We propose to utilize the aforementioned quality management systems—along with AcornSystems Cost Accounting software, and others, to measure and manage whether companies are actually making money with their customers. Directions such as customizing manufacturer products and solutions, and increasing specialized manufacturer services, to improve customer satisfaction and exceed customer expectations are but the start of beneficial outcomes from customer-based measurement and management implementations. Measures of satisfaction and loyalty may increase, but these increases are often accompanied by declining profits, especially when the increased functionality and services are not accompanied by increases in prices or order volumes. Our experience indicates that only a minority of a typical company’s customers is truly profitable.

Misalignment Incentives

Consider a scenario whereby a company’s sales more than triples over a 5-year period (325%) to nearly $3 billion. Then, factor in increases in “Selling, General, and Administrative Expenses (SG&A),” which should be a fixed, or at least, semi-fixed cost, of 337%--required to keep up with the demand of Sales growth. Despite the tripling in sales, gross margins would decline by one percentage point and the business would incur a long-term loss rather than a profit. When costs that should be fixed become variable, expenses can grow faster than revenues. Costs are important measures of profitability. However, customers provide revenues, and are therefore more important measures, towards a business’ profitability.

In order for businesses to expand their operations and increase their market share, they need to focus on new customers—capture new business by meeting or exceeding the expectations of businesses and consumers. Our Customer Profitability Measurement (CPM) approach works with LMS to increase service, by providing solutions such as:

All of these solutions create value and loyalty among customers, but none of these comes for free. Businesses would have to add extensive infrastructure to make the transition from its historic low-cost strategy to this new strategy of providing differentiated services to its customers. Without these differentiated customer services, a business can still succeed, but would have to make up for profits by maintaining the lowest cost structure possible, in case prices decrease. With these differentiated customer services, a business would be allowed to succeed with a higher cost structure by providing the products and services valued by customers. But for a differentiated strategy to succeed, the value created by the differentiation—measured by higher margins and higher sales volumes—has to exceed the cost of creating and delivering the differentiating functionality, features, and services.

In the scenario mentioned above, we can use the cost-plus policy as the dominant form of pricing, which is typical to most businesses, and is that in which the customer pays the base manufacturer price plus a mark-up for the distributor (around 7%). We can now see that because no provision was made in the price for special services requested by customers, variable costs predictably out-grew sales.

As customer demands for unpriced services increase, we can forecast two possible outcomes. First, the company incurs large losses in serving customer demands for large quantities of special services. Or, second, to avoid the losses, the manufacturer decides not to supply the services requested by its customers. For example, should the company refuse to provide either of the service solutions (listed above) to its customers, customer incentives become misaligned, leading to either excessive demand by customers or restricted supply by manufacturers. The market between manufacturer and customer breaks down which leads to loss of profits.

Such misalignment happens among many types of companies. When a company has no understanding of how the costs of the special products and services vary among its individual customers, it has no basis for recovering associated costs.

We propose that the breakdown in relationships between manufacturers and customers occurs when the manufacturer does not measure and manage customer profitability. If manufacturers understood individual customer profitability and the drivers of customer profitability, they could take a variety of actions to transform unprofitable relationships into profitable ones. Such actions benefit customers as well as manufacturers. Often, customers have to shoulder the burden of higher prices because of excessive consumer demand for unpriced services. Customers who do purchase at higher prices fail to measure their total cost of acquiring products and services. Also, manufacturers with profitable relationships do not balk at providing services valued by the customers. Valid pricing, based on the cost-to-serve, provides a critical parameter for mediating conflicts between manufacturers and customers.

Why do companies typically not understand their cost of serving individual customers and individual customer profitability? The primary reason is that financial reporting provides no requirement or incentive for companies to assign their operating expenses to customers. Companies are not allowed to assign SG&A, considered period costs, to products or customers. So calculating the cost-to-serve for individual customers and the assignment of relevant SG&A expenses to customers requires extensive extra computations. And, until recently, companies did not have accurate, machine readable and easily accessible data about the demands and ordering patterns of individual customers. So data were not available and information processing was expensive. Today, however, companies have proliferated the number of products made and customers served, and have experienced enormous diversity in customer behavior, thereby necessitating customer-focused profitability measurement and management systems. As well, the money being spent on marketing, selling, distribution and administrative expenses has escalated to keep up with the diverse demands from products and customers. While such recent increases in the scale and scope of customers would seem to make the calculation of individual customer profitability even more difficult and expensive, new information technology advances have come to the rescue. Contemporary hardware and software advances can now track transactions from thousands or even millions of customers.

As mentioned in the overview, we propose to utilize extensive Information Technology software to aggregate raw data in an economically meaningful manner. Activity-based costing (ABC), CPM, and associated software will provide the conceptual framework for linking customer transactional data from ERP and CRM systems with financial information, so that calculating individual customer profitability data becomes a straightforward exercise. The ABC cost hierarchy of order-related, channel and customer-specific costs (such as customer management and maintenance, accounts receivable, and specialized inventory) allows companies a clear and accurate picture of the gross margins and cost-to-serve components that aggregate into individual customer profitability.

The output from the ABC analysis is often portrayed as a whale curve (see Figure 1), plotting cumulative profitability versus customers. While cumulative sales usually follow the normal 20-80 rule (20% of the customers provide 80% of the sales), the whale curve for cumulative profitability typically reveals that the most profitable 20% of customers generate between 150 and 300% of total profits. The middle 70% of customers about break even, and the least profitable 10% of customers lose 50-200% of total profits, leaving the company with its 100% of total profits. And, often, some of the largest customers turn out to be the most unprofitable. A company can not lose large amounts of money with small customers. It does not do enough business with a small customer to incur large (absolute) losses. Only a large customer, working in a particularly perverse way can be a large loss customer. Large customers tend to be either the most profitable or the least profitable in the entire customer base. It is unusual for a large customer to be in the middle of the total profitability rankings.

Many companies lack the ability to track the profitability of each product used by an individual customer. But, in actuality, the profitability of a product is commonly determined by customer behavior. This presents an opportunity for applying activity-based pricing measurements and management.