program personal Low cost of switching
Loyalty
hospitals
automobiles
"Terrorists" "Mercenaries"
low
1 2 3 4 5
completely completely
dissatisfied satisfied
satisfaction
Note: Words in quotation marks have been added by the authors to describe customers exhibiting varying degrees of satisfaction and loyalty. Adapted
and reprinted by permission of the Harvard Business Review. An exhibit from ‘Why Satisfied Customers Defect’ by Thomas O. Jones and W. Earl
Sasser, Jr., November-December 1995, p.91. Copyright © 1995 by the President and Fellows of Harvard College; all rights reserved.
Figure 4 (below) suggests that there are causal among the customers. The value proposition
relationships within the core measurement (see Figure 5 opposite) is the primary concept
group. The relationships among customer for understanding the drivers of satisfaction,
satisfaction, customer retention, and cus- retention, acquisition, and market share.
tomer acquisition have a direct effect on the While these propositions will vary significant-
profitability of the firm, reducing customer ly for different organisations, typically the fol-
costs and increasing revenues. lowing common attributes are included:
Market
share
Customer
satisfaction
Market Reflects the proportion of business in a given market (in terms of number of customers,
share dollars spent, or unit volume sold) that a business unit sells.
Customer Measures, in absolute or relative terms, the rate at which a business unit attracts or wins
acquisition new customers or business.
Customer Tracks, in absolute or relative terms, the rate at which a business unit retains or main-
retention tains ongoing relationships with its customers.
Customer Assesses the satisfaction level of customers along specific performance criteria within the
satisfaction value proposition.
Customer Measures the net profit of a customer, or a segment, after allowing for the unique
profitability expenses required to support that customer.
The customer value proposition communi- The Sears model was based on the organisa-
cates throughout the organisation the expec- tional objectives that were developed to
tations for customer satisfaction, customer begin a transformation of the company. The
loyalty, and consequently customer prof- desire was for Sears to be “a compelling place
itability. The proposition is a compilation of to work, to shop and to invest”. The initial
what the company believes the customer val- model included objectives and measures (see
ues and how the firm can deliver this value, Figure 6 on page 12). Total performance indi-
as well as a statement about how the compa- cators (TPI) were developed to test and refine
ny adds value to its customers through its the model and assumptions about causal
products and services. An understanding of linkages between employee attitude and cus-
the customer value proposition is critical for tomer satisfaction and profitability were
both the balanced scorecard model and cus- refined. As a result of this process, a new
tomer profitability analysis. model was developed and tested, and
became operational company-wide with the
Benefit of increasing profitability through 300,000 Sears employees.
understanding of causal relationships
In 1992, Sears, Roebuck & Co., the large Sears’ management believed that this revised
retailer, lost almost $4 billion. By 1997 it model (see Figure 7 on page 12) indicated
reported a profit of $1.5 billion. While there measurable causal linkages in the relation-
are many reasons for the change, the Sears ship of employees to customers, and that
managers believed that it was due primarily theses linkages resulted in increased profit.
to a change in the culture of their business. Sears managers continued to seek detailed
Sears believed that there was a gap between information from individual customers
strategy and day-to-day operations that left regarding their “shopping experiences” in
Customer
recommendations
Attitude Service
about the job helpfulness
Employee Customer
retention retention
order to learn more about customer satisfac- becomes more diverse, it becomes more diffi-
tion and retention, which they believed cult to allocate overhead costs accurately.
directly affected profitability. When employ-
ees saw how their actions with customers Activity-based costing assumes that activities
mattered to the company, positive attitudes cause costs and that product, services and
were reinforced and the linkage was identi- customers are the reasons for the activities.
fied between improved attitude towards the ABC focuses on determining what causes
firm and its customers and overall improved
profitability of the company.
more easily determined through the use of Customer profitability analysis has become
ABC, since the costs can be driven directly to an important new management accounting
individual customers, some of whom place tool based on a recognition that each cus-
more demands on the company than others. tomer is different and that each
Some may require special orders, purchase dollar/pound of revenue does not contribute
just-in-time inventory, or have special deliv- equally to the firm’s profitability. Customers
ery requirements, each of these has a cost utilise company resources differently; thus
that can be allocated to the specific customer customer costs vary from one customer to
another. The following issues should be con-
sidered when analysing customer profitabili-
ty:
ABC can help identify customer
■ how to develop reliable customer revenue
activities and track those costs that and customer cost information;
■ how to recognise future downstream costs
are allocated to specific customers of customers;
■ how to incorporate a multi-period horizon
in the analysis; and
■ how to recognise different drivers of cus-
using activity-based drivers. Understanding tomer costs. (Foster, Gupta and Sjoblom
the needs and costs of each client, and how 1996:10).
each impacts corporate profitability, can help
to determine the level of customer service This requires a broader examination of the
that will benefit both the customer and the costs associated with customer service. For
company. The special needs of both large and example, post-sale customer service costs
small customers can be accommodated must be included in any analysis of customer
through a better understanding of the drivers costs. Some customers require substantially
of both the revenues and the costs associated more post-sale service than others. In addi-
with each customer (Kaplan and Cooper tion, future environmental liabilities related
1998:181). to the sales of current products are addition-
al downstream costs that must be included.
Customer profitability analysis With management’s increased focus on cus-
Typically traditional cost accounting is not tomers, this analysis can provide forward-
able to identify product and service costs or looking information about individual cus-
distribution and delivery costs for individual tomers and customer segments and more
customers. ABC can help identify customer broadly examine both the revenues and
activities and track those costs that are allo- costs related to customer transactions.
cated to specific customers. This can provide Revenues can vary among customers due to
management with unique information about variations in volume levels, and differences
customers and customer segments. The bene- in price structures, products and services.
fits include:
Costs can also vary depending on how cus-
■ protecting existing highly profitable cus- tomers use the company’s resources such as
tomers; marketing, distribution, and customer service.
■ repricing expensive services, based on cost- Unless a complete analysis of the benefits and
to-serve; costs of customer relationships is undertaken,
■ discounting to gain business with low cost- companies will unknowingly continue to ser-
to-serve customers; vice unprofitable customers. Only after a
■ negotiating win-win relationships that thorough analysis of the costs and benefits
lower service costs to co-operative cus- can a firm decide which customers to service
tomers; and strategically price its products and ser-
■ conceding permanent loss customers to vices.
competitors; and
■ attempting to capture high-profit cus- There are many costs that are often hidden
tomers from competitors (Kaplan and within the production, support, marketing,
Cooper, 1998:181). and general administrative areas. To better
1) Technical design specialists’ (TDS) time spent log 1) Determining the cus-
salaries and benefits tomer’s hardware and
2) LD telephone expense calls made invoice software needs; installation
3) Travel expenses distance and time invoice/log procedures and cost esti-
4) Computer costs including software time used log mation thereof
5) Sales support/occupancy none allocation using TDS’s 2) Researching new products
cost allocation
6) TS manager’s salary and benefits none
traceable time
service representatives, who were at the front Whether customer-specific costs are neces-
line in the training function and formed a sary and/or can be determined depends on
liaison between the company, its customers several factors, including the fragmentation
and the engineers who designed the sys- of the customer base, the cost structure of
tems, were interviewed. The company was the company, and the existence of the neces-
then able to identify seven different training sary information infrastructure. Analysis can
activities and resource uses, along with be crude and simple and even incomplete,
potential cost drivers. The estimation of cus- yet still effective at providing valuable cus-
tomer service training costs through the use tomer profitability information.
of ABC improved the company’s under-
standing of the profitability of its different Some customer models have been developed
customers. to provide companies with a framework to
analyse the pricing of different services information from its ABC customer and
for different types of customers. An store level profit and loss statements to
example of such a model can be seen in determine what its customers valued
Figure 9 (below). and wanted and then developed “menu-
based pricing”. The company began
This customer-based ABC model facili- charging fees for special services that
tates company analysis of how to be a were desired by some but not all cus-
provider to customers that desire low tomers. In this way it developed a base
cost products and minimal service and level of service that all customers
also how to provide services to high received, plus service-based pricing for
margin, high cost-to-service customers. specially desired services. Further savings
Thus profitable customers can be to consumers were obtained through
acquired and retained in many different negotiations with retailers for lower
ways. Increasingly, companies are utilis- prices on Pillsbury products and for spe-
ing menu-based pricing where the cost cial merchandising and promotion of its
to the customer is determined by both products (Kaplan and Cooper 1998:198).
the amount and type of products pur-
chased and by the delivery method and Swedbank, part of the largest bank group
customer service costs. Menu-based pric- in Sweden, resulted from a consolidation
ing is based on an ABC model that of several government-owned banks.
determines the customer service costs There were 4.5 million individual
and delivery costs (Kaplan and Cooper, accounts and 100,000 business accounts.
1998:193-194). This is an example of a customer service
company that made use of customer
Pillsbury, the giant food distributor, used profitability analysis to identify its
unprofitable customers and to become
more profitable overall. Through ABC
FIGURE 9 CUSTOMER PROFITABILITY analysis and customer surveys, the bank
determined that approximately 80% of
its customers were satisfied but unprof-
itable, while the remaining some 20% of
High the customers were dissatisfied with the
Passive Costly to service, bank’s services but very profitable – con-
■ Product is crucial but pay tributing more than 100% of the bank’s
■ Good supplier match top profits. As a result, the bank began
Net margin realised
Low High
Swedbank proceeded to examine the
relationships and results of three related
Cost-to-serve dimensions of performance: customer
value added, people value added, and
economic value added (profitability).
Source: Adapted from B.P. Shapiro, V.K. Rangan, R.T. Moriarty, and E.B. Ross, ‘Manage This combination of an ABC analysis
Customers for Profits (Not Just Sales)’ Harvard Business Review (September-October with a balanced scorecard type model
1987), 104. Reprinted by permission of Harvard Business Review.
provided the framework and the infor-
Source: Kaplan and Cooper 1998:193. mation to improve customer and corpo-
rate profitability.
Customer profitability analysis in a manu- cantly more profitable than the processing
facturing company and manufacturing of non-stocked items.
The Kanthal case provides an excellent exam- Since the existing system did not differenti-
ple of how ABC can improve the measure- ate between orders for stocked and non-
ment and management of customer prof- stocked items the difference in profitability
itability. Kanthal, the largest division of had not been apparent. The costs to produce
Swedish manufacturer Kanthal-Hoganas, had non-stocked items was greater than the costs
sales in excess of $50 million per year. Most to produce stocked items since special sched-
sales, about 95%, were exports from Sweden. uling was required for the purchase of the
Kanthal manufactured and sold heating raw materials and the production process. It
alloys for electric resistance heating elements, was also more costly to produce the items in
heating elements for industrial furnaces and small quantities.
thermo-bimetals for temperature control
devices. The company was organised into With the aid of consultants, the financial
three divisions, two of which held substantial manager of Kanthal, Per O. Ehrling, devel-
global market shares in their particular prod- oped an account management system to
ucts and the other had developed a fully analyse production, sales, and administration
integrated manufacturing system to produce costs using ABC. Two new cost drivers were
the thermo-bimetals. added to the analysis: the additional cost of
producing non-stocked items, and, the nor-
The president of the company, Carl-Erik mal expense associated with any customer
Ridderstale, saw the need for a strategic plan order such as pricing, scheduling delivery,
to increase profits while maintaining an invoicing, and collecting.
annual return on employed capital in excess
of 20% (Kaplan 1989:2). His ‘Kanthal 90 The company then accumulated, for each
Strategy’ detailed profit objectives by divi- customer, the profit and loss figures from
sion, product line, and market share. each individual order placed by that cus-
Ridderstale’s plan was to achieve this growth tomer (see Figure 10 below). The results of the
without the need for additional sales or ABC analysis showed that while gross mar-
administrative staff to handle the expected gins for different customers may be the same,
increase in sales volume. the additional costs to produce special small
orders and to fill stocked items on small
Ridderstale was also concerned that selling orders significantly reduced the profitability
and administrative expenses formed the of these customers. Kanthal now realised that
largest cost category in the company and
were growing. They accounted for 34% of
total expenses and were treated as period
FIGURE 10 CUSTOMER PROFITABILITY: RANKED
costs rather than allocated to either products
or customers. Ridderstale wanted a new cost-
FROM MOST TO LEAST PROFITABLE
ing system that could determine how much
profit was earned every time an order was P-Vol
placed. He also wanted to find the hidden 200
profits and hidden costs in each order. 150
Further, he believed that Kanthal had low
100
profit and high profit customers depending
on the demands that the customer placed on 50
the administrative and sales staff and that 0
these customers should be readily identifi-
able. -50
-100
Kanthal had about 10,000 customers and
-150
produced over 15,000 items. It stocked 20%
of those (3,000 items) which represented -200
1 2 5 10 20 40 60 80 100 120 140 160 180 190 195 198 199 200
80% of the company’s sales. After assigning
costs to customer orders, it became apparent Number of customers
that the sales of stocked items were signifi- Source: Kaplan 1989:13.
Sweden
S001 1 1,210 543 572 0 95 8%
S002 3 46,184 10,080 1,716 4,524 29,864 65
S003 8 51,102 50,567 4,576 12,064 (16,105) -32
S004 9 98,880 60,785 5,148 13,572 19,375 20
S005 1 3,150 1,557 572 2,340 (1,319) -42
S006 5 24,104 14,889 2,860 4,680 1,675 7
S007 2 4,860 2,657 1,144 4,680 (3,621) -75
S008 1 2,705 1,194 572 0 939 35
S009 1 518 233 572 0 (287) -55
S010 8 67,958 51,953 4,576 12,064 (635) -1
S011 2 4,105 1,471 1,144 0 1,490 36
S012 8 87,865 57,581 4,576 12,064 13,644 16
S013 1 1,274 641 572 2,340 (2,279) -179
S014 2 1,813 784 1,144 0 (115) -6
S015 2 37,060 15,974 1,144 3,016 16,926 46
S016 2 6,500 6,432 1,144 3,016 (4,092) -63
Cumulative profits
250
200
Profits: % of total
150
100
50
0
0 1 5 10 15 20 30 40 50 60 70 80 90 95 99 100
Cumulative % of customers
it had a few extremely profitable customers selling costs (Kaplan and Cooper 1998: 188).
and a few extremely unprofitable ones In the short term, Kanthal tried the follow-
(Kaplan and Cooper 1998: 185) and was sur- ing: reduce the size of its product lines,
prised by the wide variation in customer accept orders only for stocked items, use
profitability. Figure 10 graphically portrays external distributors to reduce the cost of
select Kanthal customers and how they add small accounts, change compensation to
or detract from profitability. Generally, the salesmen to emphasise profit rather than
first few customer sales vs cost of sales con- only sales volume, and engineer to reduce
tributed the most profit, while the last few set-up times and improve operational effi-
customers generated the largest losses due to ciencies.
high selling or post-sale costs.
In the longer term, the following are some of
Even more surprising to Kanthal was that the actions taken as a result of the new ABC
some of the customers with the most sales system:
were the most unprofitable. Two very unprof-
itable customers were in the top three in ■ involvement of salespersons was increased
terms of sales volume. One of these unprof- in discussions with management and cus-
itable high volume customers had moved to tomers;
just-in-time (JIT) ordering from its suppliers, ■ prices were increased for small, customised
placing orders weekly and sometimes twice a orders;
week. Variations in the profit margins on ■ product managers were encouraged to
individual orders ranged from -179% to reduce proliferation of sizes and variance
+65% as shown in Figure 11 (opposite). in product line;
■ salespersons emphasised standard prod-
The company also discovered that 40% of ucts; and
the Swedish customers generated 250% of ■ customers were persuaded to make larger
the profits. Finally, it also discovered that the orders of stocked items.
most profitable 5% of the customers generat-
ed 150% of the profits. This was a shocking With one particular customer, customer #200
discovery as it had been thought that most (see Figure 10 on page 19), Kanthal devised an
customers contributed to profit. This phe- excellent solution that would make the com-
nomenon of a few customers being the most pany profitable and satisfy the customer. The
profitable is present in many companies. company went to the customer, shared the
ABC analysis, and explained the implications
Traditional cost accounting often supports a
20-80 rule that 20% of the largest customers,
who purchase the most products, contribute
80% of the profits. Using ABC, analysts have
often found that 20% of the customers gen- Using ABC, analysts have often
erate 300% of the profits. The remaining 80%
of the customers are actually unprofitable found that 20% of the customers
and can result in a loss of 200% of the prof-
generate 300% of the profits
its. When plotted on a graph, (see Figure 12
opposite), the ‘hump’ of this ‘whale curve’
indicates the profit earned by the company’s
most profitable customers. The remaining
customers are break-even or unprofitable and for profitability of producing only small
bring the overall profit back down to 100%. orders of non-stocked items. Kanthal offered
The goal is to make each customer profitable. a new pricing structure that granted the cus-
tomer a 10% discount on high volume orders
With a new understanding of which cus- of stocked products and charged a 60% price
tomers were profitable and which were not, premium for small orders of non-stocked
Kanthal became dedicated to turning unprof- items. The results of this new pricing struc-
itable customers into profitable ones. The ture were reviewed one year later; Kanthal
company developed ways to retain the cus- found that customer #200 gave the company
tomers and decrease their administrative and the same volume of business but placed
orders half as many times per year, and for able to work with its existing customers for
half as many different products. Customer their mutual benefit.
#200 changed from the most unprofitable
customer into one of the most profitable in Using customer profitability analysis to deter-
the course of one year (Kaplan and Cooper mine the causes of costs and then making
1998:188). changes to reduce those costs are important
lessons to be learned from the Kanthal case.
Kanthal’s approach was to work with its cus- Customer profitability can only be increased
tomers for the benefit of both the firm and by reducing costs or raising revenues. Ways to
the customer. The company provided some increase that profitability through better man-
customers with computer terminals directly agement of customer costs are facilitated by
linked to the Kanthal office so the customers improved cost analysis. In this case, an ABC
could order directly without any sales effort analysis was critical. The managers were
being employed. Another customer, who had unwilling to take any action until they were
placed several small orders for many different presented with the data that indicated the
types of products, was converted to a distrib- profitability of products and customers.
utor. Kanthal sold larger quantities to the
customer that stocked the items for its own Customer profitability analysis in a service
use. This customer also added a profit to company
some of the products and resold them to The Co-operative Bank was founded in
other small companies. Thus Kanthal was England in 1872 as a department in a co-oper-
thus able to reduce its service costs to this ative wholesale society, which was the central
one customer and better service other small organisation formed by co-operative societies
companies. throughout the country. Co-operative societies
were formed to aid working class people in
In these instances, Kanthal discovered, like obtaining goods and services at lower costs
many other companies, that rapid improve- through trade and co-operation. The bank’s
ments in information technology could simul- main function was to serve the banking needs
taneously provide substantial benefits to both of the wholesale cooperatives and thus had
customer service and customer profitability. few personal accounts. It expanded to serve
Further, companies have recognised that cus- many of the upcoming and growing co-opera-
tive societies around the country.
established at the founding of the bank in income ratio and the service to customers. In
1872. In the early 1990s, Co-operative Bank order to accomplish this, the bank needed
found itself in the midst of an economic additional information for making changes
recession and was forced to make changes to that related to five corporate needs:
its operations in order to be more competitive
and efficient. It consolidated some operations ■ overhead reduction;
and reduced employment through voluntary ■ re-engineering of business processes, partic-
retirement. However, it also increased its cross- ularly those that did not add value to cus-
selling activities to existing customers and tomers;
began to offer a much wider choice of ■ product profitability;
products. While the bank believed it had an ■ customer profitability; and
array of excellent products and services for its ■ segment profitability (Datar and Kaplan,
customers, its cost-to-income ratio was higher 1995:5).
than its competition. Traditional responsibility
accounting was being used to measure The bank began an ambitious project of
expenses for geographic and departmental implementing ABC. It identified 210 cost
cost centres but the bank was unable to track pools and 235 activities/tasks. The bank then
costs to customers or to products. asked employees from different areas of the
bank to match resource costs to the activities
In 1993, the Co-operative Bank began an by identifying the amount of time that they
ambitious project to improve its profitability spent on various activities. A sample of the
and customer service. The goal of the new activities, cost drivers, quantities, and rates
‘Project Sabre’ was to improve the cost-to- are displayed in Figure 13 (below).
Cost per
Quantity unit of
Total of activity activity
activity cost cost
Activity description Activity cost driver cost driver driver
The total costs of each activity were deter- The initial analysis was limited to product
mined by combining all of the resource pool profitability and the bank’s team wanted to
costs assigned to each activity. The costs of extend the ABC analysis to customer prof-
each activity were then traced to the various itability by examining individual customers
bank products by defining activity cost dri- with current accounts. Specific assumptions
vers for each activity. The activity cost driver were made in the allocation of the costs of
represented the event that triggered the per- the customer accounts. The team allocated
formance of each activity, such as a deposit 55% of current account expenses to transac-
that was processed or an account that was tion costs and 45% to account maintenance.
opened. The bank was then able to distribute Customers were segmented into low, medium
the activity costs to various bank products. and high based on the turnover of funds in
Some banking expenses, sustaining costs rep- their accounts in order to allocate the trans-
resenting 15% of the total costs, were not action costs. On the revenue side, the bank
allocated to activities or bank products. These determined the income earned from the bal-
ances and fees for individual customers. By
matching income with the allocated costs,
managers were now able to estimate the prof-
itability of each customer. This revealed that
In service organisations, costs are
up to half of all current accounts, particularly
usually committed far in advance those with low balances, were unprofitable.
product profitability analysis and the ■ a delivery truck that services customers
customer profitability analysis for individual within the city;
customers and customer groups was essential ■ a delivery truck that services the area with-
to improving customer and corporate in a 40-mile radius of Rochester and visits
profitability. one of five different geographic areas each
day; and
Customer profitability analysis in a small ■ UPS and common carrier shipments
company (Krupnicki and Tyson 1997:40).
Customer profitability analysis applies to
small companies as well. When Mahany Employee profitability was analysed. Since
Welding Supply, a Rochester, New York dis- there were only seven employees, jobs were
tributor of welding supplies, examined cus- cross-functional; employees often had more
tomer profitability, there were some surprises. than one job, and no set time to do a partic-
The company employs only seven people. ular job. Possible causal relationships among
However, Mahany found a wide range in the the costs the activities and the drivers of the
profitability of both customers and employ- activities were identified.
ees.
Activities were analysed based on the time
Mahany identified four distribution methods spent per employee. Other expenses such as
for its products: advertising, telephone, legal and accounting,
insurance, rent and utilities were also tracked
■ walk-in trade and customer pick-up calls; and included in the analysis.
Activity Current Freeflow Personal Mortgages VISA VISA VISA Handy- Indepe- Pathfinder Deposit Total
Account loans Classic Affinities Gold loan ndent products
Plus /Fastline Financial
Advice/
Insurance
Net £5,283,472 £1,041,384 £ 4,530,763 £ 331,027 £2,856,713 £ 463,204 £ 808,592 £1,811,526 £ 0 £ 261,717 £960,437 £18,349,035
interest
Net 3,593,898 358,867 780,608 147,909 2,101,002 686,117 1,562,720 65,987 1,549,634 4,284 (1,141) 10,849,885
commission
Bad debts (782,000) (130,000) (1,192,000) (274,000) (882,000) (182,000) (508,000) (274,000) 0 0 0 (4,224,000)
Gross profit 8,095,370 1,270,251 4,119,571 204,936 4,075,715 967,321 1,863,312 1,603,513 1,549,634 266,001 959,296 24,974,920
Activity costs
(from Figure 13) 7,157,339 225,472 1,342,626 144,092 1,914,764 439,753 1,031,437 983,569 1,601,707 426,767 359,141 15,626,667
Direct profit 938,031 1,044,779 2,776,945 60,844 2,160,951 527,568 831,875 619,944 (52,073) (160,766) 600,155 9,348,253
Allocated
infrastructure
costs 1,014,145 36,845 204,822 4,213 156,768 22,086 81,053 20,864 263,078 65,066 59,685 1,928,625
New profit £ (76,114) £1,007,934 £ 2,572,123 £ 56,631 £2,004,183 £ 505,482 £ 750,822 £ 599,080 £ (315,151) £(225,832) £540,470 £ 7,419,628
a customer segment. Using this information (Brooks 1999:A12). Similar results were seen
some service companies encourage unprof- in the other examples cited earlier including
itable customers to leave by raising prices on Kanthal.
their services to very high levels. The infor-
mation is also used to develop marketing Customer profitability models can be
strategies to attract the proper profile and designed for any type of business and for dif-
mix of customers in the future. Companies ferent customer characteristics. Data can be
can then develop advertising programs to aggregated by size of customer, size of order,
attract customers that will purchase the ser- complexity of service, post-sale requirements,
vices within minimum costs and maximise delivery distance, etc. The information tech-
customer profitability. nology is currently available to provide
detailed information and analysis on individ-
Banks have been at the forefront in utilising ual customers or groups of customers. First
this new information technology. About half Union and many of the other banks dis-
of banks with more than $1 billion in cussed here have developed profitability mod-
deposits use profit data to make customer els from their large databases. Customer ser-
decisions. These firms spent $500 million on vice representatives can then obtain instant
computer technology and software, and it is customer profitability rankings from the com-
expected that banks will continue to spend puter.
$500 million per year in the near future as
more of them see the need for this informa- A problem can arise from reliance on cus-
tion. To a bank, the difference in profitability tomer profitability profiles that focus on a
between a good and bad customer can be single transaction type or on a single transac-
substantial, as determined by the account bal- tion period. Some customers may be unprof-
ance and the amount of services and interac- itable for a particular time period, and highly
tions with bank employees that the customer profitable for another. Further, customers
demands. According to an Atlanta bank con- may be profitable on some company products
sulting firm, the top 20% of typical bank cus- and services, and unprofitable on others.
tomers produce as much as 150% of overall
profit, while the bottom 20% of these cus- The success of customer profitability analysis
tomers drain about 50% from bank profit depends on the information reaching those
who make and influence decisions. Though est in individual customer profitability.
the modelling and raw profitability data are Subsequently, the salespersons were urged to
important, a user-friendly, multi-dimensional raise prices through surcharges and handling
on line analytical processing (OLAP) interface charges for small, customised orders. In the
is equally necessary. In addition to the proper near term, sales increased 20% with an
data delivery device, training in the interpre- employment reduction of 1%, overall corpo-
tation of the customer profitability informa- rate profitability increased.
tion is critical.
However, management must be sensitive to
Barriers to implementation required change within the organisation and
People often feel threatened by change, do be sure that employees are included in the
not understand it, and are opposed to it decision and change processes. Sears did an
within a company. Commission salespersons excellent job of change implementation.
will try to protect customers even though While the new Sears vision began with top
they may not be profitable to the company.
At Kanthal, there was a genuine concern for
retaining customers and trying to improve
the profitability of unprofitable ones. Sharing The success of customer profitability
cost and profit information with the cus-
tomer can produce a better relationship
analysis depends on the information
between customer and supplier; when a cus- reaching those who make and
tomer has a better understanding of the price
and profitability structure of the supplier and influence decisions
the reason for the price increases, there is
often a change in customer service demands
and costs.4
management, the implementation of the
Customer profitability analysis can be a large changes began with changing employee atti-
undertaking for an organisation in terms of tudes, obtaining employee buy-in, and
the resources used and the costs to complete increasing training costs for new and existing
the initiative. Barriers to implementation can employees.
include:
After Co-operative Bank obtained the
■ convincing management that potential detailed information on customer and prod-
organisational improvements justify the uct profitability there was some resistance to
resource allocation; change and management needed to address
■ obtaining the significant required resources some strategic issues. Should the bank dis-
that include information technology, courage unprofitable customers by charging
equipment, and staff for analysis and them higher fees? Should the bank phase out
preparation; unprofitable products such as Independent
■ changing the sales incentive system to Financial Advice/Insurance?
reward customer profitability rather than
sales volume; The Co-operative Bank was faced with an
■ obtaining buy-in from employees within additional conflict. Founded more than 100
the company who are often reluctant to years ago, the bank had a history of commit-
change; and ment to individuals, the community, and the
■ training employees in the use of customer cooperative movement. The guiding princi-
profitability analysis and its measurement ple of the cooperative was that it “should
and rewards. exist for the benefit of the people it served,
sharing its profits among them in proportion
At Kanthal, the salespersons felt threatened to their purchases.” (Datar and Kaplan
with the new emphasis on bigger orders, 1995:1) The bank reinforced these beliefs
more profitable orders and orders for stocked with a Mission and Ethical Statement in
items only. The employees were previously 1988. The values, culture and mission of Co-
rewarded based on volume, had been indif- operative Bank constrained the decisions it
ferent to ordering patterns, and had no inter- made; in trying to decide whether to ‘fire’
unprofitable customers, the bank was limited Statement of ethical values and its belief in
by the mission statement. As a result the the principles of cooperation have on its deci-
bank continued to work with these customers sion to implement change that affects the
to convert them into profitable ones. customers? Clearly the bank had conflicts
between its economic goal of profitability
With the new information about the prof- and increasing shareholder value, and its
itability of customers, the bank faced some social goals and commitments to the cooper-
core value decisions. Should it discourage ative movement. However, with the new
unprofitable customers? Should it charge information on the profitability of both
profitable and unprofitable customers differ- products and customers, more informed
ently? What effect should its Mission decisions could be made.
Conclusion
The development of ABC in the 1980s prompted the specification and measurement of these
managers to look more closely at the causes of relationships can the costs and revenues related
costs. More recently, increased business pressure to to improving corporate performance be properly
become ‘customer-focused’ and oriented toward managed. The goal of business is not to improve
‘shareholder value’ has increased the use of activi- employee or customer satisfaction at any cost, but
ty-based costing to better understand product, cus- rather to manage those relationships to improve
tomer, and corporate profitability. long-term corporate profitability. Managers need
to understand these relationships and the drivers
Similarly, the development of the balanced score- of customer profitability so they can better
card in the 1990s has prompted managers to look at manage and improve corporate performance.
the causes (or drivers) of profits and success.
Through a careful identification and articulation of Managers must constantly make decisions that
strategy, the development of key success factors, and involve trade-offs. They need to determine how
the development of key performance indicators, the much to invest in human resources and in cus-
balanced scorecard has helped companies imple- tomers. To make these decisions they need to
ment strategies and translate strategy into action. analyse the returns that are likely from those
investments, the costs of those investments, and
Both of these models – ABC and the balanced the managerial incentives in place to make those
scorecard – rely on an improved understanding of investments. This guideline offers an improved
the drivers of value in organisations, including a understanding of the analysis of customer prof-
specification of leading and lagging indicators of itability in order to assist managers in the alloca-
performance, the relationships between them and tion of corporate resources.
their measurement. The models rely on the
identification, measurement, and understanding of Measuring customer profitability and understand-
the drivers and causal relationships of employee ing the drivers of customer and corporate value
satisfaction, customer satisfaction, customer can lead to the improvement of overall corporate
profitability and corporate profitability. Only with performance.
ENDNOTES
2. The examples in the first part of this guideline are drawn primarily from Judge
1998; Brooks 1999; and Foster, Gupta and Sjoblom 1996.
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