How can customers be grown into more profitable ones? In an earlier article, we have stated that there are different kinds of customers who are associated with each organization. Thus, customers do not only vary in terms of their individual sales volumes and market shares, but also differ based on their profitability levels.
For a deeper understanding on that topic, read one of the previously published articles:
Management accounting focusing on the company’s customers
The article deals with the growing need of transforming management accounting’s perspective from a product-centric to a customer-centric one. That change in view and self-conception within the organization can be seen as one of the most essential requirements if customers have to turn more profitable. Furthermore, this article also introduces the activity-based costing method, which we will refer to in the following.
In the article linked above, we could as well determine that the assumption that almost all current customers are profitable is only a myth. It is important to understand that customers with a high demand are not necessarily the main profit drivers. They might generate big sales volumes, but they also request additional cost-intensive services in terms of support and shipment, for instance.
Just about 25%—which means only a small fraction of the customer base—actually contributes substantially to the company’s goal of profit maximization, the other 75% either breakeven (65%) or are unprofitable (10%). In this context, each organization should have a strong incentive to raise that level of profitable consumers considerably, making them all even more profitable.
Implications for a customer’s profitability
The question whether a customer is profitable or unprofitable is determined by his/her total sales volume and the costs incurred by his/her purchased product(s) or service(s) during their product/service life cycle phases—or, in other words, if or if not sales revenue exceeds the costs. So, to be able to grow individual customers or customer segments (homogenous groups of customers with similar behavioral patterns) into more profitable ones—which means to launch corrective, customer-specific actions and to take the appropriate future steps—the marketing and sales functions need detailed information about those two P&L variables.
To assign customer-related revenues is usually unproblematic. The challenge, however, is that traditional cost accounting does not draw a clear picture about the expenses directly and indirectly linked to a customer or customer segment. The customer cost is eventually the sum of all costs necessary to provide the products or services to the customer(s), including post-sale transactions.
These customer costs can at least be split further into product costs and “costs to serve”. In addition, where appropriate, a third category “business sustaining costs”, which means overhead/administration costs for IT, accounting, legal service, and others, might be included in the customer costs; this enables the company to function in a proper (legal) manner (but we will not focus on that category in the following).
Product costs are mainly direct costs for material, labor, and equipment; indirect product costs comprise of expenses for repairs and maintenance, electricity, or the salary of the production manager. Costs to serve, on the other hand, are channel- and customer-related costs. These include costs for marketing and sales, order processing, distribution, or customer support after the product has been purchased (helpdesk, repairs under warranty, return of products and recycling, and so on).
Especially the costs in the “costs to serve” group are usually not directly related to a product or service, and therefore, cannot directly be assigned to an individual customer or the customer segment. Conventional cost accounting typically uses a unit-based common denominator (e.g., sales revenues, production output, direct labor hours, processing time, and number of employees) to allocate those costs onto the customers in their role as final cost objects.
This procedure is widely considered as being one of the main weaknesses of traditional costing. If various indirect costs are “pooled” and assigned based solely on a single cost factor, that ultimately leads to a violation of the “causality principle”: The product’s or service’s total costs become distorted and misallocated (over- and under-costing, exceeding or hiding costs); under this allocation approach, each customer (segment), or rather each cost object, relatively consumes a homogenous amount of resources and therefore has to bear an identical sum of the costs incurred.
The activity-based costing (ABC) method
To be able to initiate effective measures of making customers more profitable, it is crucial to have a deep understanding of the cost relations and the costs each customer (segment) actually induces.
ABC is meant to be one of the methods which can reduce or even almost avoid the flaws of traditional cost allocation methods. This is because it uses a cause-and-effect approach that honors costing’s causality principle. In short, ABC in multiple stages accurately assigns the consumption of an organization’s resource expenses (material, supplies, salaries, and so on) onto the customers (the final cost objects) by using activity cost drivers. These drivers are based on work activities and their activity costs that transform the resources into the product or service.
The allocation approach lifts otherwise hidden cost components and reflects the de-facto resource consumption patterns of individual customers or customer segments. It reassigns expenses into costs with a more granular work activity level than in traditional systems that reduce costing accuracy by relying on a single cost allocation factor. Today’s integrated ABC software allows for smooth cost assignment procedures.
[For a more detailed explanation of the ABC method, please see a previously published article on that blog, already mentioned in the introductory section as well.]
Management accounting focusing on the company’s customers
Increasing customer profitability levels
Once the allocation of costs provides a “true and fair view” of the customer costs (and, in particular, of the costs to serve), it is time to identify customer profit potential and to think about activities on how to realize it properly, or rather, where to focus improvement efforts.
In the challenge of growing customers to be more profitable, there is always a balancing act between not spending too much on customer loyalty and satisfaction and destroying shareholder value. On the other hand, investing too less might harm the goal realization and even drive consumers into competitors’ arms (if they only feel treated as “cash cows”).
The chart displayed above classifies customers and/or customer segments into a two-axis grid. On the horizontal axis, the matrix separately focuses on the costs to serve as a marker for low to high impact on profits. The vertical axis, however, features an individual mix of products and services purchased as the other major layer of the profit margin in a P&L (distinguished between low and high product-profit-margin purchases on an average).
The customers are situated at different intersections within that matrix while the circle diameter reflects their sales revenues proportion. As it becomes obvious, customers who cause the highest sales volumes do not necessarily generate the highest profit levels. So, customers who are located deep in the bottom-right of the matrix are essentially unprofitable. To comply with its goal of maximizing profits, the organization has to drive its customers from their current intersection place to the upper-left corner—low costs to serve and a high product mix margin mean very profitable consumers.
A company has several options to achieve that transition incrementally, for instance by combining some of the following options:
- Introduce innovative new products and/or offer highly-valued services (from a customer perspective), which can be sold at higher prices and earn greater profit margins.
- Use the techniques of up- and cross-selling the customer’s purchases toward products with higher profit margin, e.g., next-best-offer-recommendations based on previous transactions (if customers have bought products A and B, they often also tend to purchase C as well).
- Levy specific surcharges to cover those expensive, mainly post-sales activities which cannot be reduced concerning their quantity and cost level, or cannot be substituted by less costly ones (e.g., specific legal requirements in the matter of warranty, or product take-back and recycling).
- Increase prices and/or reduce service levels in that way that unprofitable customers might be encouraged to “fire” themselves. Beware: this tactical option could stop some unprofitable customers from eroding profits further, but—especially in highly-competitive markets—profitable consumers might leave the company as well.
- Do not only encourage unprofitable, troublesome customers to de-select themselves, but also abandon products and services with low profit margins—in particular, if those are minimally valued by the customers.
- Streamline manufacturing processes, resulting in higher productivity rates, economies of scale, and lower product costs.
- Focus on reducing each customer’s significant “costs to serve” by improving business workflows and altering ways of packaging, selling, delivering, or generally servicing a customer.
- Change discounts, rebates, or the promotion structure provided to the customer. Discounted prices for such consumers with low costs-to-serve levels might push up total sales volumes and over compensate shrinking profit margins induced by less profitable customers.
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Must-read blog posts about management accounting and financial control—classical topics, as well as modern subjects, latest trends, and current challenges in the management accounting discipline. Aimed to inform, inspire, and entertain management accountants and anyone with a deeper interest in management accounting.