CUSTOMER PROFITABILITY AND SHORT RUN PRODUCT MIX DECISIONS

LECTURE 3 - AGENDA Traditional and costs-to-serve approach to customer profitability What is customer value and how it is different form profitability Theory of Constraints and why the definition of variable cost matters Prof. Teemu Malmi 2016

I – TRADITIONAL WAY Product sales price less variable costs (less some fixed costs) = product (contribution) margin Sum up customer purchases and resulting total (contribution) margin per customer Sometimes adequate enough method to assess customer profitability! In which circumstances? Prof. Teemu Malmi 2016

CUSTOMER COSTS ? - How our customers are different what comes to costs they impose on us? Prof. Teemu Malmi 2016

II – COST-TO-SERVE Prof. Teemu Malmi 2016

Direct Materials & Packaging Batch level costs Product level costs Product profitability Customer profitabilityCompany profitability Sum of production margins of all orders Customer service Sales activities Delivery costs R&D costs Facility sustaining activities Unused capacity Total customer margin Production margin Customer margin Net profit Typical ABC model

WHAT DO ABC TELL US? CONCLUSIONS? SO WHAT? Prof. Teemu Malmi 2016

COST VS. VALUE Customer value builds up from all such things we are able to generate cash flow! Customer costs do not reflect: – Prof. Teemu Malmi 2016

III – CUSTOMER VALUE How would you calculate customer value? This might be of importance in situations where some of the largest customers appear unprofitable based on your customer profitability analysis Prof. Teemu Malmi 2016

CASE: CUSTOMER VALUE AT ONE MAJOR BANK Based on idea of Economic profit / Return on Economic Capital Discounts future cashflows to present value Is used e.g. for pricing in corporate banking Inputs: –Product mix, for example loan, cash limit, transaction volumes –Assumptions about the use / change in use per year –Banks margin per product –Transaction fees per product –Process / activity costs per year –Funding cost Prof. Teemu Malmi 2016

CASE: CUSTOMER VALUE AT ONE MAJOR BANK As a first step, estimated cash revenues from each product (margins + fees) for the lifetime of a loan are calculated Similarly, both process and funding costs are estimated for each year This ends up to a net cash flow from this customer If we would discount these to present values, would this be enough for a bank to estimate the profitability or value of its customer? Prof. Teemu Malmi 2016

CASE: CUSTOMER VALUE AT ONE MAJOR BANK The issue with banks is that certain products (e.g. loan, limit) tie up capital where as some do not (e.g. transactions) This also brings in risks Further inputs based on Basel II –Probability of default (PD, is based on internal rating) –Exposure at default (EAD, luottovasta-arvo in finnish) –Risk Weight (RW, is based on rating information and how economic capital is calculated) –Cost of capital –Funding cost Prof. Teemu Malmi 2016

CASE: CUSTOMER VALUE AT ONE MAJOR BANK For both loan and limit, bank calculates Risk Weighted Assets (RWA), which equals EAD x RW. As Basel requires Banks to have at least 8% of equity, it can now be calculated how much these products tie up banks own funds. (Capital required = RWA x 8%) This is then multiplied by the cost of capital to end up with a capital charge for these products ( e.g. 10% of cost of capital x capital required) When these capital charges are deducted from net cash flows computed earlier, bank ends up with economic profit (excluding taxes) this customer generates each year. Prof. Teemu Malmi 2016

LECTURE 3 - AGENDA Traditional and costs-to-serve approach to customer profitability What is customer value and how it is different form profitability Theory of Constraints and why the definition of variable cost matters Prof. Teemu Malmi 2016

AN EXAMPLE OF SHORT TERM PRODUCT MIX DECISION UNDER CONSTRAINT CONVENTIONAL VARIABLE COSTING Income -Direct materials -Direct labour -Variable overhead = Contribution margin THROUGHPUT ACCOUNTING Income -Direct materials = Throughput (margin) Prof. Teemu Malmi 2016 Question: What products to produce in order to maximize firm profitability?

Prof. Teemu Malmi 2016

THEORY OF CONSTRAINTS LESSONS Maximize contribution per unit of limiting factor In other words, typically which product yields highest €/hour The idea is to maximize profitability of existing facilities Irrespective of TOC ”theory”, the truly variable costs are of interest => In other words, you get different results depending on how you compute your contribution margin Prof. Teemu Malmi 2016

USING THROUGHPUT Prof. Teemu Malmi 2016

USING TRADITIONAL CONTRIBUTION MARGIN Prof. Teemu Malmi 2016

SUMMARY How would you analyze the reliability of the product / service / customer profitability figures your company accounting system provides you? Key learning points today? Prof. Teemu Malmi 2016