Bringing Customer Profitability to the Enterprise
Information Management Special Reports, November 2004
Determining which customers are profitable - and by how much - and which products are profitable - and why - has become the focus of many corporate finance organizations. Customer profitability analysis, the ability to understand profit contribution by individual customer or customer segment, is proving to be one of the most powerful tools available to business managers today.
Arguably, customer profitability analysis is the single most important activity toward improving overall corporate profitability and should be considered a fundamental procedure for success for any company. This is especially true in organizations that have been effective at cost management and revenue growth and that are now looking for their next large boost in performance and profitability.
Uncovering the Hidden Losses
Profitable organizations often overlook their hidden losses. This drop in customer profitability is urging leading companies to quickly respond to increase overall profitability and improve overall financial performance. But industry experts often highlight the potential hazards of an incomplete profitability analysis approach. Geoffrey Colvin and Larry Selden, for example, have emphasized the importance of customer profitability in their book, Angel Customers and Demon Customers (Portfolio, May 2003). Colvin and Selden suggest that in some cases, the top 20 percent of a company's customer base produces 150 percent of its economic profit. The remaining customers may not contribute to profitability at all. Worse, they may contribute losses that eat away the profit of the top contributors.
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From All Customers to Some Customers - The Profit Shift
Globalization, competitive pressure and "overhead creep" are often cited as causes of customer profitability drop. Whatever the causes, a general, across-the-board decline in gross margins has made all customers less profitable. And in the extreme, where profits were slim to begin with, some customers have become unprofitable with this decline. Unfortunately, the unprofitable customers are not always easy to spot.
In Profit Patterns (Random House, February 1999), Adrian Slywotzky and his co-authors describe factors that have led to this shift from positive profitability of all customers to the condition where a huge portion of customers is unprofitable. These authors indicate that this is a shift that in many companies has taken place without notice and is a trend that is evident in all industries.
As an example, Company A is trying to better serve its customers - and to grow. The company has increased its product and service offerings but its customers consume products and services at different rates - so service levels vary widely. Accurately measuring customer service levels has been an ongoing problem for the company. With the increase in offerings, Company A simply can't accurately measure and understand exactly how much it costs them to serve and support different customers. Since organizations can't manage what they can't measure, attempting to improve performance before gaining accurate and complete insight is futile.
What is Eroding Customer Profitability?
The previous scenario demonstrates just one way companies can find themselves losing profits -unaware of the hidden costs and without adequate tools or processes to provide the information they need to improve profitability. Here's a list of some of the causes of customer profitability drop:
- Decline in gross margins from overhead creep and competition
- Vague understanding of the businesses costs and what drives them
- Increased variability in customer service offerings
- No visibility into the costs to serve customers
- Unguided customer behavior - and no understanding of how to guide customers to more profitable behavior
Four Steps to Advanced Customer Profitability Analysis
While most companies have attempted some ad hoc approach to resolving the customer profitability analysis challenge (usually founded in endless disconnected spreadsheets and cost reports) some businesses have taken a comprehensive approach to analyzing and managing customer profitability. Companies such as Merrill Lynch, Abbott Labs, Kroger, Morgan Stanley, Toshiba and FedEx are focusing on developing best practices to give them the insights they need to improve performance and obtain real results.
Step One - Understand Revenue and Cost Drivers
Fundamental to understanding customer profitability is an understanding of your own business. The framework used to analyze customers must be determined by the focuses of your business. These include: 1) the volume of demand against the cost to produce each product, 2) the costs to deliver products and services by channel and region, 3) the costs to acquire customers by process, and 4) the costs to serve and support by activity or customer offering. These values are the building blocks of customer profitability analysis and, when applied to individual customers or customer groups, they help you determine which customers are profitable, which are not and by how much.
For most companies, step one means moving beyond disconnected spreadsheets and onto a single robust analytic platform such as an OLAP platform. The platform should be able to aggregate multiple sources of data into a single location. It should also enable you to collect revenue and break it down by product, service, customer, channel, region and period. In the first and most simple analysis, costs taken directly from the general ledger are allocated evenly across products and customers to deliver average costs and simple profitability indicators.
The right analytic platform will take data directly from transaction systems and ultimately render customer profitability information through a variety of delivery vehicles, categorized by customer and will include:
- Online profitability and cost analysis of customers, products and services
- Profit and loss reports by customer
- Profitability and service cost dashboards
Step Two - Advanced Customer Segmentation Identifies Customer Behavior
By applying cost and profitability information to each customer, companies can start to see profitability patterns. Detailed customer segmentation, or micro-segmentation as Slywotzky termed it, is the process of analyzing and grouping customers into families in order to determine commonalities. Meaningful trend summaries result and form the basis for making program and operation decisions as well creating strategic plans to improve customer profitability.
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