CHAPTER 6

Managing Customer Profitability

Chapter Outline
A. Cost Management Challenges Chapter six addresses five cost management challenges. 1. 2. 3. 4. 5. B. How can you determine in advance whether investments of time, effort, and information systems to prepare customer profitability information are worthwhile? How can customer profitability analysis be more relevant for service and governmental organizations than for others? How do you evaluate the trade-offs among the desires for relevant, accurate, and timely information? How do you evaluate the trade-offs among the desires for relevant, accurate, and timely information? How can you determine whether operational changes in customer service have been beneficial or harmful?

Learning Objectives 1. Explain the value of analyzing customer profitability according to major customer types. 2. Organize and prepare customer profitability analyses and reports using activity-based analysis. 3. Identify alternative actions and recommend improvements for overall and customer profitability based on analyzing customer related activities.

C.

Customer profitability analysis applies the concept of activity-based costing to determine how serving particular customers causes activities to be performed and costs to be incurred. Some activities that differ among customers include ordering in small quantities frequently or ordering in large quantities occasionally; changing orders; requiring special packaging or handling; requesting special (expedited) delivery or other special treatment. It is important to know customer profitability through identifying costs and benefits of specific customers or customer types to be able to improve an organizations overall profitability. Identifying and assigning costs to customers can be a challenge. Customers may cause costs from the time marketing and salespeople have their first contact with them until they stop being customers. Identifying costs and then determining profits generated from different customers requires completion of customer profitability analysis. 1. The first step in developing a customer profitability system is to develop an activitybased costing analysis of certain customer-related costs. These costs can range from processing orders to special packaging.

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2.

The next step is to estimate costs, customer by customer, to see which customers cause how much cost. Revenue information is combined with cost of goods sold to get gross margin by customer. The customer costs that have been identified are subtracted from gross margin to get operating income generated by each customer. Companies whose customers are other businesses usually have major customers who generate a lot of revenues but who may also cause a lot of cost. Sometimes customers who generate little revenue cause a lot of cost too. These customers may actually be unprofitable. The third step is to perform trend analysis of customer profitability to see if profit performance of customers is predictably high or low or following an upward or downward pattern. The most useful type of graphing is customer by customer, with a separate line for each major customer cost. Then managers can see which costs need attention. A useful fourth step is to rank customers based on the amount of operating income they generate. A graph of this information is called a customer profitability profile. It is important to identify effective and ineffective customer-related activities. Sometimes, we may suffer from over-satisfied customer-relations activities where customers are satisfied, but the company starts losing money because of providing excessive services.

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D.

Traditional profitability analysis by product line is often done without adequate scrutiny and proper identification of costs to the relevant product lines. The approach taken in this chapter is to provide more accurate customer profitability analysis using the activity-based costing concepts. 1. 2. 3. 4. Through establishing a customer profile, customers may be categorized according to major activities or factors that drive revenues and costs. It must be noted that if the customer values a service, he would be probably be willing to pay for it. Free service escalates costs, and the company providing it could suffer. It is also useful to keep track of customers sales patterns and the profitability that they generate. Customer profitability analysis involves closer scrutiny of selling costs, marketing costs, ordering costs, distribution costs, and general and administration costs. a. Customer selling costs include the costs of all personnel databases, equipment, and facilities devoted to sales activities. The challenge is to segregate these costs by customer type. b. Marketing costs include the costs of personnel, databases, equipment, and facilities devoted to marketing research, marketing strategy, and marketing plans. The challenge here again is to be able to segregate these costs by customer type. c. Customer distribution costs include the costs of packing, shipping, and delivering the products or services to customers, and it should be determined how much of these resources are consumed by what type of customers.

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d. Customer general and administration costs include costs of research and development and other related administrative costs. E. Product life-cycle costs encompass the costs of five phases in a products life cycle. They are (1) product planning and concept design; (2) preliminary design; (3) detailed design and testing; (4) production; and (5) marketing, distribution, and customer service. 1. In order to justify a products costs, sales revenue that it will generate over its life should be sufficient to cover all of these costs. This is especially important for products with short life cycles, because there is little time to adjust ones pricing strategy or production methods to ensure that the product will be profitable.

F.

With all the information on customer profitability, the final task is to see what we can do with it. 1. A common-size profitability report can show profitability by type of customer. If margins are satisfactory on all customer types or product lines, no action may be necessary. If some product lines are losing money, action should be taken to improve their performance or review possible alternatives in case those product lines or customers are phased out. If decision is made to phase out some product lines or customers, the company must make sure that the operating activity costs are proportionately reduced rather than being shifted to another product line.

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