III. Management accounting focusing on the company’s customers.
In former times, companies could defend or even extend their market position by simply satisfying customer needs with standardized products and services pushed into the market. Over time, they gained advantages through economies of scale, which, in turn, resulted in lower costs, and therefore, lower quotation prices. But the times of market mass production and mass marketing are gone.
Today, customers increasingly view suppliers’ products and standard service lines as commodities. Furthermore, customers no longer accept any kind of product quality and service level, but want their special needs to be met completely. In addition, competitors can easily replicate an enterprise’s standard products and services. This means that the competitive edge resulting from product advantages is reduced or even entirely neutralized.
So, each organization has to step up its efforts to attract potential customers and retain the existing ones while establishing sustainable relationships with them. Business marketing and sales techniques need to shift from a product-centric to a customer-centric focus and require predictive planning. Only then can the companies stay competitive, generate customer value, and create competitive advantages.
How is management accounting affected by the developments described?
Management accounting is directly involved in the company’s budgeting and planning processes in which the company’s short- and long-term routes are determined. In succession, it identifies, measures, analyzes, and interprets data, and eventually communicates information on whether the organization has met its targets. Furthermore, it provides general economic feedback to decision-makers and supports in controlling costs and improving the company’s operational effectiveness and efficiency.
To sum it up, the management accounting discipline contributes to organizational performance and profitability, and provides crucial information for planning, controlling, decision-making, and strategy formulation. What all these tasks in many companies have in common is a strong (and often exclusive) focus on internal processes.
Management accountants have to ensure that the information provided to the management and other executive staff is relevant and useful in doing their jobs. If the company wants to increasingly shift its focus from a product-centric to a customer-centric one, management accounting has to grasp a more market-oriented approach, too, providing actual and relevant information about customer accounts, customer needs, customer loyalty, as well as channel and customer profitability.
In other words, some kind of customer relationship management—long assumed to be solely a marketing function—becomes an essential part of management accounting. It actively takes part in the procedures and processes on how relationships with customers are developed and retained, and especially, on how to grow customers into bigger ones, making them more profitable, and serving them more cost efficiently as well.
The different types of customers
Customer differentiation can be a complex and complicated field, because there is a broad range of low- and high-demand customers. The latter group might generate big sales volumes through its purchases. However, in contrast to low-demand customers, they also might create additional costs for the company. For instance, high-demand customers might regularly call customer service, often return goods, change delivery schedules, complain more forcefully about supposed product deficits, or need other special and expensive treatment (nonstandard delivery requirements, etc.). The organization incurs extra expenses to serve its customers’ behavioral patterns and demands.
So, in the end, high-demand customers can prove to be less profitable than low-demand ones (at least, in relative terms), even if in the first instance you might assume otherwise, when you only look at the bigger sales volume of their buys. From this, it follows that it is not all about increasing market share and growing sales volume but also about gaining profitable customers.
Usually, companies might presume that almost all but a few of their customers are profitable. However, the truth, as brought to light by research, is that the opposite is true. As those field studies suggest, about 25% of customers generate between 150% and 300% of the company’s profits. About 65% of the organization’s customers are at breakeven point, which means the sales revenues and the occurring costs are balanced. Eventually, about 10% are unprofitable, that is, customer costs exceed their revenues. In other words, those people reduce or destroy anywhere from 50% to 200% of a company’s profits (as the overall profit of the enterprise finally gets back to 100%).
The fact that only a relatively small fraction of customers substantially contributes to a company’s profits and the other ones are either breakeven or unprofitable may surprise or shock the management at first. So, there is a need to replace “gut feeling” with a measurement system that supports decision-makers with adequate information and analysis.
But how do companies measure customer profitability properly? At first, they need to understand that there are costs not only of their standardized product-and-service-line mixture (direct costs), but also non-product-related expenses. These have implications for a customer’s profitability, or rather, the products’ and services’ profit margin, too, as it can be seen in the following sections.
The different types of costs
Whereas customer-related revenues can be assigned relatively easily to each customer or customer segment (combining customers with particular similarities), it is much more problematic with customer-related costs. A company does not only have to bear expenses directly related to its product(s) or service(s). There are also “costs to serve” incurred by sales and distribution channels, and by other needs of potential or existing customers (e.g., 24/7 helpdesk support). Eventually, customer costs are the sum of all costs necessary to provide the products or services to the customer. These can be split into three main categories: product costs, costs to serve, and corporate sustaining costs.
Product costs comprise direct costs for material, labor, and equipment. Indirect product costs, such as additional costs for manufacturing and support (e.g., machinery insurance, repairs and maintenance, electricity, salaries of the indirect manufacturing personnel) are typically assigned using a unit-based allocation approach (direct labor hours, processing time, production output, number of employees, etc.).
Costs for marketing, sales, order processing, distribution, and customer service can be assigned to the “costs to serve” category. This also applies to repairs under warranty, disposal costs, and other post-sale services, for instance.
Costs to sustain the business comprise overhead costs (administrative costs) linked to corporate functions like accounting, IT services, procurement, legal department, management, and so on. Whether these costs should be included in customer costs is situational and depends on each individual case.
Direct costs normally do not raise questions about their allocation to customers or customer segments as the cost object. Indirect product costs, as well as the (typically indirect) costs to serve and to sustain, are usually assigned to a cost object using unit-based allocation schemes. However, it often violates cost accounting’s causality principle and distorts the product’s or service’s overall cost accounts, if various indirect costs are “pooled” and allocated, based on a single cost factor.
The trouble with conventional costing to determine customer costs
Traditional cost allocation methods focus on products and cost centers, but are not customer-centric. So, they imply that all customers, or rather, customer segments are homogeneous. This also means that a homogeneous consumption of indirect costs by cost objects—the customers—is assumed. This—in most cases inappropriate—assumption represents that indirect costs are allocated on the basis of a unit-based common denominator, such as production output, sales revenues, number of employees, processing time, or number of customers. Unfortunately, that approach typically does not reflect the de-facto resource consumption patterns by individual customers or customer segments.
Eventually, it leads to an incomplete costing, below the customer gross profit margin line, or rather, a misallocation of costs (over- and under-costing). This is especially troublesome because indirect costs, such as indirect manufacturing costs, have increased significantly over the decades and are less likely to be caused by the quantity of direct labor or production machine hours. The broad averaging of non-causal overhead cost allocations flaws the customer costs accuracy.
Ideally, indirect costs should be spread according to the amount of resources consumed by each cost object, using a cause-and-effect approach. The activity-based costing method allocates such activity costs based on its activity cost driver rate and the customer-related consumption of that activity. This provides causally assigned costs based on customers’ or customer segments’ behavioral patterns.
The activity-based costing method
Activity-based costing (ABC) transforms resource expenses into costs based on resource or activity drivers. It is a cause-effect cost assignment system. Eventually, the approach provides additional cost visibility that is otherwise hidden in traditional cost allocation methods.
Generally, ABC consists of a multi-stage process. At first, you need to identify the activities, that is, the work performed by employees or assets. Resources (direct material, supplies, electrical power, staff salaries, office rental, etc.) provide the available capacity to perform that work. If there are no resources, activities cannot be started neither. Activities, on the other hand, convert the resources into some kind of output, such as products, supplies, and services, which the customers or the customer segment eventually consume.
Using resources and performing activities always comes with costs for the company. Customers are the final cost objects. This means they bear the costs of the resources needed in the work activities, as they can also be seen as the origin of those costs. That is, because of the demand-pull from customers for a product or service, they create the need for the resource expenses to be supplied.
So, to be able to measure the customer costs—and thus, customers’ profitability—resource expenses have to be assigned to the customers or the customer segments. Activity cost drivers are the intermediary parameter for that allocation. In a first step, the resource costs are assigned to the activities they are consumed by (via resource drivers), leading to activity costs. In a second step, these activity costs are assigned to the customer cost objects via activity drivers, which may be based on transactions (counts) or duration (time)—for instance, the minutes spent on performing a particular work activity, the number of orders placed, the number of returns, the machine setup hours, or the number of checks cashed and housing loans processed.
Final implications for management accounting
The management accountant is one of the central figures to measure customer profitability, helping sales and marketing functions optimally focus their efforts. In an ideal case, implemented customer profitability management identifies the relative profitability of different customers or customer segments to derive ideas and strategies that add value to most-profitable customers, make less-profitable customers more profitable, and stop unprofitable customers from eroding profits further.
To fight competition, each company needs to know which customers to acquire, grow, retain, or win back, as well as which ones to “cast out” because they will probably never become profitable. To maximize returns, it is also important to figure out the exact level of spending necessary for each customer segment to achieve these tasks. Excessive spending might destroy shareholder value. However, too little might drive loyal consumers into competitors’ arms.
Further exploration of the topic: Migrating customers to higher profitability
Migrating customers to higher profitability can be a complex and tricky task. Therefore, that topic has been addressed in a separate article:
Migrating Customers to Higher Profitability
Read on with Part 4: IV. The management accountant getting useful hold of Big Data
Or read the previous parts at first:
I. Raising awareness of predictive analysis by management accounting
II. The management accountant taking on the role of a change agent
About this blog
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.