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Chapter Measuring and Managing Customer Relationships 6 After completing this chapter, you will be able to: 1. Assign marketing, selling, distribution, and administrative costs to customers. 2. Measure customer profitability. 3. Explain the differences between a low- and a high-cost-to-serve customer. 4. Calculate and interpret the “whale curve” of cumulative customer profitability. 5. Explain why measuring customer profitability is especially important for service companies. 6. Describe the multiple actions that a company can take to transform breakeven and loss customers into profitable ones. 7. Appreciate the value of the pricing waterfall to trace discounts and allowances to individual customers. 8. Align salespersons’ incentives to achieving customer profitability and loyalty. 9. Understand why calculating customer lifetime value is valuable to a business. 10. Explain why companies need nonfinancial measures of customer satisfaction and loyalty. An Unprofitable Customer at Madison Dairy Jerold Browne, CEO of Madison Dairy, had just received a quarterly report that summarized the profitability of all of the company’s customers. He was surprised to see that Verdi, a retail chain of 133 specialty ice cream shops and one of Madison’s oldest customers, had become one of Madison’s most unprofitable customers. Despite annual sales to Verdi of more than $4 million, Madison had just incurred a quarterly operating loss 218 of $100,000 with this customer. Browne had known that producing ice cream for Verdi was expensive, with its special recipes, multiple flavors, and direct store delivery to its multiple outlets. Until viewing this report, however, Browne had believed that the higher prices per gallon charged to Verdi exceeded the extra costs of these special services. He could now see that the small lot production and labeling, frequent deliveries of lessthan-truckload quantities to multiple locations, and the high degree of follow-up calls to respond to the customer’s service requests had led to a highly unprofitable customer. He wondered how he should break the news to Mr. Rancantore, the chain’s owner, who took such pride in having founded a successful retail chain. In Chapter 5, we illustrated how to use activity-based costing to assign factory expenses, such as indirect labor and machinery, to individual products. But an organization’s expenses are not limited to its factories. Companies, in addition to the costs of producing their products and services, also incur marketing, selling, distribution, and administrative (MSDA) expenses. Most of these expenses are independent of the volume and mix of products that the company produces, so that they cannot be traced through causal relationships to products (as we did in Chapter 5). Many of these expenses are incurred to market and sell products to customers through multiple distribution channels. And, like the different demands by products for factory resources, customers and channels differ considerably in their use of MSDA resources. For example, consider a mutual fund company that markets products, such as retirement investment programs, directly to companies and also markets investment and retirement programs to millions of retail customers. The cost of reaching company clients is much lower than the cost of marketing, selling, and supporting its millions of small retail customers. In addition the size of a typical company relationship is many times larger than an individual customer’s retail account. Companies need to understand the cost of selling through various channels to diverse customer segments. In this chapter, we show how to extend activity-based costing to trace MSDA expenses directly to customer orders and to individual customers. This chapter’s focus on customers also links us back to the Balanced Scorecard strategy framework introduced in Chapter 2. The costing concepts introduced in Chapters 3, 4, and 5 enable companies to calculate financial metrics related to product and process costs. Metrics such as gross margins and product-line profitability can appear in the financial perspective of the Balanced Scorecard (BSC), while the process perspective can include metrics related to the costs of production and purchasing processes. But if the only information that managers have about customers is their financial performance, then they may take actions that improve financial performance in the short-term but damage long-term customer relationships. Managers, therefore, need both financial and nonfinancial metrics to manage their performance with customers. In this chapter, we introduce nonfinancial customer metrics that can appear in the BSC’s customer perspective. We will describe some common customer metrics, such as customer satisfaction, loyalty, and willingness to recommend, that many companies select for their Balanced Scorecard’s customer perspective and that serve as leading indicators of future revenue and profit performance in the financial perspective. Many companies today are already quantifying their customer relationships by using nonfinancial metrics on satisfaction and loyalty, but they do not trace MSDA Chapter 6 Measuring and Managing Customer Relationships 219 costs to customers to facilitate an accurate measurement of customer profitability. Although the nonfinancial customer metrics are certainly valuable, as we will discuss later in the chapter, an excessive focus on improving customer performance with only these metrics can lead to deteriorating financial performance. Companies, in order to achieve high customer satisfaction and loyalty scores, may offer special features, highly customized products and services, and highly responsive customer service. This careful attention creates satisfaction and loyalty. But at what price? Companies run the risk of going beyond being customer focused to being customer obsessed, and when asked by customers to “Jump,” they simply reply, “How high?” To balance the pressure to meet and exceed customer expectations, companies should also be measuring the cost to serve each customer and the profits earned, customer by customer. Measures such as percentage of unprofitable customers and dollars or Euros lost in unprofitable customer relationships provide valuable balancing metrics for a company’s strategy and its Balanced Scorecard. The ability to accurately calculate such metrics represents an important role for activity-based costing in a company’s BSC. M EASURING C USTOMER P ROFITABILITY: E XTENDING THE M ADISON DAIRY C ASE We illustrate the assignment of marketing, selling, distribution, and administrative expenses to customers by considering another division of Madison Dairy, one that produces and sells many dairy products (including yogurt, sour cream, milk, and ice cream) to large wholesalers, distributors, and retailers. Currently, the division has annual revenues of $3,000,000; its MSDA expenses are about $900,000, or 30% of revenues. The division has two important customers, Carver and Delta, with approximately the same sales revenue. In the past, Gene Dempsey, the division’s controller, allocated MSDA expenses to customers as a percentage of sales revenue leading to the following customer profitability statement for the two customers: Sales Cost of goods sold Gross margin MSDA expenses at 30% of sales Operating profit Profit percentage CARVER DELTA $320,000 190,000 $130,000 96,000 $34,000 10.6% $315,000 195,000 $120,000 94,500 $25,500 8.1% Both customers seemed highly profitable for the company. Dempsey, however, did not believe that these two customers were equally profitable. He knew that the account manager for Delta spent a huge amount of time on that account. The customer required a great deal of hand-holding and was continually inquiring whether Madison could modify products to meet its specific needs. Many technical resources, in addition to marketing resources, were required to service the Delta account. Delta also tended to place many small orders for special products, required expedited delivery, and tended to pay slowly, increasing the demands on Madison’s ordering, invoicing, and accounts receivable processes. Carver, on the other hand, ordered only a few products and in large quantities, placed its orders predictably and with long lead times, and required little sales and technical support. Dempsey believed that Carver was a much more profitable customer for Madison than the financial statements were currently reporting. 220 Chapter 6 Measuring and Managing Customer Relationships Dempsey launched an activity-based cost study of the company’s MSDA costs. He formed a multifunctional project team that included representatives from the marketing, sales, technical, and administrative departments. The team developed capacity cost rates for all of the resources in these support departments (such as the accounts receivable department). It then estimated the time demands on the various resources to obtain and process customer orders, to distribute the orders to customers, and to service each customer. This enabled them to assign the $900,000 in MSDA expenses down to every customer. The picture of relative profitability of Carver and Delta shifted dramatically, as shown here: ABC CUSTOMER PROFITABILITY ANALYSIS Sales Cost of goods sold Gross margin Gross margin percentage Marketing and technical support Travel to customers Service customers Handle customer orders Ship to customers Total MSDA activity expenses Operating profit Profit percentage CARVER DELTA $320,000 190,000 $130,000 40.6% 7,000 1,200 4,000 1,400 12,600 26,200 $103,800 32.4% $315,000 195,000 $120,000 38.1% 54,000 7,200 42,000 26,900 42,000 172,100 $(52,100) (16.5%) As Dempsey suspected, Carver Company was far more profitable than calculated in his previous report, which had allocated MSDA costs as a fixed percentage of revenues. Carver’s ordering and support activities placed few demands on the company’s MSDA resources, so almost all of the gross margin earned on the products sold to it dropped to the operating margin bottom line. Delta Company, in contrast, was now seen to be Madison’s most unprofitable customer. While Dempsey and other managers at Madison intuitively sensed that Carver was a more profitable customer than Delta, none had had any idea of the magnitude of the difference. We summarize some of the differences in high- and low-cost-to-serve customers in Exhibit 6-1. Exhibit 6-1 Characteristics of High- and LowCost-to-Serve Customers HIGH COST-TO-SERVE CUSTOMERS LOW COST-TO-SERVE CUSTOMERS • Order custom products • Order standard products • Small order quantities • Unpredictable order arrivals • High order quantities • Predictable order arrivals • Customized delivery • Change delivery requirements • Manual processing; high order error rates • Large amounts of pre-sales support (marketing, technical, and sales resources) • Large amounts of post-sales support (installation, training, warranty, field service) • Standard delivery • No changes in delivery requirements • Electronic processing (EDI) with zero defects • Pay slowly (have high accounts receivable from customer) • Pay on time (low accounts receivable) • Little to no pre-sales support (standard pricing and ordering) • No post-sales support Chapter 6 Measuring and Managing Customer Relationships 221 As we will learn later in the chapter, companies can still make money with highcost-to-serve customers, and lose money with low-cost-to-serve customers, but the information on the MSDA costs incurred for each customer is vital for effective management of the customer relationship. Reporting and Displaying Customer Profitability One of the most important empirical regularities in business and economics is the 80–20 rule, originally formulated about 100 years ago by an Italian economist, Vilfredo Pareto. As originally stated, Pareto found that 80% of a region’s land was owned by 20% of the population. It was subsequently extended to show that 80% of a region’s income or wealth was earned or held by the top 20%. For our purposes, Pareto’s interesting discovery applies to products and customers as well (see the distribution shown in Exhibit 6-2). When companies rank products and customers from the highest volume to the lowest, they generally find that their top-selling 20% of products or customers generate 80% of total sales. Interestingly, the 80–20 curve also produces a 40–1 rule. By studying Exhibit 6-2, you can see that the lowest volume 40% of products and customers generates only 1% of total sales. Although the 80–20 law applies well to sales revenues, it does not apply to profits. A graph of cumulative profits versus customers, constructed from an ABC customer profitability analysis, generally has a very different shape, which we call a whale curve. Exhibit 6-3 shows a typical whale curve of cumulative customer profitability. In this exhibit, customers are ranked on the horizontal axis from most profitable to least profitable (or most unprofitable). The whale curve of cumulative profitability in Exhibit 6-3 shows that the most profitable 20% of customers generated about 180% of total profits; this is the peak, or hump of the whale above sea level. The middle 60% of customers about break even, and the least profitable 20% of customers lose 80% of total Exhibit 6-2 100.0% Product and Customer Diversity: Pareto’s 80–20 (or 40–1) Rule 90.0% Cumulative Percent of Revenue 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0% Cumulative Percent of Products or Customers 222 Chapter 6 Measuring and Managing Customer Relationships A Typical “Whale Curve” of Cumulative Customer Profitability 20% most profitable generate 180% of profits Operating Profit Profile 20% least profitable lose 80% of net profits 200% Cumulative net operating profit Exhibit 6-3 160% 120% 100% Actual Net Profit 80% 40% 0% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Cumulative percentage of customers, ranked from most-to-least profitable profits, leaving the company with its 100% of total profits (“sea level” in the whale curve represents the company’s actual reported profits). The hump (or maximum height) of a cumulative profitability curve generally hits 150% to 250% of total profits, and this height is usually achieved by the most profitable 20% to 40% of customers. Another interesting finding on most company’s whale curves is that some of the largest customers, such as Delta for Madison Dairy, fall on the far right-hand side of the curve. They are among the company’s most unprofitable. In retrospect, this finding should not be unexpected. A company cannot lose a large amount of money with a small customer because it does not do enough business with it to incur large losses. Only a large customer, demanding high discounts from list price and also making many demands on a company’s technical, sales, distribution, and administrative resources, can be highly unprofitable. Large customers are typically a company’s most profitable or its most unprofitable. They are rarely in the middle of the whale curve. High-profit customers, such as Carver, appear in the left section of the profitability whale curve (Exhibit 6-3). Companies can celebrate the high margins that they earn on products and services sold to such customers. These customers should be cherished and protected. Because they could be vulnerable to competitive inroads, the managers of companies serving such customers should be prepared to offer discounts, incentives, and special services to retain the loyalty of these valuable customers, particularly were a competitor to begin selling to this customer. Customers like Delta appear on the right tail of the whale curve, dragging the company’s profitability down to sea level with their low margins and high cost to serve. The high cost of serving such customers can be caused by their unpredictable order patterns, small order quantities for customized products, nonstandard logistics and delivery requirements, and large demands on technical and sales personnel. One telecommunications equipment company, after doing such a customer profitability study, learned that for 20 percent of the orders in the previous year, the up-front cost of getting the order (the marketing, sales, and technical resources used to win the order) exceeded the size of the order. Even if the company could have produced, delivered, and installed the product at zero cost, it would still have lost money on the order. The opportunity for a company to identify its unprofitable customers and then transform them into profitable ones is perhaps the most powerful benefit that a company’s managers can receive from an ABC system. Chapter 6 Measuring and Managing Customer Relationships 223 IN PRACTICE Building a Whale Curve of Customer Profitability A whale curve of customer (or product) profitability is easy to construct once you have calculated each customer’s profit (or loss). Start with a two-column spreadsheet with the customer’s name or identification code in column A and its profit or loss in column B. The spreadsheet should have as many rows as you have customers; let’s assume a company has 2,000 customers (and, therefore, 2,000 active spreadsheet rows). Use the spreadsheet’s Data Sort command to rank the customers from most to least profitable, based on the data in column B. After running this command, the highest profit customer should be in row 1, the next highest in row 2, and the least profitable—or most unprofitable— customer in row 2,000. Copy the profit of the most profitable customer into column C of row 1. The entry in column C of all other rows is the cumulative profit from all previous customers (in the cell above) plus the profit of the current customer, which appears in column B of that row. For example, the equation for cell C10 (row 10, column C) would be “⫽ C9 ⫹ B10.” After copying this equation into rows 2 through 2,000 (the last row), the entry in C2000 should be the total operating profit of the company (the sum of profits earned from all 2,000 customers). In column D, calculate the ratio of the entry in column C divided by the entry in cell C2000; the equation in cell D10 would be “⫽ C10/C$2000.” The $ sign in front of the row 2000 entry ensures that every entry in column D is divided by the bottom cell entry, the company’s total operating profit. Format column D so that entries appear as “%” rather than a decimal. Column D contains the cumulative profitability by number of customers. The number in cell D10 represents the percentage of total profits earned by the most profitable 10 customers in the company. The entries in column D increase through all of the profitable customers, and then decrease back down to 100% (which should be the entry in cell D2000) as you start to add in the unprofitable customers. In column E, compute the cumulative percentage of customers by dividing each customer’s rank by 2000. For the most profitable customer, this is 1/2000. For each subsequent customer, add 1/2000 to the cumulative total. Use the spreadsheet’s graphing capabilities to produce a curve where the y axis represents the entries in column D and the x axis represents the entries in column E. The height of the whale’s hump represents the profits earned by all of the profitable customers (generally 150% to 250%), and the decline in the curve from the hump back to sea level (which represents 100% of profits) is the amount lost by the unprofitable customers). An unprofitable banking customer receives extensive customer service but maintains low balances and conducts many manual transactions per month. Alamy Images Royalty Free Customer Costs in Service Companies Service companies must focus, even more than manufacturing companies, on customer costs and profitability because the variation in demand for organizational resources is much more customer driven than in manufacturing organizations. 224 Chapter 6 Measuring and Managing Customer Relationships How much technical and personal service a customer requires affects the profitability of the transaction. Alamy Images Royalty Free A manufacturing company producing standard products can calculate the cost of producing the products without regard to how their customers use them; the manufacturing costs are customer independent. Only the costs of marketing, selling, order handling, delivery, and service of the products might be customer specific. For service companies, in contrast, customer behavior determines the quantity of demands for organizational resources that produce and deliver the service to customers. To illustrate, consider a standard product from a service company, such as a checking account in a bank. It is relatively straightforward, using ABC methods, to calculate all of the costs associated with a checking account. These can be easily matched with the product’s revenues, such as interest earned on monthly balances and the fees charged to customers for services. The analysis will reveal whether such a product is, on average, profitable or unprofitable. But such an average look at the product will hide the enormous variation in profitability across all customers using this product. One customer may maintain a high cash balance in his checking account; make very few deposits, withdrawals, balance inquiries, or service requests; and use only electronic channels (i.e., automatic teller machines and the Internet). Another customer may manage her checking account balance very closely, keeping only the minimum amount on hand, and use her account heavily by making many small withdrawals and deposits via manual transactions with bank tellers. The second customer’s checking account may be highly unprofitable under current pricing arrangements. Customer balances or sales volume are poor proxies for profitability. Small-balance customers can be quite profitable and large-balance customers can be highly unprofitable. As another example, customers of a telecommunications company can order a basic service unit in several different ways—through a phone call, a letter, or a visit to a local retail outlet. The customer may order two phone lines at once or just one; engineers may have to appear to install the new line, or they may make a change at the local switching center. The customer may make only one request or several and can pay either by direct debit over the Internet, by a telephone banking transfer, by a mailed check, or in person. The cost of each option is quite different. Therefore, measuring revenues and costs at the customer level provides the company with far more relevant and useful information than at the product level. Chapter 6 Measuring and Managing Customer Relationships 225 I NCREASING C USTOMER P ROFITABILITY Manufacturing and service companies alike have many options to transform their breakeven or loss customers into profitable ones: • • • • Improve the processes used to produce, sell, deliver, and service the customer. Deploy menu-based pricing to allow the customer to select the features and services it wishes to receive and pay for. Enhance the customer relationship to improve margins and lower the cost to serve that customer. Use more discipline in granting discounts and allowances. Process Improvements Managers should first examine their internal operations to see where they can improve their own processes to lower the costs of serving customers. If most customers are migrating to smaller order sizes, companies should strive to reduce the costs of processes such as setup and order handling so that customer preferences can be accommodated without raising overall prices. For example, Madison Dairy could strive to become more efficient in handling orders by encouraging customers to access a purchasing web page and place their orders over the Internet. This would substantially lower the cost of processing large quantities of small orders. If customers have a preference for suppliers offering high variety, manufacturing companies can try to customize their products at the latest possible stage, as well as use information technology to enhance the linkages from design to manufacturing so that greater variety and customization can be offered without cost penalties. Activity-Based Pricing Pricing is the most powerful tool a company can use to transform unprofitable customers into profitable ones. Activity-based pricing establishes a base price for producing and delivering a standard quantity for each standard product. In addition to this base price, the company provides a menu of options, with associated prices, for any special services requested by the customer. The prices for special services on the menu can be set simply to recover the activity-based cost to serve, allowing the customer to choose from the menu the features and services it wishes while also allowing the company to recover its cost of providing those features and services to that customer. Alternatively, the company may choose to earn a margin on special services by pricing such services above the costs of providing the service. Pricing surcharges could be imposed when designing and producing special variants for a customer’s particular needs. Discounts would be offered when a customer’s ordering pattern lowers the company’s cost of supplying it. Activity-based pricing, therefore, prices orders, not products. When managers base prices on valid cost information, customers shift their ordering, shipping, and distribution patterns in ways that lower total supply chain costs to the benefit of both suppliers and customers. Managing Relationships Companies can transform unprofitable customers into profitable ones by managing customer relationships, which includes persuading them to use a greater scope of the company’s products and services. The margins from increased purchases contribute to covering customer-related costs that do not increase proportionately with volume, 226 Chapter 6 Measuring and Managing Customer Relationships such as the cost of the salesperson assigned to the account. Companies can establish minimum order sizes from unprofitable customers, so that the margins from higher volumes more than cover the costs of processing an order and setting up a production run for the customer. Customers of service companies often have more than one relationship with them. Consider a commercial bank with a basic entry-level product: commercial loans. The interest spread on such loans—the difference between the bank’s effective borrowing rate and the rate it charges the customers—may be insufficient to cover the bank’s cost of making and sustaining the loan because of intense competition and the customer’s low use of the lending relationship. However, the bank may make enough profit on other services that the customer uses—for example, investment banking services and corporate money management—that in aggregate the customer is a highly profitable one. Alternatively, however, a small borrower who uses no other commercial banking or investment banking services may be quite unprofitable. In this case, the bank could ask the customer to expand its use of the loan facility (that is, borrow more) and use other and more profitable services offered by the bank’s services. A customer of a telecommunications company may have, in addition to a basic landline phone account, a high-speed data line, an Internet line, a television cable connection, a maintenance and service contract, and equipment rentals. Therefore, before taking drastic action with a customer who has an unprofitable basic landline phone account, the company’s managers should understand all of the relationships it has with the customer and act on the basis of total relationship profitability, not just on the basis of the profitability of a single product. As one example of how a commercial bank dealt with an unprofitable customer, the loan officer tried to fire an unprofitable corporate customer, who had only a single banking relationship and did not use its banking facility intensively. The officer shared the economics of the unprofitable relationship with the customer and suggested that it seek other financial institutions for its borrowing needs. The customer, however, wanted to retain its relationship with the bank and offered to find ways to increase the bank’s profitability on this account. The CFO offered to travel to New York for periodic meetings, rather than have the loan officer visit its Midwestern headquarters. He also offered to use more of the bank’s products and services so that the relationship could be transformed into a profitable one for the bank. Some customers may be unprofitable only because it is the start of the relationship with the company. The company may have incurred high costs to acquire the customer, and the customer’s initial purchases of products or services may have been insufficient to cover its acquisition and maintenance costs. No action is required at this point. The company expects and hopes that the customer’s purchases of products and services will increase and soon become profitable, including recovering any losses incurred in the start-up years. Companies can afford to be more tolerant of newly acquired unprofitable customers than they can of unprofitable customers they have served for 10 or more years. Later in this chapter, we will discuss customer lifetime profitability, a more formal way of managing newly acquired unprofitable customers. The Pricing Waterfall Beyond the factors already discussed, heavy discounting and granting of special allowances can also lead to breakeven or highly unprofitable customers. Before confronting a customer with an explicit price increase, the company should examine the many ways it has already reduced the effective price the customer actually pays. Exhibit 6-4 shows how a producer of kitchen appliances had offered multiple discounts and allowances to one of its largest customers, a major home improvement Chapter 6 Measuring and Managing Customer Relationships 227