Dr. Robert Kaplan of Harvard Business School stated “…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.”
This means that as many as 80% of your customers are at best, break even, and you may be “shipping dollars” to as many as 20% of your customers! Most managers are surprised when they see this but they shouldn’t be. Most accounting systems provide data on product cost and profitability by product line, department or geographic location but NOT by customer.
The way to get at this critical information is to embark on a process of Customer Profitability Analysis (CPA). The key idea in CPA is that each dollar of revenue does not contribute equally to net income and you should manage your business accordingly.
- Captures and assigns costs to individual customers, not products, services or departments.
- Can be used at either a very aggregate, somewhat aggregate or detailed customer level. This allows management the flexibility to either analyze a particular customer or a large group of customers.
- Focuses on multiple products sold to a single customer rather than a single product sold to multiple customers.
The benefit to the company that conducts a CPA (and acts on it!) is that simply by eliminating the customers that cost you profit, you may increase bottom line company profitability by 50% – 200%. Further strategic efforts to bring break-even customers to an acceptable level of profit will improve the bottom line even further.
Differences in customer profitability are the result of either differences in revenues or differences in costs. Differences in revenues arise mainly because of differences in price per unit charged to different customers, usually in the form of discounts, and without regard for the profitability of the sale. Differences in customer costs arise from the way customers use the company’s resources. Most of this cost difference lies in the use of functions such as customer service, sales, marketing, administration and distribution.
A CPA properly allocates costs (beyond Cost of Goods Sold) to customers who use such resources and offers lower prices to those customers who do not use such resources.
How Do We Do This?
The CPA is a strategic process with all departments within a company having a role and a stake because the implications for sales, marketing and operations may be significant.
- High level – segment analysis.
- Mid level – analyze logical customer grouping.
- Detailed – net profit per customer.
- Establish time horizon for analysis.
- Gross profit per customer.
- Subtract customer-specific activity costs.
- Sales costs
- Processing costs
- Delivery costs
- Servicing cost
- Financing costs
- Allocate Other Overhead costs.
This should be a dynamic process repeated multiple times a year or monitored continuously.
Jerry Comer is owner and a principal of Comer & Associates, LLC and a partner with IMPACT Management Systems. For more than 35 years he has helped companies improve productivity and profitability through innovative programs and training focused on external market opportunities and internal team and individual development. We are honored that he has agreed to contribute to our blog.