Finance - Direct Customer Profitability

Follow the Money!

by Nils Randrup

 

If you want to get more profit out of your current stock of customers, it is necessary for you to know the direct customer profitability per customer, and not just the total sales figure or gross margin. Tools like Activity Based Costing applied to your individual customers will help. They give you the ammunition to make better decisions about how to increase bottom line profits and on how to spend your marketing and sales resources better than you do today.

With apologies to “Deep Throat” of Watergate fame, this is not about political shenanigans.  Rather, it is about the changing income statement.  Did you look at your corporation’s income statement lately and maybe compare it to the income statement of some years ago?

If your company is like most, there is a constant movement, over time, of expense from the Cost of Sales line to the SG&A (Selling, General, and Administrative) line.  Studies show that where twenty years ago 70% of expenses were variable, it is now not unheard of to see only 30% being so.  The big changes are caused by the cost of additional marketing expenses, sales resources, HR, the IT department, etc.  Thus, where a meaningful discussion about customer profitability might once have centered around the Gross Margin exclusively, it is now essential to look at the – traditionally “invisible” – expenses two lines down.

What does that mean for your business?  Among many other things, it means that where it might have been relatively easy some years ago to break down the cost of sales into the specific market areas and customer classifications to identify the profitable customers, this is now much harder to do.  To do a customer profitability analysis you now need to know the specific SG&A contribution by class of customer or market segment.  Do you know how much marketing effort you expend per market segment?  If not, you’d better find out.

If you are like the participants in a recent study of medium-to-large size Danish companies, right now you are losing money on one out of every four customers when you add up all the expenses, including the SG&A.  And the profitability of a further 15% of your customers is below the hurdle rate for return on invested capital.

At this point, your Marketing and Sales people will start talking very fast about strategic accounts, etc.  And of course they might very well be right.  The point of this is not to tell you to get rid of all customers who do not create returns above the hurdle rate.  Rather, it is to suggest that you should know in detail what each class of your customers is really bringing you in terms of profitability, image, brand value, second level opportunity, etc.

We shall save the discussion of brand value for another time.  For now, let us concentrate on the issue of quantification/separation of SG&A expenses by market segment.  Traditional cost accounting allocates SG&A cost according to some metric, quite often total sales volume.  So, if one segment has twice the sales, it will get twice the allocated SG&A.  This might be perfectly fair though, as we have all seen, to sell a contract for X amount of product might take the same effort as selling a contract for 10X.  If that is the case, it is unfair to allocate by sales volume.  Enter “Activity Based Costing” – ABC.

In the Activity Based Costing model you identify activities that you can quantify and identify the cost for each, for example – to stay with the sales example – the number of sales meetings necessary to close a contract.  If the number of sales meetings is not correlated with the contract value, the allocation of SG&A to the segment by contract size will be quite different.

So, the takeaway is:  follow the money.  Know what your customers bring you in terms of profitability and other benefits and look at Activity Based Costing.  The more you know, the easier it will be to make the necessary decisions and still sleep at night.

 

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