The Five Myths of Customer Profitability
by Scott Benfield
The subject of customer profitability has been in distribution knowledge circles for a quarter of a century. Starting with Activity Costing in the early 1980s, distribution consultants were quick to pick up the idea of allocating operating expenses to customers to determine their individual profitability.
The idea of customer profitability has spawned numerous articles and books for distributors over the years. The basis of the knowledge, that customers can be evaluated on their unique profitability and action can be taken to make them more profitable, is logical in thought and reasonable in practice. Distribution is an aggressive step-cost business where operating costs, or the popular moniker "costs to serve," step up with sales volume of the customer. Traditional financial accounting does little to help distributors understand these costs and there needs to be some type of allocation methodology to help distributors understand where the profit comes from. Recently, there has been a resurgence of customer profitability literature and efforts which indicates the general interest in the subject and its potential in distribution companies.
After working with customer profitability and its antecedents of territory, branch and segment profitability, we have seen fleeting success and spectacular failures in the subject area and have gone through the history files to bring clients, readers and the curious our perspective on the myths of customer profitability. We list them in the remainder of this article in no particular order.
Myth 1: Negative profit customers can be made profitable
Our work finds that some 130 percent of operating profits come from less than half of all customers. Making all customers profitable would, conceivably, balloon profits and distributor owners and operators could afford two country club memberships and two vacation homes. The problem is that making all negative profit customers profitable is a Pollyanna. Why? First, some customers are hopelessly negative profit including those that buy small transactions and those who buy much of their mix from the counter while being assigned to an outside salesperson. Beyond this, some segments of the business simply take more in service support than they deliver in margin dollars. Our answer to the idea that negative profit customers can be made positive is that the idea is mostly myth. The best distributors can expect to do is make many of the negative profitable customers less unprofitable.
Myth 2: Firing small customers makes financial sense and increases profits
No other myth of customer profitability is so well-established as the small customer fallacy. There is, in distribution circles, the story of the distributor who put a bucket of $20 bills on the counter with the sign to small customers "Take one and never return." The only sure things that one can say about small customers is that they are small, seldom will turn into large customers and are, generally, less price sensitive than other customer groups. The problem in labeling them as unprofitable depends largely on how they buy. If an over-the-counter transaction costs $30 and the small customer buys $50 transactions at a 35% margin, the customer is unprofitable. However, if the small customer buys twice a year and the transactions are $500 each at a 20% margin, they are profitable. There is very little correlation between customer size and profitability at the operating profit level. In aggregate, small customers are often unprofitable but blindly aggregating customers is only good if one's markets are un-segmented and the segment method starts with customer size in revenues. As a long-term marketing strategy, assuming all small customers are negative profit is a losing proposition.
Myth 3: Salespeople, armed with customer profitability statistics, can make customers profitable and operating profit will improve
Several years back, a book on baseball called Moneyball detailed the use of statistics and higher math to change the landscape of competitive baseball. For example, the long trusted metric of base running speed was dropped and metrics such as on-base-percentage were adopted. One experiment, during the early days of the knowledge development, was to give the players the new statistics and knowledge in hopes that they would make the game better. The result was an unimpressive effort by players to use the new knowledge. Managers found it was better to change the batting line-up than try to educate players on the new knowledge.
A similar effect applies to sellers when driving customer profitability. Arming sellers with a plethora of accounts, and their unique profitability statistics, with instructions to change the profit picture, means little. Telling them to increase order size or raise pricing can be disastrous. Why? What if the seller increases the account size by selling more non-stock products which are, traditionally, money losers? What if the seller raises prices on commodity items and the account flees? Before instructing sellers what to do, management should have a plan and logic in place before getting sellers excited. Pricing should be planned and parameters, rules and regulations given to sellers before they raise price. Services should be defined for segments, otherwise sellers may give away, take away, or modify services without proper knowledge of the downstream implications. Sellers can be effective change agents but management must have strategies and tactics well-defined and the boundaries understood before sellers are engaged. Giving sellers a bunch of numbers and saying "go get 'em" is naïve and generally turns out worse than not doing anything at all.
Myth 4: All customer profitability models are the same
The new customer profitability models run the gamut. In our judgment, some are sound and some are misleading. The creator of Activity Costing, Robert Kaplan of the Harvard Business School, recanted much of Activity Costing in a 2006 release of a working paper on the subject. Kaplan advised that new approaches should have one baseline logic instead of many drivers of activities. Kaplan uses time as the baseline logic while we use transactions. Some models, currently available, use numerous drivers including number of purchase orders, number of payments, number of shipments, customer hassle factors, number of sales calls, number of receiving lines, number of counter visits, etc. The problem with numerous drivers is two-fold. They make it near impossible to write coherent algorithms (formulas) that relate costs to the customer and they drive complexity and upkeep cost to the stratosphere. If your customer profitability model service provider uses numerous drivers, they probably don't adhere to one baseline logic, and the model has the problems found in the early activity costing models.
Secondly, we argue against dividing fixed costs over cost drivers. Dividing fixed costs over volume has inherent flaws, including overburdening customers with costs and causing the firm not to take orders that contribute to fixed costs. We don't consider fixed costs in our customer profitability. Why? Because they are largely not influenced by customer volume, except in the very long run, and hence they are not all that important to strategies forthcoming from the customer analyses.
Our advice for evaluating new-age customer profitability models is simple. Does the model have one primary baseline logic and does the model keep fixed costs out of the equation? If the answer to these questions is no, we consider the model retrograde and repeating the same mistakes of activity costing of yesteryear.
Myth 5: Changing the sales compensation will positively change customer profitability
Having a significant part of compensation on margin dollars (20% or more) typically clashes with maximizing customer profitability. The issue is that margin dollars don't mean all that much unless service costs are allocated to customers, and service costs can easily make a high margin dollar customer profit negative. Simply changing sales compensation, however, to reward sellers on customer profitability is potentially dangerous. First, sellers without proper training and systems fall victim to Myth No. 3. Secondly, negative profit customers can, depending on the time period, help float the boat. Customer profitability looks at the long run while period accounting looks at the short term. If sellers get rid of too many profit negative accounts, in the short term, the company may not have enough margin dollars to pay bills in the next accounting period.
Finally, sales compensation as a strategic change option is way overdone. Strategic changes most often come from executives who have the power and scope to drive them. Mixing up sales compensation has been tried, in one form or another, for many years and the results, on the whole, are unimpressive. Changing compensation may make the troops feel good, but don't expect a tremendous pop in earnings after the new compensation takes hold.
These myths still pervade much of the field of customer profitability. They should not destroy one's desire to engage the field but they should help with much disinformation or slanted information proffered by "experts." By understanding and digging into the myths, distributors can make more informed decisions about which advice and knowledge experts to follow and engage.
Scott Benfield is a consultant to distributors and manufacturers on channel issues. He has consulted, since 1998, for a variety of medium sized and Fortune rated clients. His work is grounded in significant early and mid-career experience in large distributors and Fortune 100 industrial companies at managerial and executive levels. He is the author of five books and numerous research and trade articles. He can be reached at (630) 428-9311 or email@example.com. His work can be seen at www.benfieldconsulting.com.
I have a new customer and the Operating income as a percentage of sales is -13.9 what should i do and recommend to this company
I think your comment was about the $1,000 yearly customer that buys $50 transactions at a 35% margin when the transaction costs $30. Our overwhelming research is that small customers, below transaction breakeven, almost always remain small. After three years, 95% of the small accounts are small accounts even with increased sales and marketing efforts aimed at them. The idea that they are "thin buyers" with upside potential has appeal, but our work finds that most small customers are not core buyers. If they are core buyers, they are usually unprofitable at a wholesaler since they are using them as a secondary or tertiary source and the increase in business, if it comes in volume, is often a result of foul-ups or changes in relationships from the primary supplier.
In essence, if I read your commentary correctly, you seem to be saying that small customers can become big customers which I patently dismiss. The idea that they can become less unprofitable is where we generally aim our efforts. And, we don't put much effort in them when we do aim.
I agree... it is usually silly to fire customers unless they are a total disruption to your business. I compute customer profitability both on a net basis and a "contribution to general fixed overhead." If customers are contributing to overhead, in other words, the GP$ less direct activity based costs of order taking, picking, delivering, etc., then you don't want to fire them unless you can identify exactly what fixed overhead you will eliminate. Good luck with that! If you fire them, you are out the GP$ that contribute to fixed overhead and your profit will decline for certain!
Customer profitability can also be looked at by segment... with stats by average order size, number of orders, number of line items per order, number of orders with more than 2 product categories, etc. Looking at an aggregate of profitability for customers in a segment is a valuable tool for changing policies and marketing strategies, especially pricing.
After you have calculated ABC costs for each customer, just have your database add up the costs for a spec: such as small contractors with $2 to $9,000 of purchases per year. Look at the average order size, GP$ level, avg. GP$ per order and compare to other segments.