Measure and Manage Your Customer Profitability

• 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 serve different types of customers?
• Does the customer’s sales volume justify the discounts, rebates or promotion structure we provide to that customer?
• Which products are relatively more profitable to cross-sell or up-sell?
• Can we realize the benefits from our changing strategies by influencing our customers to alter their behavior to buy differently (and more profitably) from us?
• Can we shift work to or from some of our suppliers based on who is more capable or already has a superior cost structure compared with ours?

Risks from Inaccurate Cost Calculations
Companies plan and control their operations using accounting information that is assumed to accurately reflect the costs of their products and standard service lines. In fact, this is often not the case. The recorded expenses, such as salaries and supplies, may be exact in their amounts because they are externally audited and automated accounting systems capture them – but the problem is then transforming those expenses into their calculated costs of the business processes and the products that in turn consume those process costs.

The costing systems of many companies, with their aggregated summaries and their broad averaging allocation of indirect costs, mask reality with an illusion of precision. In fact, traditional cost systems typically provide misleading information to decision makers with minimal transparency to understand what constitutes a product’s cost. Companies that apply activity-based costing (ABC) principles and their supporting software systems resolve the cost distorting error of allocating expenses using broad averages (e.g., number of units produced, sales amount, or labor input time). These cost allocations violate the accounting principle of a cause-and-effect relation to transform consumed expenses into calculated costs. ABC replaces broad averages with quantified activity cost drivers that trace each work activity (at a reasonable level of disaggregation) to the type of output, product or standard service-line that causes and consumes the work activity.

To further complicate matters, with the shift in attention from products to customer services, managers are also seeking granular ‘costs to serve’ customer-related information. These are not all the costs related to making a product or delivering a standard service line (e.g., a bank checking account), but rather they are the costs from interactions with customers, such as a help desk call. The problem with accounting’s traditional gross profit margin reporting (i.e., restricted to only product cost profit margins) is managers cannot see the bottom half of the total picture – all the profit margin layers eroded from distribution, selling, credit, payments, and marketing costs. Exhibit 30.1 illustrates an organization’s entire expenses. The product and standard service-line costs are in the shaded area. The concern here is tracing the non-shaded area costs to types of channels and customers.

Exhibit 1. Costs from Sales and Marketing Are Not Product Costs


The unacceptable result of not converting these types of expenses into customer-related costs is that executives, managers, and employee teams receive incomplete profit reporting that is not segmented by customer; and the product profitability data they do receive is flawed and misleading. They deserve fully loaded cost and profit reporting that encompasses all the traceable expenses of their end-to-end value stream costs–from supplier-related purchasing to customer service. How can recent advances in managerial accounting methods and technology deploy the vast potential that companies have from their business intelligence systems?

Costs Need to be Causally Traced, Not Allocated on Broad Averages
Businesses with thousands of customers want to scale-up their cost and profit reporting and visibility at the individual customer level, but their costing systems cannot accomplish this. As a result, organizations lack the essential information for making much better decisions about product mix, customer mix, marketing, channel strategies and sales programs.

To better analyze revenue, cost and the resulting profit margin information, businesses need to be able to define segmented reports on the fly. This includes tracking profit for different time periods by individual customers, by individual products and by specific sales channels, distribution channels, branches, service centers, or sales outlets. To enhance the identification and investigation of problems, organizations also need the flexibility of at-a-glance and drill-down views to see costs and profits with fine granularity.

ABC systems are designed to produce profit and loss income statements for customer segments and if needed for individual customers. With ABC product and service-line related work activity costs are layered into each product and service line. In addition cost-to-serve related work activity costs are additionally layered into each channel and customer. The volume and mix of products, service lines, and channel costs that each customer consumes is also layered in.

Accountants rarely isolate and directly charge customer-related activity costs to the specific customer segments causing these costs. As a result, in financial accounting terms, the costs for selling, advertising, marketing, logistics, warehousing and distribution are immediately charged to the time period in which they occur. Accountants refer to these as period costs. But classifying expenses that way is for external financial accounting for banks, investors, and regulatory agencies. What we are discussing here is internal managerial accounting to support the analysis and decision making of managers and employee teams. The accountants must begin applying the same costing principles for product costing, typically ABC principles, to types of channels and types of customers so that there is visibility to all traceable and assignable costs. Otherwise, you have no clue where you are making and losing money.

The problem is the accountants are not tasked to trace them to channels or customer segments. But today’s selling, merchandising and distribution costs are no longer trivial costs – they are sizable. There should be a focus on the customer contribution margin devoid of simplistic and arbitrary cost allocations. Companies with goals of sales growth at any cost need to temper their plans with a goal of profitable sales growth.

In the end, services will be added to products, and unique services will be tailored for individual customers. Activity-based costing data will be essential to validate and prioritize the financial merits of which services to add and for which customers.

ABC resolves the costing accuracy problem with its rational cause-and-effect cost tracing logic. It complies with accounting’s causality principle. ABC transforms each department’s expenses as captured in the general ledger accounting system into its calculated costs of work activities (that belong to business processes) and ultimately into its products, service lines, channels and customers.

Exhibit 2 illustrates an organization’s enterprise-wide expense structure flowing into the ultimate final costs of its end-customers and its organizational sustaining cost (i.e., those expenses transformed into work activity costs that are not caused or traceable to products or customers).

Exhibit 2. Activity-Based Cost/Management Cost Assignment Network


Equipped with a costing methodology that correctly models the consumption of resources base on accounting’s causality principle, one can rely on its information to be valid for reliable analysis, control, planning and decision support.

What Is Needed Is a Profit and Loss Statement for Each Customer
Exhibit 3 illustrates the individual customer profitability statement that is the result of these cost layers. Using ABC, there can now be a valid profit and loss (P&L) statement for each customer as well as logical segments or groupings of customers. A tremendous amount of detail lies below and within each of these reports. For example, the individual products and service lines purchased can be examined in greater detail; they comprise a mix of high and low margins based on their own unit costs and prices. In other words, in a customer-specific P&L summary, the product or service line is reported as a composite average, but details about the mix are viewable. In addition, within each product or service line, the user can further drill down to examine the content and cost of the work activities and materials for each product and standard service line.

Exhibit 3. Customer Profit and Loss Statement


ABC users refer to this data mining and navigating as ‘multidimensional reporting;’ and they use the online analytical processing (OLAP) software tools for viewing the output of the ABC calculation engine. This is powerful information. The sum of all the customer P&L statements for this type of report will be the entire business’s enterprise-wide profit (or loss). That is, it can be reconciled with the company’s official books: Its total spending and the resulting ‘bottom line.’

Performance management systems combine ABC information with planning and performance measure and alignment tools; but what makes performance management so appealing is that it is work-centric. The foundation for performance management is built on what people and equipment do, how much they do it, and why.

With valid cost modeling, Exhibit 4 displays a graph line at the top – referred to as the ‘profit cliff’ of the true cumulative build up of each product’s profit rank ordered from the most profitable to the least (often products at a financial loss where their costs exceed their revenues). The graph illustrates how unrealized profits can be hidden due to inadequate costing methods. The accountants are not properly assigning the expenditures based on the causality principle of accounting. The graph is of each product’s cost, net of sales, to reveal each product’s and service line’s profit.

Exhibit 4. Cumulative Profit Distribution by Product



The products are rank-sorted left-to-right from the largest to the smallest profit margin rate. The very last data point equals the firm’s total net profit, as reported in its profit and loss (P&L) statement. For this organization, total revenues were $20 million with total expenses of $18 million, to net a $2 million profit, but the graph reveals the distribution of the mix of that $2 million net profit. Although not empirically tested, experiences with these measures show that the total amount of the profits, excluding any losses, usually exceeds 200% of the resulting reported net profit; greater than 1000% has even been measured.

ABC information is typically shocking to executives and managers since their prior belief from their traditional broadly averaged costing method is the flat graph line at the bottom with the small decline where each product’s cost was distorted. This graph line has its accuracy removed by the broad-brush averaging of traditional cost allocations rather than tracing and assigning each activity cost using its proportionate activity cost driver.

Migrating Customers to Higher Profitability
What does all this information reveal? First, it quantifies what everyone may already have suspected: All customers are not the same. Some customers may be more or less profitable based strictly on how demanding their behavior is. Although customer satisfaction is important, a longer-term goal is to increase customer and corporate profitably. There must always be a balance between managing the level of customer service to earn customer satisfaction and what the impact from doing that will have on shareholder wealth. The best solution is to increase customer satisfaction profitably. Because increasingly more customers will expect and demand customization rather than standard products, services, and orders, understanding this balance will be important.

ABC data facilitate discussions about arriving at that balance. Many managers are unwilling to take any actions until presented with the facts.

In the company P&L in Exhibit 3, there are two major ‘layers’ of contribution margin:

1. By mix of products and service lines purchased
2. By ‘costs-to-serve’ apart from the unique mix of products and service lines

Figure 5 combines these two layers. Any single customer (or cluster) can be located as an intersection. Figure 5 provides a two-axis view of customers with regard to the two layers just described, the ‘composite margin’ of what each purchases (reflecting net prices to the customer) and its ‘costs-to-serve.’ The exhibit debunks the myth that companies with the highest sales must also generate the highest profits.

Note that migrating customers to the upper-left corner is equivalent to moving individual data points in the profit profile in Exhibit 30.3 from right to left and bottom – to top. Knowing where customers are located on the matrix requires ABC data.

Exhibit 5. Migrating Customers to Higher Profitability


Segmenting customers with ABC requires some different filters that we will discuss next.

Options to Raise the Profit Cliff Curve
What does a commercial organization do with the customer profit information? In other words, what actions can an organization take to increase its profits? This is all about the ‘M’ in activity-based management (ABM), the managing of costs and profits. Some customers may be located so deep in the lower-right corner of the customer profitability matrix that the company will conclude that it is impractical to achieve profitability with them and they should be terminated. After all, the goal of a business is not to improve customer satisfaction at any cost, but rather to attempt to manage customer relationships in order to improve long-term corporate profitability.

The objective is to make all customers more profitable, represented by driving them to the upper-left corner. Although this is a partial list, making customers more profitable can be accomplished by:

• Manage each customer’s costs-to-serve to a lower level
• Establish a surcharge for or re-price expensive cost-to-serve activities
  Reduce services
• Introduce new products and service lines
• Raise prices
• Abandon products, services, or customers
• Improve the process
• Offer the customer profit-positive service level options
• Increase costs on activities that a customer shows a preference for
• Shift the customer’s purchase mix toward richer, higher-margin products and service lines
• Discount to gain more volume with low cost-to-serve customers
  

• This snapshot view of a time period’s cost does not reflect the life-cycle costs of the products, service lines, or customers that have consumed the resource and activity costs for that particular time span.
• The information represented in the graph should not be prematurely or spontaneously acted on. Analysts must appreciate the large difference between what information is and what making an actionable decision is. They are not the same.

The important point is that ABC provides fact-based data from which discovery and questions can be asked. Always remember this: In the absence of facts, anyone’s opinion is a good one. And usually the biggest opinion wins! This includes the opinion of your boss or of your boss’ boss. So, to the degree senior managers are making decisions based on intuition, gut feel, misleading information or politics, then your organization is exposed to the risk of poor decisions.

Computer Technology Enables Customer Profitability Reporting
A revolution has occurred in computer technology that allows large-scale and detailed profitability reporting. In the past, achieving ever-higher levels of cost accuracy were simply not justified given the extra work involved. But today, applying computer technology converts that administrative effort to near zero (after the automated cost system is initially designed and configured). Further, data storage capacity is now economical.

The attraction of effective costing system is that it can economically scale to accommodate billions of transactions, access data from diverse multiple source systems, and be deployed for remote Web-enabled analysis. It reports validly calculated profits on a moment’s notice rather than two weeks after a month has ended. As a bonus, with projected sales volume and mix, it enables reliable what-if scenarios for test-and-learn as well as pro forma profit-and-loss forecasts.

Profitability reporting at a detailed level gives a meaningful business context to the realm of business intelligence (BI). In the end, managerial accounting is just data. It is to be used as a means to an end – namely decision making. The quality and accuracy of managerial accounting data is therefore critical.

Because most businesses today have automated transaction and production systems, the data that costing error is sensitive to is already accurately captured. 1This means customer profitability information can be instantly reported at any time on demand. This provides robust information for customer profit analysis.

Future competitive differentiation will be based on the rate of speed at which organizations learn, not just the amount they learn. Having all this revenue, cost and profit margin data is only a beginning. People have to act on and make decisions with the data.

Coming to Grips with Reality
The CFO can and should work more closely with the marketing and sales functions to measure and report the nonfinancial balanced scorecard key performance indicators (KPIs) that impact or reflect the customers’ total experience and satisfaction. Progressive CFOs understand how customer experience drivers achieve strategic objectives and indirectly influence financial results.

Increasingly more organizations are coming to this realization of flawed or dysfunctional cost reporting, however, they are intimidated by the perceived tall heights that they would need to scale to return to the levels of cost accuracy once enjoyed when output diversity was narrow and overhead expenses were small. Inevitably they come to grip with their predicament. Should they reform their managerial accounting method using ABC principles and lean accounting techniques? Or should they take no action and remain with the status quo hoping that the lack of transparency of indirect costs, their drivers, and the degree of misleading information will not too adversely result in bad decision making. In either case, they are both a choice the accountants are making. That is, to change or not to change–both are choices, where either option could be inappropriate.

1For advanced systems, there are extraction, transform, and load (ETL) tools that are applied for input data cleansing to assure higher accuracy of the calculated and reported information.

This article is an excerpt from Gary Cokins’ book: Performance Management: Integrating Strategy Execution, Methodologies, Risk Management, and Analytics; ISBN 978-0-470-44998-1; John Wiley and Sons (2009). Reprinted with permission.