Are All of Your Customers Profitable?

Strategic ABM supports an organization's BPM by measuring which products and customers are profitable so that it can apply its resources to the highest returns. If some customers are excessively high-maintenance, then those customers erode profit margins. Is the extra work worth it? Who are the troublesome customers, and how much do they drag down profit margins? More important, once these questions are answered, what corrective actions should managers and employees take?

Some customers purchase a mix of only low-margin products. After adding the costs-to-serve for those customers apart from the profits (or losses) from the products and service lines they purchase, a company may determine that these customers are unprofitable. Other customers who purchase a mix of relatively high-margin products may demand so much in special services that they, too, could potentially be unprofitable. What kinds of customers are profitable? How does an organization properly measure customer profitability? With that information, how and when does a company deselect, or fire, a customer? The concern here is not only determining the profit contribution of customers, including accurate costs for the products and service lines they buy, but also understanding the elements of customer-specific work that make up the entire costs to serve each customer.

Strategic ABM information builds business cases for actions that management would usually take based on intuition or hunches. With more accurate and robust profit and cost data, a company can answer questions about its customers, such as "Do we push for volume or for margin with a specific customer?"; "Are there ways to improve profitability by altering the way we package, sell, deliver, or generally service a customer?"; "Does the customer's sales volume justify the discounts, rebates, or promotion structure we provide to that customer?"; and "Can we realize benefits from our changing strategies by influencing our customers to alter their behavior to buy differently (and more profitably) from us?"

Traditional methods of costing products result in under- and overcosting from flawed, volume-based averaging methods of cost allocation. The profit margin math subtracts the true ABM product and service-line costs from the revenues. The profit margin is always a derivative -- it is the money that is left over. With ABM, product and service-line costs shift from what the company believed them to be, while the price and volume do not shift but remain unchanged. As a result, the profit margins are also revealed to be substantially different than what the organization had believed. This result is also due to the fact that margins are usually very thin, so even slight changes in costs make a large difference in profits.

Exhibit 2 is a graph that shows how unrealized profits can be hidden because of inadequate costing methods. The accountants are not properly assigning the expenditures based on cause-and-effect relationships. The graph -- often referred to as a profit cliff -- displays the result of the cost subtracted from its sales to reveal each product's and service line's profit.

The products are rank-sorted, left to right, from the largest to the smallest profit margin, and then cumulatively added. The very last data point equals the firm's total net profit, as reported in its company P&L statement. For this organization, total revenues for the period were $20.0 million, with total expenses of $18.2 million -- a $1.8 million net profit. But the graph reveals the distribution of the product mix of that $1.8 million net profit. It shows that roughly $8 million of unrealized profits came from the most profitable three-fourths of the products and roughly $6 million was lost on the remainder. This revelation can be shocking to the management team.

Think of the last data point, the one that ties to the P&L, as being on a vertical metal track; it can only slide up or down. Looking at the graph this way reveals that products and service lines to the left of the profit cliff's peak (where an item's sales amount exactly offsets its costs at the peak) are also fair game for increasing profits. Many managers focus only on the losers to the right, but increased profits can also come from up-selling and cross-selling the most profitable products located to the left of the peak. When the cost-to-serve for each customer is combined with the unique P&Ls of the product or service-line mix that the customer purchased, then a P&L statement for each customer (or typically customer segment) can be reported and analyzed. This adds power to BPM and links it to customer relationship management programs.