2.2 Determining customer profitability
For commercial enterprises, customer profitability (actual or potential) will be a major factor in deciding which customers to deal with and what type of relationship to cultivate. The traditional management accounting approach was to assume that selling product X to one customer was pretty much the same (in terms of profitability) as selling it to another. This assumption was reflected in common management accounting practice, which was to calculate product costs and measure product profitability, but not calculate the cost of serving particular customers in order to measure customer profitability. However, the profitability of a particular product can vary enormously across customers. The 80:20 rule (the so-called Pareto rule, named after the Italian economist Vilfredo Pareto) often applies to customer profitability: 80% of profit comes from 20% of customers. Consequently, the decision as to which customers to deal with and on what basis, is a very important one.
Yet many organisations’ management accounting systems do not provide adequate information on customer profitability. Even where customer profitability is measured, the approach taken is often inadequate. The problem and a possible solution are described in Box 2.
Box 2 Measuring customer profitability
Two common approaches are:
- only measuring customer profitability at the level of gross margin (i.e. sales value minus product cost)
- assigning average cost by function (e.g. sales order processing cost is typically 2% of sales value).
The first approach is inadequate because gross margin is not a good guide to true profitability. Evidence suggests that selling and distribution, service and support costs may constitute up to 60% of sales value. Christopher (1992) gives a typical checklist of attributable (i.e. to particular customers) costs:
- cost of sales
- sales calls
- key account management time
- order processing costs
- promotional costs
- non-standard packaging and unitisation
- dedicated inventory holding costs
- dedicated warehousing costs
- material handling costs
- transport costs
- credit taken.
Yet only the first of these will normally be reflected at the gross margin level.
The second approach is inadequate due to the enormous variability of cost among different customers. Bellis-Jones (1989) cites evidence of cost variability by function as follows:
|Function||Cost as percentage of sales value|
|Selling and order taking||2–20|
|Storage and distribution||2–35|
|Production and purchasing||20–70|
|Marketing and advertising||1–20|
Activity-based costing (ABC) techniques may provide a basis for ascertaining the costs attributable to a particular customer. ABC works by assigning costs to products or customers according to their consumption of the activities that give rise to costs. This may be contrasted with the traditional approach which apportions functional/departmental costs on some, more or less arbitrary, volume basis (e.g. percentage of sales value).
ABC views the organisation as a range of activities which often cross traditional functional boundaries. (These however are activities at a much more disaggregated level than the value chain activities – e.g. machine set-ups and production scheduling are activities which would be the concern of ABC, yet would be subsumed under ‘operations’ in the value chain framework. Similarly, raising purchase orders and inspection of incoming goods are examples of activities which would be subsumed under ‘inbound logistics’ in the value chain, but would be the concern of ABC.) The range of activities necessitated by serving different customers can vary enormously and so consequently can the real costs. ABC implementation consists of two stages:
- An activity analysis: this is a detailed exercise to identify the activities performed at a fairly disaggregated level, based typically on interviews with employees. The resources consumed by each activity are then determined and hence its cost.
- Costing customers: this involves determining how much of each activity serving a particular customer will require.
The activities which form the basis for allocating overheads are called cost drivers. Examples of cost drivers are: number of sales invoices raised – as a basis for allocating sales invoicing costs; number of customer complaints – as a basis for charging the costs of handling customer complaints.
Activity 3 The inadequacy of traditional management accounting systems for customer relationship marketing (CRM)
Write some notes explaining why traditional cost and management accounting systems may not provide adequate support for customer relationship marketing and what the likely adverse consequences of this failure might be.
Customer relationship marketing (CRM) requires knowledge/understanding of customer profitability, rather than just turnover/revenue, since the cost of serving different customers differs greatly and is not necessarily proportional to the revenue generated by them.
In the early days of industrial capitalism, the emphasis was on standardisation and economies of scale; selling a product to one customer was pretty much the same, in terms of profitability, as selling it to another. This situation was exemplified by Henry Ford’s famous statement concerning the product offered to his customers: ‘They can have any colour, as long as it’s black!’ In today’s much more competitive business environment, this is not often the case, with the modern emphasis on customer service and catering for the differing demands of different customers.
Measuring customer profitability is therefore as important as measuring product profitability as it is likely to be a major factor influencing the sort of relationship that is developed with a particular customer. Customer costing is of vital importance, yet many organisations do not undertake this in any systematic way. Traditional costing systems focus on product costs rather than customer-related costs; this is likely to result in dealing with, and perhaps even giving preferential treatment to, unprofitable customers and/or, conversely, failing to court highly profitable ones.