Managing Customer Profitability

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006

 6-2

Customer Profitability Analysis

Analyzing
Analyzing the
the activities,
activities, costs,
costs, and
and profit
profit
associated
associated with
with serving
serving specific
specific customers.
customers.

Customer makes
For frequent order changes.
Forvarious
various
reasons,
reasons, some
some Customer needs special
customers
customersareare attention.
less
lessprofitable
profitable
than
thanothers.
others. Customer is difficult
to please.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006
 6-3

Customer Profitability Analysis

Two
Two primary
primary objectives
objectives

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006

 6-4

Measuring Customer Profitability

Studies
Studies have
have shown
shown that
that only
only 20%
20% of of aa
company’s
company’s customers
customers contribute
contribute toto profits.
profits.
The
The remaining
remaining 80%
80% generate
generate losses.
losses.

Possible qualitative reasons to

retain unprofitable customers:
 Customer prestige.
 Potential future profitability.
 Loss leader to enter market.
 Nonmonetary benefits such
as knowledge or expertise.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006
 6-5

Measuring Customer Profitability

A
A graph
graph of of five
five of
of our
our customers
customers reveals
reveals
that
that two
two of
of the
the five
five are
are unprofitable.
unprofitable.
Customer Profitability

Bar graphs
are common
analytical
tools.

Customer Number
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006
 6-6

Measuring Customer Profitability

We
We will
will focus
focus our
our attention
attention
on
on customers
customers 102 102 and
and 114.
114.

Question:
Customer Profitability

Why are these

two customers
unprofitable?

Customer Number
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006
 6-7

Measuring Customer Profitability

Comparing
Comparing the
the customer-related
customer-related costs
costs for
for
each
each customer
customer can
can reveal
reveal helpful
helpful insights.
insights.
We Investigate and find. . .

Order
Orderprocessing
processingcosts,
costs, Special
Special packaging
packagingcosts
costs
engineering/design
engineering/design for
for Customer
Customer114114are
arefour
four
changes,
changes, and
andspecial
special times
timesthe
thenorm
normand
and
handling
handlingcosts
costsfor
for special
special handling
handlingcosts
costs
Customer
Customer102102are
are are
aresix
sixtimes
timesthe
thenorm.
norm.
above
abovenormal.
normal.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006
 6-8

Customer Profitability Analysis

Once
Once wewe know
know why
why the
the customers
customers areare
unprofitable,
unprofitable, we
we can
can modify
modify customer
customer
relationships
relationships to
to improve
improve profitability.
profitability.
We’ll
We’llsend
sendaateam
teamtotoyour
yourplant
plant
b uut t next
, b nextweek
weekandandhelp
helpyou
youset
setup
up
ththisis,tinnuuee ordering
o ddoo coonnti ithh orderingand
andhandling
handlingprocedures
procedures
t to n’t’t c wwit that
t ee
a t a n s thatwill
willreduce
reducecosts
costsand
andprovide
provide
I Ihhauststccasinineesss you
j u u s youwith
withbetter
betterservice.
service.
wwee jinggbbuyoouu. .
ddooin y
IfIfyou
youask
ask for
forfewer
fewer
changes,
changes,we wecancancharge
charge
you
youlesslessand
anddeliver
deliveryour
your
orders
orders faster!
faster!
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006
 6-9

Identify Effective & Ineffective

Customer-Related Activities
Study
Study closely
closely all
all the
the customer-related
customer-related
activities
activities that
that drive
drive costs.
costs.

Typical
Typical Customer-Related
Customer-Related Activities
Activities Include:
Include:
 Processing
Processing Orders
Orders  Billing
Billing
 Sales
Sales Contacts
Contacts  Engineering/Design
Engineering/Design
 Sales
Sales Visits
Visits Changes
Changes
 Processing
Processing
 Special
Special Packaging
Packaging
Shipments
Shipments  Special
Special Handling
Handling
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006
6-10

Customer Profitability Analysis

(Textbook
(TextbookExample)
Example)

HealthWave,
HealthWave, Inc.
Inc. sells
sellsnon-prescription
non-prescription
pharmaceuticals,
pharmaceuticals, supplements,
supplements, and
andherbal
herbal
remedies
remediesto
tothree
threemajor
majorcustomer
customertypes:
types:
••Pharmacy
Pharmacy
••Grocery
Grocery
••Herbal
Herbal Therapist
Therapist
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006
 Exh.
6-11 6.2

Customer Profitability Analysis

Healthwave
Healthwave reports
reports product
product line
line profitability.
profitability.
Research
Research andand Development
Development (R (R && D)
D) costs
costs are
are traced
traced
to
to products,
products, but
but General,
General, Selling
Selling and
and Administrative
Administrative
(G,S
(G,S and
and A)
A) costs
costs are
are allocated
allocated based
based onon sales.
sales.

The profitability goal is a 10 percent return on sales.

Is the problem products or customers?
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006
6-12

Customer Profitability Analysis

We
We now
now know
know that
that the
the supplements
supplements lineline
has
has aa low
low return
return on
on sales
sales and
and that
that herbal
herbal
remedies
remedies hashas aa negative
negative return
return on
on sales.
sales.

An
An analysis
analysis of
of sales
sales records
records shows
shows the
the following
following
customer
customer sales
sales patterns
patterns for
for these
these products:
products:

Traced Product Sales Pharmacy Grocery Herbal Therapist

Sales of:
Non-prescription drugs 78.0% 22.0% 0.0%
Supplements 8.0% 83.0% 9.0%
Herbal Remedies 5.0% 34.0% 61.0%

Now let’s look at contribution margin per customer type.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006
 Exh.
6-13 6.5

Customer Profitability Analysis

78% of 26,900,000 + 8% of 44,260,000 + 5% of 19,840,000 = $25,514,800

[(78% of 26,900,000) × .52] + [(8% of 44,260,000) × .61]

+ [(5% of 19,840,000) × .69] = $13,755,008

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006

 Exh.
6-14 6.5

Customer Profitability Analysis

Sales
Salesto
toPharmacies
Pharmaciesprovide
providethe
the
highest
highestcontribution
contributionmargin
marginratio.
ratio.
Let’s
Let’sexamine
examinefurther.
further.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006

6-15

Sales & Administrative Cost

Analysis
We
We will
will analyze
analyze these
these costs
costs to
to determine
determine howhow much
much ofof each
each
cost
cost to
to subtract
subtract from
from customer
customer margin.
margin. OurOur objective
objective is
is
customer
customer income
income and
and return
return of
of sales
sales for
for each
each customer.
customer.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006

 Exh.
6-16 6.6

Selling Cost Analysis

HealthWave
HealthWavesells
sellsits
itsproducts
productsusing
usingsales
salespersonnel
personnel
in
inthe
thefield
fieldand
andby bytelephone
telephoneordering.
ordering.

45 sales reps @ $55,000

25 sales reps @ $42,000 + 4 major
account managers @ $200,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006

 Exh.
6-17 6.6

Selling Cost Analysis

HealthWave
HealthWavesells
sellsits
itsproducts
productsusing
usingsales
salespersonnel
personnel
in
inthe
thefield
fieldand
andby bytelephone
telephoneordering.
ordering.
 40,000 grocery orders × 85% by telephone = 34,000 grocery telephone orders
 34,000 ÷ 80,000 total telephone orders = 42.5 percent of telephone orders
 42.5 percent of $130,000 total telephone cost = $55,250

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006

 Exh.
6-18 6.6

Selling Cost Analysis

HealthWave
HealthWavesells
sellsits
itsproducts
productsusing
usingsales
salespersonnel
personnel
in
inthe
thefield
fieldand
andby bytelephone
telephoneordering.
ordering.

Percentage based on
62% of $480,000 = $297,600
personnel interviews

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006

 Exh.
6-19 6.7

Marketing Cost Analysis

Marketing
Marketingcosts
costsinclude
includepersonnel,
personnel,databases,
databases,equipment,
equipment,and
and
facilities
facilitiesused
usedfor
forselling,
selling,market
marketresearch,
research,strategy,
strategy,and
andplanning.
planning.

Percentage based on
personnel interviews

55% of $360,000 56% of $2,250,000

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 Exh.
6-20 6.8

Distribution Cost Analysis

Distribution
Distributioncosts
costsinclude
includepacking,
packing,shipping
shippingand
anddelivering
delivering
products
productsor orservices
servicestotocustomers.
customers. HealthWave
HealthWavedelivers
deliversgoods
goods
using
usingits
itsown
owntrucks
trucksand
andaaprivate
privatedelivery
deliveryservice,
service,
PackageXpress.
PackageXpress.

12% of $16,085,800 Herbal Therapist Revenue (rounded)

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 Exh.
6-21 6.8

Distribution Cost Analysis

Pharmacy deliveries 286,000 87.66%

Grocery deliveries 40,248 12.34%
Total deliveries 326,248 100.00%

87.66% of $8,080,000 12.34% of $8,080,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006

 Exh.
6-22 6.9

Research and Development cost

Analysis
RR&&DDcosts
costsare
arecharged
chargedtotoproduct
productlines
linesin
inthe
theyear
yearof
ofspending.
spending.
For
Forthe
thecurrent
currentyear,
year,40
40percent
percentof
ofRR&&DDcosts
costsare
arecharged
chargedto
to
supplements
supplementsandand6060percent
percentto
toherbal
herbalremedies.
remedies.

Product
Non-prescription 0% $ 0
Supplements 40 480,000
Herbal remedies 60 720,000
Total R & D costs 100% $1,200,000

Next,
Next,the
theamounts
amountscharged
chargedto
toproduct
productlines
linesare
are
allocated
allocatedto
tocustomer
customertypes
typesbased
basedon
onsales
salesrevenue.
revenue.

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 Exh.
6-23 6.9

Research and Development cost

Analysis

78% of $0 + 8% of $480,000 + 5% of $720,000

22% of $0 + 83% of $480,000 + 34% of $720,000

0% of $0 + 9% of $480,000 + 61% of $720,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006
 Exh.
6-24 6.10

General & Administrative Cost

Analysis
These
Thesecosts
costscan
canoften
oftenbe
bedifficult
difficultto
totrace
traceto
tospecific
specificcustomers.
customers.
HealthWave
HealthWavebreaks
breaksthem
theminto
intothese
thesecategories:
categories:manufacturing
manufacturingsupport
support
(30%),
(30%), customer
customerservice
service(50%),
(50%),and
andgeneral
generalbusiness
businessactivities
activities(20%).
(20%).
Percentages
Percentageswere
wereobtained
obtainedfromfrommanagement
managementinterviews.
interviews.

(20% + 50 %) or 70% of $8,270,000 30% of $8,270,000

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 Exh.
6-25 6.10

General & Administrative Cost

Analysis From Exhibit 6-5, revenues traced to each customer type
Traced Revenue Percentage
Allocate customer Pharmacy $ 25,514,800 28.04%
service based Grocery 49,399,400 54.29%
Herbal Therapist 16,085,800 17.68%
on revenues. Total traced sales $ 91,000,000 100.00%

28.04% of $5,789,000 17.68% of $5,789,000

54.29% of $5,789,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006

 Exh.
6-26 6.10

General & Administrative Cost

Analysis From Exhibit 6-5, cost of goods sold for each customer type

Allocate Variable COGS Percentage

Pharmacy $ 13,755,008 25.16%
manufacturing Grocery 30,140,662 55.13%
service based on Herbal Therapist 10,780,530 19.72%
variable COGS. Total traced sales $ 54,676,200 100.00%

25.16% of $2,481,000 19.72% of $2,481,000

55.13% of $2,481,000

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 Exh.
6-27 6.11

Customer Profitability Analysis

Finally,
Finally,we
weput
putall
allthe
theinformation
informationtogether
togetherto
todetermine
determine
which
whichcustomer-type
customer-typeis isthe
themost
mostprofitable.
profitable.

Even
Eventhough
thoughPharmacy
Pharmacyhas
hasthe
thehighest
highestmargin,
margin,itithas
hasaanegative
negative
return
returnon
onsales.
sales.What
Whatshould
shouldHealthwave
Healthwavedo?do?
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006
6-28

What To Do?

The
ThePharmacy
Pharmacycustomers
customersare arenot
notcontributing
contributingto
to
HealthWave’s
HealthWave’sprofitability.
profitability. What
Whatare
arethe
theoptions?
options?
Decrease
Decrease
Do
DoNothing
Nothing operating
operating
costs
costs

Increase
Increase Drop
Drop
efficiency
efficiencyof
of pharmacy
pharmacy
serving
servingpharmacy
pharmacy customers
customers
customers
customers
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006
6-29

What To Do?

 Do nothing is unacceptable given the magnitude of the loss.

 Dropping the pharmacy customers should only be

considered if the cost savings are greater than the
$11,759,792 of contribution that would be given up.
 Decreasing operating costs and/or increasing the
efficiency of serving pharmacy customer appear to
be the best options.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006

6-30

Common-Sized Profit Statements

To
Tobetter
bettercompare
comparedifferent
differentsets
setsof
ofdata,
data, the
thedollar
dollar
amounts
amountscan
canbe
berecast
recastas
asaapercentage
percentageof
ofrevenues.
revenues.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006

6-31

Common-Sized Profit Statements

Pharmacy margin is high, but
Potential Savings? some costs seem out of line.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006

6-32

End of Chapter 6

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2006