Customer and Product Profitability. ‘Islands of Profits in Seas of Red Ink’, written by Jonathan Byrnes, addresses the reality that in most businesses, there are losses that are incurred in servicing certain customers or selling certain products. These losses are not easily evident and are a result of financial reporting showing a single consolidated picture of the financial performance of a business.
Having these hidden losses can massively reduce the profits generated in other areas of the business, but by breaking a business out and measuring profitability by customer or product, these losses can be identified and addressed, resulting in massive improvements in profits and cash flow.
Customer profitability
As some customers cost more to service than others, many businesses are also incurring massive losses concerning customer profitability.
Examples of this include customers that purchase lower-margin products or place small orders. They can often require delivery to outlying areas, which may not be recoverable. Customers can be overly demanding, resulting in higher levels of employee servicing time.
Customers often ask for and expect you to stock products that are seldom bought, leaving businesses with an increase in inventory holding and procurement costs. Customisation of products and services are also often expected for their individual and unique needs to be met.
Although there are customers that remain loyal to your business and add lifetime value, there are others that prefer to shop around and need a higher level of sales effort to keep them coming back. Lastly, businesses often experience customers that require credit or tend to settle payments late.
Evaluating customer profitability is an important part of the financial management of any business. The process of evaluation is obtaining the gross profit generated per customer, or customer grouping through similar profiles. The next step is to then determine a basis to allocate costs to service the customer or group. This may require you to measure the time taken to complete the activities required for the customer.
Determining allocation can be done by evaluating the following:
- Cost of quote preparation
- Cost of picking a line of inventory
- Cost of generating invoices
- Cost of debt collection
- Cost of time spent in key account management
- Cost of handling queries
These costs would then be allocated against each customer or group based on their utilisation of these services.
If the time taken to prepare a customer quote is 20 minutes, and the average cost of an internal sales salary is R120.00 per hour, then the cost per quote is R40.00. If you generated 50 quotes during the year for a customer, this would represent a cost of R1000.00, which could then be deducted from the customer’s gross profit, to arrive at the profit for said customer.
The process of allocating these costs is called, ‘activity-based costing’. This is where you determine the time required to perform an activity, then, based on this time, you calculate the cost of the activity. Once this is done, you can then allocate the cost per activity based on how many units of a particular activity have been used.
You don’t need to get to 100% accuracy in the allocation of these costs – 70% will suffice. What you do want to ensure, is the basis of allocation and the level of detail applied to give you a reasonable approximation of the profit per customer or group.
Where customers are identified as being unprofitable, you need to find ways to make the customer profitable by renegotiating your terms or arrangements with the customer or group – in failing to do so, you would need to stop servicing the customer or group and direct your sales effort to find more profitable customers for the benefit and sustainability of your business.
Product profitability
Similarly, different products or service offerings may have different profitability depending on:
- Storage costs could be higher for large products or slow-moving products.
- Procurement costs to order the product.
- Sales order processing and delivery costs.
- The number of defects or customer complaints arising out of a product or service.
- Marketing and sales costs to promote and sell the product.
- After-sales service and support costs.
- Level of complexity of the product or service.
Once again, by assigning ‘activity-based costs’ involved in the sale of a product or service, you can arrive at a better measure of product profitability.
