Betsy: It’s very possible if you’re not tracking finances by customer. For instance, in a service business, you might not track the results of each individual customer relationship in your financial records. So, one might be costing you a disproportionate amount to support, and unless you have other mechanisms other than a general ledger, you’re not going to detect that.
Jay: This is also true for a producer of goods, an OEM, or a manufacturer.
Mark: Even if you are trying to track some costs or profitability by customer, unless you're doing something such as Activity Based Accounting, you really could be losing a lot of money without realizing it.
Traditionally, profitability is determined by taking your sales by either customer or product and then subtracting materials, labor and some sort of allocation of overhead as well as making an allocation, traditionally as a percentage of sales, for general and administrative and research and development costs.
As an example, I had a client where ten percent of their revenue came from one customer and the customer was outside of their usual business model. It was a job shop that did a lot of engineering. The customer was in the automotive industry where the client was competing with discreet manufacturers and dedicated manufacturers, not other job shops.
Well, if we did an allocation only based upon percentages of revenues, the customer looked profitable. However, almost the entire quality department, which represented a significant cost to the company, was only required because that customer required the client to maintain all the certifications and the automotive quality systems.
When we properly allocated the cost of the quality department based upon the cost driver, they were actually losing money -- a lot of money -- on their largest customer. They would’ve been better off eliminating the sales, eliminating the materials, eliminating direct labor, eliminating quality, and they would’ve ended up with more cash.
Betsy: That’s a good point, Mark, because it brings up the difference between direct costs and indirect costs. So, there’s two ways that you can measure losing money on a customer. One is via direct costs (which is incomplete), and then the other is after assigning indirect costs. Which is why I think there’s a higher propensity to have disproportionate costs in service organizations.
Mark: And that’s a fairly common problem; very few companies use Activity Based Accounting. Almost everybody uses the old traditional accounting methodologies from the 1920's and '30's when labor and material were the biggest costs.
Mark: Tracking profitability is especially challenging because almost every entrepreneur chases sales rather than profit.
Betsy: Often when you show a client that one of their larger customers is unprofitable, they go through a cycle where they don’t want to believe you at first. And then you have to keep presenting the evidence until they’re to a point where they can accept it.
Mark: Yes, almost never is it accepted the first time through.
Jay: Well, also there’s always the thought on the owner’s part, we can’t change anything or we will lose this customer. And you have to walk them through and say, “no, the way this relationship is currently structured, we cannot afford to keep this customer.”
Betsy: That’s really tough for someone who has been conditioned their whole career to chase revenue.
Here’s an example of an activity based cost system from my experience with a service organization that had a call center. In a call center environment under a traditional accounting system as Mark referenced, you would have the call center department with a lump sum of labor dollars assigned to it.
And if you had ten customers, you would have no idea which of the ten you were supporting. You would probably have an idea what percent of the time the call center reps were on the phone versus not on the phone, and you’d have other metrics such as the average call duration and the average speed to answer a call. But you wouldn’t know how it got divvied up between the ten customers.
What an activity based cost accounting system did in this case was when the call center rep answered the phone, they logged in to indicate which of the customers they were on the phone with.
So that’s how we found out that the one was taking ten times the average amount of call center time as the others. And it was based on the customer’s inefficiencies. So, they were causing us to suffer because they were inefficient in something they were doing.
And the interesting thing with this customer is after we raised their price they walked away, but a year and a half later they came back and agreed to a much higher price.
Mark: Basically, if you think about it, the difference between traditional accounting and activity based accounting is that all the overhead, selling, general and administrative, and research and development costs, you try to put as direct instead of a general allocation.
Betsy: That’s a really good point. So really, in a thorough analysis, you want less than twenty percent of your costs being considered overhead. Whereas, if you look at a typical service organization, probably eighty percent starts out as overhead, so you’ve got to flip it.
Betsy: It depends. I think the whole key is that you need to have some mechanism to try and measure customer profitability, either an interactive system that works with your general ledger system or an ad hoc financial analysis that you do on a periodic basis.
Jay: A problem you frequently run into is your largest customer not only negotiates the lowest price possible, but also requests you provide additional engineering, administrative or selling services free of charge.
Mark: The vast majority of the time when I sit down with a new client and we look at the customers they feel are profitable, we find absolute surprises that change their strategy.
Jay: We often find hidden costs on the balance sheet. What we are seeing over the last number of years is bigger customers are trying to push down the cost of the supply chain to suppliers. One of my client companies just received a request from a very large customer to cut our lead times, which if you translate that, means carrying a larger inventory along with its associated costs.
Jay: Well, typically when I go into a company and they’re losing money on a big client, they don’t have a lot of excess funds to implement additional accounting and finance operations. So, we have to look at each customer and make judgments on what we’re going to do.
You often get into looking at how they price in the first place and find they’re doing something incorrect. So, not only are you attacking their existing client base, but you’re helping them price on future clients.
Betsy: You can model pricing and profitability. If they’re not a current client, you’re going to be projecting it using certain assumptions, but it’s a prudent thing to do -- particularly if in the agreement you’re entering into with the customer you can specify the expectations of scope. Then if the scope differs from what was expected, you have the mechanism to go back and renegotiate the price.
Jay: When you deal with a huge company that has a whole department whose sole existence is to beat down your price, you’re going to have to make some sacrifices if you truly think that business is in your strategic best interest.
This can be a situation where you’re overly dependent upon one sector of an industry and you want to get into another sector. You may have to be a little lower on your pricing, on your margins, to get a foothold. But if you’re not careful, that can be self-defeating. It’s very tricky to “buy” market share with pricing. You really do need to understand your profitability to do this.
Mark: You can lose money on small customers. You can lose money on big customers. The customer size really goes back to looking at the profitability in different ways. And usually the way this thing gets started is the CEO or the entrepreneur will come up with a new proposed big customer, or a big or a new product line where you have to take a look and make a judgment on it. That’s the easiest way to get the entrepreneur excited about this concept -- when he or she is looking at a new program that might require some special pricing, some additional investment, that may change things.
Betsy: And attracting smaller profitable customers as a result of having a big strategic customer can pay off. But you’d have to look carefully at the overall strategy of having a big customer at breakeven.
Jay: You’d have to have a pretty good game plan in place to intentionally take on an unprofitable customer. You have to have an almost iron-clad game plan or strategy to do that.
Mark: When we do the analysis, it’s almost never cut and dried as to what the answer is. There’s almost always positive and negative factors, advantages and disadvantages, of doing these sorts of things. My approach is to define the risk and present what I recommend.
Jay: Right. Plus, when you’re dealing with a big customer, you may not be dealing with just one product. We have some big customers with one of my clients, where we sell them upwards of fifteen or twenty different products, and some of them turned out to be less profitable than we thought. So, we are discussing with this client that we cannot continue the existing pricing on these very unprofitable products.
This is typical of most cases I’ve seen, it’s not just one product to one customer. It’s a family of products; and some of them can be profitable and some unprofitable. In that case, we work on the unprofitable to improve margins.
Jay: With the client in my example, I would say three-quarters of the products that we sell are profitable. So, we’re working with the bottom quarter to begin with. We’ve sent these customers a letter notifying them of a price increase with the understanding we’ll continue the existing price for six months while they find another supplier if they do not want to go with the price increase. In some cases, they take the unprofitable parts elsewhere, but many have accepted the higher price and stayed with us. But, if they take an unprofitable part away, it generally is not that big of a deal as we were losing money on that part to begin with.
Betsy: So, they typically keep the other parts with you?
Jay: We haven't lost the profitable products. We’ve only lost the unprofitable products. But in each case, we analyzed what it would mean to lose the whole customer, and we’re willing to run that risk. But maybe it’s just the time in this economic cycle because we’re backlogged.
Mark: Maybe that’s sort of the crux of it, that each situation is a little bit different, and almost never is there just a black and white answer. It’s all about trade-offs, and that requires a discussion among people that understand the strategy.
Jay: Yes, but if this were 2008, we probably would not be putting out letters with price increases to our customers.
Mark: Even if you’ve got additional capacity, you might or might not want to let the customer walk away. Many times, you may see something happening three, four, five months from now. You might be in the position where you have to add capacity in the future so you have a different perspective. You might want to lay somebody off now, or reduce cost, or you might decide to defer that decision.
Betsy: I think we skipped over the step when you realize that a product or a customer is unprofitable, the first thing you look to see is if there’s cost in the equation that you can get rid of, if you’re being wasteful and not as efficient with your process is to deliver a product or a service. So that’s the first course of action you go to. When you determine that you’re being as efficient and effective as possible, then you would go to the customer to say look, we need to renegotiate.
Mark: And to take Betsy’s example of the call center support hours; it might be you can go to the customer and see if there a way for you to reduce your costs.
Betsy: This was a call center supporting multiple financial institutions’ customer credit card programs. What we discovered was this particular customer was running very, very low credit limits for their customers leading to their customers making multiple calls in to see how much credit they had available. This was approximately ten times higher call volume than other financial institutions.
Mark: But going through that analysis enables you then to come up with a different pricing structure for customers you’re not even looking at initially.
Betsy: In this case, after both pre- and post-activity based cost accounting and profitability modeling, we went to a tiered price structure where we had six different tiers of pricing depending on different attributes of the relationship. We achieved over ninety-eight percent of the customers being profitable once we fit them into one of those six buckets.
Betsy: You can model costs and profitability based on certain assumptions and it’s a prudent thing to do, particularly if the agreement you’re entering into with a customer lets you specify the expectations of scope. Then, if the scope differs from what was expected, you have the mechanism to go back and renegotiate the price.
Mark: A lot of costs are step costs, not incremental, as in my example of the client that had a quality department just for one customer. The department goes away if the customer goes away. However, there are situations where it’s not just as straightforward as just plugging in the numbers. It requires somebody looking at things and making judgments – it’s almost always gray, not black and white.
Betsy: This is where bringing in a higher-level resource that’s able to do the analysis from an activity based approach that can truly assist the company become more profitable. You're adding overhead as you’re adding to the finance and accounting team. But if it’s helping you manage your customers better and get higher prices, it will pay off in the long run.
Betsy: I think an entrepreneur or CEO needs to have someone available to them that really understands how to analyze the cost side because usually the sales department or the entrepreneur understands the revenue side. So, they really need to understand the cost side to be able to drive it down to a profitability equation on a customer basis.
Jay: Yes, I’ll go along with that.
Mark: And it’s usually not the direct costs that are mislabeled or misallocated. It’s all those indirect costs.
Jay: I think one of the things we bring to a company is the ability to sit the owner down with the salespeople, once we have the numbers, and determine where we are going from here. What is the game plan for this customer and is it desirable to keep them? Are they profitable and if not, is there some way to make them profitable? We can be the focal point, in a company, for that discussion.
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