Businesses know that customers are important. But even when companies achieve the right orientation towards customers, instinctively they know that some customers are more profitable than others and that some are probably loss-making. In the first of a new series of 7 articles written for FSN, Brian Plowman, contributing FSN author and managing director of Develin & Partners highlights the importance of completely understanding customer behaviour, in-house systems and processes in the drive for better profitability.
For some businesses, this doesn’t matter much. If margins are good enough, for whatever reason (a captive market, or a patent, or regulatory protection…) overall profitability is sufficient. But few businesses have that luxury.
The business may also have some idea of which customers are probably the least profitable and which are the most profitable. A walk around the business listening to anecdotes in different departments will tell which customers are demanding of time and effort and cost: these are the customers who order unpredictably, amend their orders, change specifications at the last minute, delay payment, and require special deliveries, and so on. Every department will have its own, separate experiences of customer behaviour. Nobody will have the whole picture. So anecdotal evidence will pick up the extremes – the ‘worst’ and the ‘best’ customers. What about the others?
Customer profitability is a black hole in most managers’ understanding of their business. Identifying customer revenue is easy: it's called the sales ledger. Identifying what individual customers cost – so we can understand whether or not they are profitable – is difficult. In a world in which competition, and often regulation, put increasing pressure on margins, it is vitally important to understand both product and customer profitability. As if competition were not enough to put pressure on margins, electronic commerce promises lower unit costs and creates customer expectations of lower prices.
Inevitably, not all customers are created equal - they behave differently from one another and have a variety of characteristics, so they generate different costs and margins. Some are highly profitable, others are spectacularly unprofitable, and many lie in-between. It important to know who is whom because very often a small, anonymous group of customers contributes the major share of profits, while an equally invisible segment erodes it.
A clear understanding of customer profitability allows a business to differentiate the level of service it provides to various customer segments according to their needs and their value to the company. For example, it may offer individual attention to prized customers in the form of dedicated telephone lines, free delivery, incentive pricing or customised products. At the same time, it might choose to reduce service to unprofitable customers – or to increase prices – even at the risk of losing them. A comprehensive view of the costs that customers drive allows a business to refine its processes and policies and focus its resources where they will have the greatest effect on profits: cementing customer relationships; avoiding excessive costs; matching prices to the service given.
In many sectors the customer continues to provide revenue and to drive costs well after the initial sale, through after-sale service, repeat purchasing or general administration. All these costs, as well as the revenues, need to be identified and analysed to ensure that the initial terms are profitable and that the customer segments a company targets have a high probability of being profitable over the lifetime of the relationship.
An added benefit of customer profitability analysis is that it highlights the costs of poorly-designed internal processes. As the true costs of processes emerge, managers can sense which costs are suspiciously high. This triggers a cycle of further investigation, problem identification and process improvement, thereby correcting profit-harming defects that would otherwise continue undetected.
This is where Activity Based Management (ABM) can really make a difference. ABM enables managers to understand product and customer profitability, the cost of business processes, and how to improve them. Since conventional management accounts and standard costing systems do not provide this information, it is perhaps surprising that ABM is not more widely used. This begs the question – Why?
We have understood manufacturing activities for years. We measure the consumption of direct labour and materials in making products. On average, however, direct labour, materials and components account for around two thirds of total costs in manufacturing businesses. The other, unmeasured, third is overhead activities and costs. In service industries, the ratio is the other way round – the unmeasured ‘overhead’ accounts for two-thirds or more of costs.
Overhead costs are the black hole in conventional management information systems. ABM shines light into the hole. Knowledge of a business at the level of activities is the basic building block upon which new understanding can be built of where profits are being made and where they are being eroded. By making visible what was previously invisible, ABM throws a spotlight on those aspects of a business where action can directly improve business performance. In fact research shows that 80 per cent of companies that have employed activity-based techniques found them to be successful.
Unfortunately, because ABM deals with ‘financial numbers’ it is often seen as the preserve of the Finance function? But in practice its real strength lies in providing genuinely useful information for all functions in an organisation. Managers throughout the business need the right information to understand and address two key issues. Firstly, how the company can position itself better in the market – for which accurate product and customer profitability information is vital. Secondly, how it can improve its internal capability and lower unit costs – for this, it needs to understand and change the procedures, systems and processes that create products and deliver services to customers.
Most organisations are complex. Building an ABM model of a business requires a structured approach and the dedication of a team to achieve a result in a reasonable timescale. But building a model is only the start. Embedding ABM into the business means giving managers not only a new understanding of what drives costs, but the means to measure and act on the drivers to reverse adverse trends.
The next article in this series will explore customer and product profitability in more detail.
Related FSN reading
Why Activity Based Costing may be just the tonic in a downturn
