Tom’s Ten Data Tips – April 2007
Customer Profitability
Measuring and understanding customer profitability at the individual level enables a firm to appreciate the distribution of relationship value so it can allocate resources accordingly. Valuation of a firm equals the aggregate value of its customer relationships. Hence, the search for shareholder value is akin to managing a portfolio of customers.
GM has always been renown for their keen cost calculations. In the first half of the 20th century their purchasing model gave them a competitive edge. For decades GM enjoyed a 30 percent cost advantage over its direct competitors (including Ford and Chrysler) when the American market was still fiercely competitive. Their initial attempts at Activity Based Costing gave management the insight to steer the company towards profit and growth.
1. Activity Based Costing Points Out Where You Can Compete
There is a direct line from corporate strategy, to meeting the market need, to creating value and customer profits. It has become clear that accounting's contribution to corporate strategy is not cost accounting, but rather value accounting. This transition parallels the move from calculating profit at the process or corporate level, to calculating customer profits.
2. Activity Based Costing Enhances Internal Alignment
The shift from cost accounting to Activity Based Costing signifies a dramatic advance for IT in terms of adding value. Activity Based Costing began in manufacturing. Traditional product costing used to spread overhead as a function of direct labor hours per unit of product. Activity Based Costing is based on the premise that not products, but rather the activities in planning, procuring and producing products are responsible for costs.
3. Customer Relationships Are Assets
Customer relationships are assets that should be managed as rigorously as any financial or physical assets. It is the relationship, not the customer that is the asset. This is because the relationship gives rise to future cash flows that can be estimated and valued. The firm's value is ultimately the sum of the value of its relationships.
4. A Lifetime Is A Very Long Time
Customer Lifetime Value is like any asset value: it depends on the net cash flow over time. This is also referred to sometimes as "customer equity". The challenge in estimating cash flows further out in to the future is that there are many possible career trajectories for a customer, each with widely different revenue streams. Also, attrition needs to be factored in, and in many industries this can have a large impact. As a result, Life Time Values become unreliable. Estimating as much as 2-5 years out with any reasonable level of reliability is often enough of a challenge already.
5. Calculating Profitability Requires Committing To A Strategic View
Typically, calculating Activity Based Costing is not a matter of gathering more data, but rather a matter of consolidating information. Most companies already have some trace of customer activities that are accountable for the costs in serving their customer. What needs to be gleaned from this, in close cooperation with finance people, is how fixed and indirect costs can be allocated to activities necessary to serve the customer. This is not an easy task, but deriving this financial model is essential in coming up with an equitable measure of Activity Based Cost.
6. Incentive Systems Need To Drive Profit, Not Revenue!
Although BI may have insight into who are the best customers in terms of gross profit, this doesn't automatically mean this information will trickle down all the way to the sales force. Everybody "knows" that revenues do not equate profits, but unless both are explicitly stated, it is still anybody's guess. The calculations need to be as transparent as possible, to foster trust in the measures. A desirable side effect may be that front-line staff will become more aware of which products drive profits.
7. Manage Profits Throughout The Customer Lifecycle
Although Activity Based Costing began in manufacturing, but it makes great sense in service businesses as well as non-profit organizations. It shows where expenses pay off in terms of the "value" being produced. Peter Drucker: "Activity-based costing therefore gives not only much better cost control; increasingly, it gives result control."
8. Creating Value And Satisfying Customers Should Not Be A Conundrum
Some companies feel they need to "stretch" in between pleasing their customers, yet at the same time running a profitable business. What this really signifies is either a lack of strategic direction altogether, or not knowing how to execute the strategy in place. In today's ever more competitive markets, it's absolutely necessary to focus on generating value for the customer. However, generating profitable growth requires focusing on the right customer relationships.
9. Factor In As Many Indirect Costs As (Reasonably) Possible
When calculating customer profitability, the primary objective is to inform management about value creation and cost structures. Because direct labor costs have become a decreasing proportion of total costs, the impact of choosing a particular financial model on which customers show up as profitable, and which don't, has grown.
10. Customer Profitability Aligns The Company With The Market
Customer profitability is like "true north" for a business. Unless you are maintaining profitable relations with your customers, you cannot run a profitable business. Then how come so many companies are sailing without a compass? Not all customers are created alike, but unless you quantify these differences, how can you sensibly differentiate?
Further reading
Some excellent books on Customer Profitability:
Robert Wayland & Paul Cole (1997) Customer Connections. ISBN# 0875847994
Adrian Slywotzky & David Morrison (1997) The Profit Zone. ISBN# 0812933044
Andrew Black, Philip Wright & John Davies (2001) In Search of Shareholder Value. ISBN# 0273650821
Michael Lanning (1998) Delivering Profitable Value. ISBN# 1900961040
Richard Boulton, Barry Libert & Steve Samek (2000) Cracking the Value Code. ISBN# 0066620635
Roland Rust, Valerie Zeithaml & Katherine Lemon (2006) Driving Customer Equity. ISBN# 0684864665
Peter Drucker (1999) Management Challenges for the 21st Century. ISBN# 0887309984