Question

As companies shift from a product-centric focus to a customer-centric focus, a myth that almost all current customers are profitable needs to be replaced with the truth. Some high-demanding customers may indeed be unprofitable! Here’s the basic problem. With accounting’s traditional product gross profit margin reporting, managers can’t see the more important and relevant “bottom half” of the total income statement picture–all the profit margin layers that exist and should be reported from customer-related MSDA expenses. Based on your new knowledge on measuring customer profitability, what other considerations should a company look at when measuring customer profitability?

Answer 1

Customer profitability (CP) is the profit the firm makes from serving a customer or customer group over a specified period of time, specifically the difference between the revenues earned from and the costs associated with the customer relationship in a specified period. According to Philip Kotler,"a profitable customer is a person, household or a company that overtime, yields a revenue stream that exceeds by an acceptable amount the company's cost stream of attracting, selling and servicing the customer."

Calculating customer profit is an important step in understanding which customer relationships are better than others. Often, the firm will find that some customer relationships are unprofitable. The firm may be better off (more profitable) without these customers. At the other end, the firm will identify its most profitable customers and be in a position to take steps to ensure the continuation of these most profitable relationships. However, abandoning customers is a sensitive practice, and a business should always consider the public relations consequences of such actions.

Considerations a company should look at when measuring customer profitability:-

Good vs. Bad Customers

Some customers purchase a mix of mainly low-profit-margin products. After adding the nonproduct-related costs to serve for those customers, apart from the costs of the mix of products and standard service lines they purchase, these customers may be unprofitable to a supplier. But customers who purchase a mix of relatively high-profit-margin products may demand so much in extra services that they also could potentially be unprofitable. How does a company measure customer profitability properly? In extreme cases, how does it deselect or “fire” a customer that shows no promise of ever being profitable?

Every supplier has what I call good and bad customers. Low-maintenance “good” customers place standard orders with no fuss, whereas high-maintenance “bad” customers always demand nonstandard offers and services, such as special delivery requirements. For example, the latter constantly returns goods or contacts the supplier’s help desk. In contrast, the former just purchases a company’s products or service lines and are rarely bothersome to the supplier. The extra expenses for high-maintenance customers add up. What can be done? After the level of profitability for all customers is measured, they all can be migrated toward higher profits using “profit margin management” techniques.

Pursuit of truth about profits

Why would a company want to know the answers to the questions about customer profitability levels? Possibly to answer more direct questions about its customers, such as:

• Do we push for volume or for margin with a specific customer?
• Are there ways to improve profitability by altering the way we package, sell, deliver, or generally service a customer?
• Does the customer’s sales volume justify the discounts, rebates, or promotion structure we provide to that customer?
• Can we influence our customers to alter their behavior to interact differently (and more profitably) with us?
• Can we shift work to or from some of our customers based on who, them or us, is more capable or has lower process expenses?

To be competitive, a company must know its sources of profit and understand its own expenses and cost structure. With the facts, what actions can be taken to increase profits? For outright unprofitable customers, a company can explore passive options of gradually raising prices or surcharging for extra work, hoping the customer will go elsewhere. For profitable customers, a company may want to reduce customer-related causes of extra work for its employees (e.g., unneeded extra product packaging), streamline its delivery process, or alter the customers’ behavior with pricing incentives so those customers place fewer workload demands on the company.

Activity-based costing (ABC) is the method that will economically and accurately trace the consumption of an organization’s resource expenses (e.g., salaries, supplies) to products and to the types and kinds of channels and customer segments that place varying degrees of workload demand on the company. It should no longer be acceptable not to have a rational system of assigning so-called nontraceable costs to their sources of origin. ABC is that system. Yet many companies still don’t use it.

ABC is a multilevel cost reassignment network

ABC uses multiple stages to trace and segment all the resource expenses as calculated costs through a network of cost assignments into thefinal cost objects: products, service lines, channels, and customers. It facilitates more accurate reporting because it honors costing’s causality principle (i.e., the relationship between cause and effect) for expense consumption relationships.

In complex, support-intensive organizations, there can be a substantial chain of indirect work activities that occur prior to the direct ones that eventually trace into the final cost objects. These chains result in activity-to-activity cost assignments, and they rely on intermediate activity cost drivers traced to consuming activities in the same way that final cost objects rely on activity cost drivers to reassign costs into final cost objects based on their diversity and variation.

Making indirect costs direct costs is no longer an insurmountable problem as it was in the past. Integrated ABC software allows intermediate direct costing to a local process or to an internal customer or required component that is causing the demand for work. It further allows tracing costs among the final cost objects. Resource and activity cost drivers reassign expenses into costs with a more local, granular work activity level than in traditional systems, such as the accountant’s rigid cost center step-down cost allocation method that reduces costing accuracy by relying on a single cost allocation factor for an entire support department.

ABC software is arterial in design, so it flows costs flexibly and proportionately. Eventually via this expense assignment and tracing network, ABC reassigns 100% of the resource expenses into the final accumulated costs of products, service lines, channels, customers, and business-sustaining work. Visibility of costs is provided everywhere throughout the cost assignment network, including for how costs are “driven” by the activity cost drivers that comply with the cause-and-effect relationships. This visibility aids in identifying where to focus improvement efforts.

Future profit potential via customer lifetime value (CLV)

For business-to-consumer (B2C) companies, such as banking and telecommunications, customers pass through life cycles. This means there’s a difference between a currently profitable customer and a customer who may be more valuable in the future.

This difference shifts attention from the current run rate of past-period profit levels from their consumers to their future potential profit level. For B2C companies, accountants can calculate each customer’s CLV before and after various marketing campaigns and targeted offers and deals. This provides sales and marketing the ability to apply return on investment (ROI) measures to evaluate which customers can achieve the highest profit increase from actions.

Migrating customers to higher profitability

The crucial challenge is not to use ABC just to calculate valid customer profitability information from transactional data but to really use the information–and use it wisely. The benefit comes from identifying the profit-lift potential from customers and then realizing the potential with smart decisions and actions.