US Deloittereview Customer Profitability Jul09

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issue 5 | 2009

Cmmer rce rer

How proftableare yourcustomers… really?

By Ed Johnson, MikE siMonEtto,

JuliE MEEhan and RanJit singh

> illustRation By Ralph voltz



4 ARTICLE T ITLE

Deloitte Review dELoITTEREvIEw.Com



deloittereview.com Deloitte Review

5How pRofITAbLE ARE youR CusTomERs … REALLy?

How proftable are yourcustomers … really?By Ed Johnson, MikE siMonEtto, JuliE MEEhan and RanJit singh

> illustRation By Ralph voltz

With thousands of golf courses needing to be

mowed, watered and fertilized, the U.S. West

Coast looked like the perfect new market for

one Midwest-based lawn care products manufac-

turer. Initial forays into the region yielded strong

sales, high market penetration, and a 26 percent

gross margin. So why was the company’s bottom

line still stagnating? Because the cost of freight

to the West Coast, which the company provided

free as a standard industry practice, was not

being factored into the company’s profitability

metrics. When it was, leaders realized that the

company was actuall y losing six to eight per-

cent on every West Coast transaction. If it had

not looked more closely at these customers’ real

profitability before finalizing plans to expand its

West Coast operations, the company could have

literally grown i ts way into bankruptcy.

No company can aord a awed understanding o customer proftability, least

o all in a recession when the margin or error (as well as proft) is whisper-

thin. The ip side is that improvements in this area can be a very eective way o

bolstering the bottom line — and companies can oten make those improvements

with only a modest initial investment. In act, because employees tend to be more

accepting o change in a downturn, now may be a good time to invest in changes

that can not only deliver a badly needed revenue boost, but help your company

better take advantage o the eventual recovery.




6 How pRofITAbLE ARE youR CusTomERs … REALLy?

Pocketing the Profits

A customer proftability analysis, done right, tells you not just which custom-

ers are proftable, but why certain customers are more or less proftable than

others. At a strategic level, this inormation can help guide decisions on everything

rom growth initiatives to marketplace segmentation. And, tactically, the inorma-

tion can suggest a variety o ways to improve proftability, such as lowering the

cost to serve, improving the sales orce’s bargaining position, and developing more

eective prices and promotions.

However, many com-

panies that believe they

understand customer

proftability are actually

working with the wrong

inormation. Most use

aggregate measures o

proftability, typically

gross margin, that ail

to account or costs that are difcult to measure or that can’t be attributed to indi-

vidual transactions (such as marketing expenses or distribution costs).

Even when these costs are considered, they’re oten computed at an aggregate

level using metrics that ignore the nuances o serving particular customers, seg-

ments or other populations o interest. One $10 billion U.S. retailer, or example,

subtracted a at “cost-to-serve” percentage rom each transaction’s gross margin to

calculate the transaction’s proftability. But because the same percentage was ap-

plied to all stores regardless o their efciency, this metric ignored important varia-

tions in store selling costs. Adjusting the calculation to reect individual stores’

cost to serve gave leaders better inormation on which to base a number o deci-

sions, such as whether to close a certain store or where to place a regional ofce.

In act, when it comes to specifcs, more is always better. That’s why compa-

nies should analyze proftability on a transaction-by-transaction basis, looking not

just at every customer but at every transaction each customer completes. But the

drill-down shouldn’t stop there. To gain true actionable insight, companies needto examine each transaction’s proftability based on its “pocket margin” — the

undamental metric on which all higher-level proftability metrics are based.

Pocket margin reers to the amount let in a company’s “pocket” ater all o the

costs related to a transaction, as well as the cost o goods sold, are subtracted rom

the list price. These costs can range rom the obvious, such as o-invoice discounts

and promotions, to the easily overlooked, such as costs associated with reight,

Pocket margin refers to theamount left in a company’s

“pocket” after a l l of the costs

related to a transact ion, as wel l

as the cost of goods sol d, are

subtracted from the l i st pr ice.





warehousing and other activities that may be generally classifed as “overhead.”

The costs incurred at each point in a transaction are oten graphically represented

in a “price waterall,” a bar chart that depicts the impact o each successive cost-to-

serve element on the list price (Figure 1).

Unlike measures that gloss over dierences among customers or omit cost-to-

serve elements, pocket margin gives a company a clear view o how much revenue

each transaction generates, how much it costs the company to generate that rev-

enue, and — crucially — when and why those costs are incurred. And because

pocket margin is measured or every transaction, metrics based on pocket margin

can provide insight into costs and revenues at any desired level o detail, rom in-

dividual clients all the way up to broad marketplace segments.

L i s t P r i c e

$700

$600

$500

$400

$300

$200

$100

$0

C u s t o m e r S p e c i f i c D i s c o u n t

I n v o i c e P r i c e

C r e d i t R e b a t e

C r e d i t P a y t e r m s

N e g o t i a t e d N e t P r i c e

O t h e r P r o m o t i o n a l A d j u s t m e

n t s

N e t P r i c e

C u s t o m e r S p e c i f i c C

o s t

M e r c h a n d i s i n g C

o s t

C u s t o m e r W a r e h o u s e C

o s t

C r o s s d o c k C

o s t

M a r k e t i n g C

o s t

P r o m o t i o n s

P o c k e t P r i c e

C O G S F i x e d

C O G S V a r i a

b l e

P o c k e t M a r g i n

Figure 1. An illustrative price waterall. A price waterall portrays the progression rom

list price to pocket margin or a specifc “slice” o the business — such as a customeror customer segment — based on cost-to-serve data collected at the transaction level.





what your customers won’t tell you (but Pocket margin can)

Metrics based on pocket margin can give companies a wealth o insight into

what they spend to make how much rom whom — and how they might

be able to improve the outcome. Here are some o the ways we’ve seen it work.

One obvious use o customer proftability metrics is to identiy the customers who

cost more to serve than they generate in revenue. Once a company knows who

those money losers are, it can either try to transorm them into proftable buyers or

attempt to ush them out o the business altogether.

Best Buy, the U.S. consumer electronics retailer, took just such an approach in

its eorts to boost the bottom line. As described in the Wall Street Journal , the com-

pany used customer proftability analyses to dierentiate between “angels” — cus-

tomers who buy high-defnition televisions, portable electronic devices, and other

items at ull retail price — and “devils” — customers who only buy sale items or

loss leaders, return a large raction o their purchases, and generally “wreak enor-

mous economic havoc” on margins, according to then-CEO Brad Anderson. The

company then made changes designed to attract more business rom angels, such

as stocking more merchandise and enhancing customer service, and to discourage

sales to devils, such as removing them rom marketing lists. The company also

took steps to reduce the negative impact o the devils it couldn’t shed, such as

enorcing a 15 percent restocking ee on returned merchandise.1

“Yu’re spedig t much t serve me”

Many times, relationships with large customers that are presumed to be pro-

itable actually have special terms, unusual shipping conditions, or other “belowthe radar” idiosyncrasies that erode proftability until those idiosyncrasies are ad-

dressed. Price waterall inormation can help companies identiy such accounts by

agging “outlier” customers whose cost to serve in certain areas is disproportion-

ately high or whose pocket margin across transactions is consistently lower than

average. The company can then look more closely at those customers to uncover

and address the reasons or their atypical proftability profle.

“Yu’re lsig mey me”





In one extreme case, a $9 billion global manuacturer discovered that one o its

largest customers was arbitrarily reducing the invoice amount every time orders

were not flled 100 percent correctly. These unilateral adjustments had gone un-

noticed until the company delved into the details o the relationship to build a

price waterall. Not wanting to make waves with what was assumed to be its most

proftable customer, the company’s accounts payable sta had been crediting the

dierence to an “outstanding clarifcations” expense account that was not included

in the calculation o the customer’s specifc proftability metrics. (In act, when the

adjustments were actored in, the customer turned out not to be the company’s

most proftable buyer ater all.) The company is considering ways to address thisissue in its uture negotiations with the customer, on the principle that such penal-

ties should be agreed upon by both sides beore being imposed.

“I’m i the wrg segmet”

Companies oten segment their customers along demographic lines or accord-

ing to how much revenue each customer generates or the business. But while

these approaches are suitable or some purposes, such as marketing and product

development, segmenting customers according to proftability can be much more

useul in managing margins. Examining the dierences between customers at di-

erent levels o proftability can give companies valuable insights into what their

more proftable customers look like — what they buy, how they buy, what it costs

to serve them — and guide eorts to change their less proftable relationships to

better ft a proftable mold.

A revised segmentation approach based on customers’ overall value to the busi-

ness helped the lawn care manuacturer mentioned previously ocus its plans or

making the West Coast proftable. The company drew heavily upon its improved

understanding o customer proftability to create its new segmentation scheme,

which also considered actors such as location (“How badly do we want to establish

a presence in this area?”) and customer brand (e.g., “Is this customer Pebble Beach

or a no-name public course?”). The company then evaluated the probable impact o

various pricing and service changes on each segment’s proftability. For some seg-

ments, the company decided that going against industry tradition by charging its

customers or reight — in exchange or more requent sales visits, extended war-

ranty terms, and other concessions that customers valued but cost the company less

to provide — would be the most easible way to boost profts. For other segments,

the company decided to continue to oer ree reight, but charge higher prices or

adjust the terms o service to compensate.

Another company, an international beverage distributor, used customer proft-

ability data to refne a segmentation approach that classifed customers into “large”





and “small” buyers based on each customer’s contribution to revenue. Ater di-

viding each category into proftable and unproftable sub-segments, the company

discovered that the drivers o proftability diered markedly between its large and

small customer groups. Large customers’ proftability depended on product mix,

while small customers’ proftability depended on the cost o sales visits. This in-

sight helped the company understand that it would need to use dierent tactics

with each segment to increase overall proftability. It launched a tailored, two-

pronged improvement eort aimed at changing the product mix among large

customers and reducing sales costs among small customers, which is expected to

increase profts by $10 million annually — an improvement o more than one per-cent in proft driven by relatively small changes.

fixing the mix

“33 percent more in every bottle!”

That’s the offer that played havoc with

profits at the international beverage

distributor described in the main text.

On the surface, the issue seemed simple

enough: Unprofitable large customers

were buying too much of the company’s

low-margin value brand and too l ittle of its high-margin premium

brand. Leaders were mystified, however, as to why many large

customers had only recently switched to this unprofitable buying

pattern after a long history of acceptable profitabil ity.

A review of the company’s promotional efforts solved the puzzle. In

a bid to boost sales of its value brand, the company had increased

its serving size by more than 30 percent while keeping its price

almost the same. But while volume of the super-sized value brand

did indeed rise, the net effect was to reduce overall profits due to

extensive cannibalization of the premium brand.

How could the company direct its large customers back toward a

more profitable balance? A detailed analysis of transaction-level

data helped leaders tailor its tactics to suit specific markets. By

examining historical purchase patterns, the company discoveredthat the super-sized value product actually was driving new volume

in certain areas of the country. In other regions, however, cost-con-

scious customers were merely “trading down” to the value brand.

The eventual fix involved first adjusting prices on a region-by-re-

gion basis to drive customers’ product mix back to profitabil ity, and

then using the introduction of a new product to reset all relative

prices and restore volume to the premium brand.

Photo: rune thorstein





“Yu shuld be chargig me mre fr …”

Price isn’t all that matters to most customers. Many also have defnite preer-

ences about aspects o the transaction process that aect your cost to serve, such as

how oten they place orders or the way products are shipped. It’s not unusual or

salespeople, especially in a business-to-business context, to oblige such requests

gratis or or a nominal ee. They may be worried about preserving the customer

relationship, or they simply may not know how much extra to charge to cover any

additional costs. By clariying the impact o customer requests on individual cost-

to-serve elements, a customer proftability analysis can help your company avoid

leaking margin through such missteps, giving salespeople the inormation theyneed to negotiate more proftable prices and terms o service.

By the same token, a detailed breakdown o costs to serve can help you identiy

opportunities to improve profts by changing buying behavior in ways that are

relatively unimportant to the customer, but drive large cost-to-serve savings or

you. Companies may need to make concessions on price or other actors to gain cus-

tomers’ acceptance or such changes. Here again, a cost-to-serve analysis can guide

negotiations by quantiying the impact o various price and service adjustments on

proft. For example, the international beverage distributor mentioned previously

is planning to cut sales costs by reducing the requency o sales visits to some o

its less proftable small customers. To oset the impact o asking customers to

consolidate their purchases, the company may consider lowering prices, extending

credit terms, or other steps that would accommodate customers’ needs while still

delivering a net proft increase to the company.

To execute tactics like these, a company needs two types o inormation. First,

it needs to identiy the elements that go into the cost to serve, determine the im-pact o any changes on pocket margin, and assess the easibility o making those

changes. It’s essential, too, to get this inormation to the people in a position to

use it — with technology that gives salespeople instant, dynamic access to price

waterall inormation, or instance.

Second, a company needs to understand what its customers value about their

relationship with the business and how much they’re willing to pay — or what

concessions they might demand — or any changes. Sometimes, a salesperson may

be able to make this call based on his or her personal knowledge o a customer. A

“voice o the customer” survey, supplemented by interviews as necessary, can also

help clariy customers’ priorities. Business-to-consumer companies oten conduct

market research or just this reason. And i asking one’s actual customers isn’t prac-

tical, publicly available industry and marketplace data can oten serve as a proxy.






13How pRofITAbLE ARE youR CusTomERs … RE ALLy?

products are eective “hooks.” That’s where a historical view o customer proft-

ability can help. By examining customers’ transaction histories, a company can

determine which products are likely to drive proftable add-on sales. Conversely,

a company can also use historical customer proftability data to identiy product/

price combinations that tend to encourage unproftable “cherry-picking” by cus-

tomers that pay no dividend in uture loyalty.

One major U.S. boutique retailer drew on historical customer proftability in-

ormation to reclassiy its products into our categories — “invest,” “develop,”

“preserve,” and “harvest” — that reected the role o each product in driving mar-

gins and revenue. The new classifcation model allowed the company to improveits pricing, promotion and store layout eorts in several ways. For instance, the

company realized that some “hot” products that were being heavily promoted dur-

ing the holiday season were actually items that appealed primarily to “cherry-

pickers” and hence did not drive proftable long-term customer relationships. The

company thereore de-emphasized those products by moving them closer to the

back o its holiday circulars. The analysis also helped the company’s merchants

develop bundles o products or promotion in ways that had been demonstrated

to drive customer loyalty and proftability (such as by oering discounts on acces-

sories instead o rebates in the orm o git cards). All o these insights helped align

the strategy or managing each product more closely to its actual contribution to

company perormance.

why you can’t afford noT to act now

A widespread myth about establishing a pocket price-based view o customer

proftability is that it’s expensive, impractical and time-consuming — cer-

tainly not something most companies can aord to do in a downturn. It’s true

that making improvements can require a certain amount o upront investment.

But many companies we’ve worked with fnd that even a modest investment can

yield substantial returns. A company can start small, ocusing frst on a portion o

revenues or a single product line, business unit or location, and then expand the

eort as resources permit.

In act, a pilot project can be both a useul proo o concept and also yieldincreases in proftability that can help und urther improvements. One global

chemical company, not wanting to put all o its eggs in one basket, ran a pilot pro-

gram at three o its poorest-perorming business units, reasoning that they would

be more willing to try something new than would better-perorming divisions.

During the pilot, the participating business units made many minor adjustments

— including “fring” customers, rationalizing products and oerings, and raising





prices in certain segments — that increased their profts by $165 million within

12 months. This amount represented a greater than 1000 percent return on ini-

tial investment, surprising even the initial project sponsors and yielding more

than enough cash to und the project’s subsequent global rollout. As an additional

welcome surprise, the company discovered that many customers that had initially

been “fred” or unproftability returned to buy rom the company again under

more proftable terms, showing that a company that knows how to sell its value to

customers, and has the data to know when to hold the line, can aord to take bold

steps with customers to improve their value to the business.

Contrary to popular belie, a company doesn’t need activity based costing ora customer loyalty program to gather detailed cost-to-serve data, assign costs to

individual transactions, or create a customer transaction history. Most companies

routinely collect much o the inormation needed to analyze customer proftability

or other purposes. A

little digging in the

right places — sales-

person time and ex-

pense reports, reight

systems, marketing

budgets, documenta-

tion o payment and collection terms — can allow them to piece together enough

inormation or at least a rudimentary customer proftability analysis. Even inor-

mation that was never explicitly collected can sometimes be derived rom primary

data. For instance, one retailer that originally thought that its lack o a loyalty card

program would preclude a customer proftability analysis was able to constructcustomer purchase histories by combing individual transactions or linkages be-

tween credit card numbers, phone numbers and e-mail addresses customers gave as

part o their warranty inormation.

How long does it take or a company to beneft rom customer proftability

improvements? In our experience, many companies start to see results in as little

as 8 to 12 weeks, oten as a result o relatively simple changes. One automotive

manuacturer, struggling to fnd a silver lining in a down economy, realized that

signifcant proft-enhancing opportunities could exist in the hundreds o thou-

sands o parts the company sold in the atermarket. During a 12-week analysis o

the market and o supplier costs, the company ound that many parts were over-

priced, reducing the competitiveness o the dealers that sold them, while others

were underpriced and losing money or each sale. The company quickly adjusted

these prices to more appropriate levels while the analysis was still underway and

experienced a signifcant revenue lit in the very next reporting period.

So consider v iewing the recess ion,

not as a barr ier, but as a catalyst

for transformation in the way youtreat customer prof i tabi l i ty.




Finally, one o the strongest arguments or starting now is that a recession can

make it easier to push through organizational changes that might be difcult to

make in times o growth. Your customers, your sales orce, and your operations

people are probably much more willing to accept tough decisions today than they

might be in a strong economy. Their greater receptivity can not only speed adop-

tion o new processes and procedures, but allow you to make much more sweeping

changes than might be easible in better times.

So consider viewing the recession not as a barrier, but as a catalyst or trans-

ormation in the way you treat customer proftability. Start with the low-hanging

ruit, think about ways to reinvest the benefts, and aim high with respect to orga-nizational change. The sooner you begin, the aster you’ll start to understand how

proftable your customers really are — and the better equipped you’ll be to pursue

renewed growth when the economy recovers.

Ed Johnson is a manager in Deloitte Consulting LLP, specializing in customer and market strategy.

Mike Simonetto is a principal with Deloitte Consulting LLP, and leader o the Pricing and Proftability

Management practice.

Julie Meehan and Ranjit Singh are senior managers in Deloitte Consulting LLP, specializing in customer

and market strategy.

Endnotes

Gary McWilliams, “Analyzing Customers, Best Buy Decides Not All Are Welcome,”1. The Wall Street Journal , November

8, 2004,

Documents

US Deloittereview Customer Profitability Jul09