1. Managing Customer Profitability6
Managing Customer Profitability

2. Customer Profitability Analysis
Analyzing the activities, costs, and profit associated with serving specific customers.
Customer makes frequent order changes.
Customer needs special attention.
Customer is difficult to please.
For various reasons, some customers are less profitable than others.

3. Customer Profitability Analysis
Two primary objectives
Identify Effective
and Ineffective
Customer-Related
Activities
Measure
Customer
Profitibility

4. Measuring Customer Profitability
Studies have shown that only 20% of a company’s customers contribute to profits. The remaining 80% generate losses.
Possible qualitative reasons to retain unprofitable customers:
Customer prestige.
Potential future profitability.
Loss leader to enter market.
Nonmonetary benefits such as knowledge or expertise.

5. Measuring Customer Profitability
A graph of five of our customers reveals that two of the five are unprofitable.
Bar graphs are common analytical tools.
Customer Profitability
Customer Number

6. Measuring Customer Profitability
We will focus our attention on customers 102 and 114.
Question:
Why are these two customers unprofitable?
Customer Profitability
Customer Number

7. Measuring Customer Profitability
Comparing the customer-related costs for each customer can reveal helpful insights.
We Investigate and find. . .
Order processing costs, engineering/design changes, and special handling costs for Customer 102 are above normal.
Special packaging costs for Customer 114 are four times the norm and special handling costs are six times the norm.

8. Customer Profitability Analysis
Once we know why the customers are unprofitable, we can modify customer relationships to improve profitability.
We’ll send a team to your plant next week and help you set up ordering and handling procedures that will reduce costs and provide you with better service.
I hate to do this, but we just can’t continue doing business with you.
If you ask for fewer changes, we can charge you less and deliver your orders faster!

9. Identify Effective & Ineffective Customer-Related Activities
Study closely all the customer-related activities that drive costs.
Typical Customer-Related Activities Include:
Processing Orders
Sales Contacts
Sales Visits
Processing Shipments
Billing
Engineering/Design Changes
Special Packaging
Special Handling

10. Customer Profitability Analysis
HealthWave, Inc.
(Textbook Example)
HealthWave, Inc. sells non-prescription pharmaceuticals, supplements, and herbal remedies to three major customer types:
Pharmacy
Grocery
Herbal Therapist

11. Customer Profitability Analysis
Exh.
6.2
Customer Profitability Analysis
Healthwave reports product line profitability.
Research and Development (R & D) costs are traced to products, but General, Selling and Administrative (G,S and A) costs are allocated based on sales.
The profitability goal is a 10 percent return on sales. Is the problem products or customers?

12. Customer Profitability Analysis
We now know that the supplements line has a low return on sales and that herbal remedies has a negative return on sales.
An analysis of sales records shows the following customer sales patterns for these products:
Now let’s look at contribution margin per customer type.

13. Customer Profitability Analysis
Exh.
6.5
Customer Profitability Analysis
78% of 26,900, % of 44,260, % of 19,840,000 = $25,514,800
[(78% of 26,900,000) × .52] + [(8% of 44,260,000) × .61]
+ [(5% of 19,840,000) × .69] = $13,755,008

14. Customer Profitability Analysis
Exh.
6.5
Customer Profitability Analysis
Sales to Pharmacies provide the highest contribution margin ratio.
Let’s examine further.

15. Sales & Administrative Cost Analysis
We will analyze these costs to determine how much of each cost to subtract from customer margin. Our objective is customer income and return of sales for each customer.
Selling
Costs
R & D Costs
Marketing
Costs
Distribution Costs
General & Administrative Costs

16. Exh.
6.6
Selling Cost Analysis
HealthWave sells its products using sales personnel in the field and by telephone ordering.
45 sales $55,000
25 sales $42, major account $200,000

17. Exh.
6.6
Selling Cost Analysis
HealthWave sells its products using sales personnel in the field and by telephone ordering.
40,000 grocery orders × 85% by telephone = 34,000 grocery telephone orders
34,000 ÷ 80,000 total telephone orders = 42.5 percent of telephone orders
42.5 percent of $130,000 total telephone cost = $55,250

18. Percentage based on personnel interviews
Exh.
6.6
Selling Cost Analysis
HealthWave sells its products using sales personnel in the field and by telephone ordering.
Percentage based on personnel interviews
62% of $480,000 = $297,600

19. Marketing Cost Analysis
Exh.
6.7
Marketing Cost Analysis
Marketing costs include personnel, databases, equipment, and facilities used for selling, market research, strategy, and planning.
Percentage based on personnel interviews
55% of $360,000
56% of $2,250,000

20. Distribution Cost Analysis
Exh.
6.8
Distribution Cost Analysis
Distribution costs include packing, shipping and delivering products or services to customers. HealthWave delivers goods using its own trucks and a private delivery service, PackageXpress.
12% of $16,085,800 Herbal Therapist Revenue (rounded)

21. Distribution Cost Analysis
Exh.
6.8
Distribution Cost Analysis
Pharmacy deliveries 286, %
Grocery deliveries 40, %
Total deliveries 326, %
12.34% of $8,080,000
87.66% of $8,080,000

22. Research and Development cost Analysis
Exh.
6.9
Research and Development cost Analysis
R & D costs are charged to product lines in the year of spending. For the current year, 40 percent of R & D costs are charged to supplements and 60 percent to herbal remedies.
Product
Non-prescription 0% $
Supplements ,000
Herbal remedies ,000
Total R & D costs 100% $1,200,000
Next, the amounts charged to product lines are allocated to customer types based on sales revenue.

23. Research and Development cost Analysis
Exh.
6.9
Research and Development cost Analysis
78% of $0 + 8% of $480, % of $720,000
22% of $0 + 83% of $480, % of $720,000
0% of $0 + 9% of $480, % of $720,000

24. General & Administrative Cost Analysis
Exh.
6.10
General & Administrative Cost Analysis
These costs can often be difficult to trace to specific customers. HealthWave breaks them into these categories: manufacturing support (30%), customer service (50%), and general business activities (20%). Percentages were obtained from management interviews.
(20% + 50 %) or 70% of $8,270,000
30% of $8,270,000

25. General & Administrative Cost Analysis
Exh.
6.10
General & Administrative Cost Analysis
Allocate customer service based on revenues.
28.04% of $5,789,000
17.68% of $5,789,000
54.29% of $5,789,000

26. General & Administrative Cost Analysis
Exh.
6.10
General & Administrative Cost Analysis
Allocate manufacturing service based on variable COGS.
25.16% of $2,481,000
19.72% of $2,481,000
55.13% of $2,481,000

27. Customer Profitability Analysis
Exh.
6.11
Customer Profitability Analysis
Finally, we put all the information together to determine which customer-type is the most profitable.
Even though Pharmacy has the highest margin, it has a negative return on sales. What should Healthwave do?

28. What To Do? HealthWave, Inc.
The Pharmacy customers are not contributing to HealthWave’s profitability. What are the options?
Decrease operating costs
Do Nothing
Increase efficiency of serving pharmacy customers
Drop pharmacy customers

29. What To Do? HealthWave, Inc.
Do nothing is unacceptable given the magnitude of the loss.
Dropping the pharmacy customers should only be considered if the cost savings are greater than the $11,759,792 of contribution that would be given up.
Decreasing operating costs and/or increasing the efficiency of serving pharmacy customer appear to be the best options.

30. Common-Sized Profit Statements
To better compare different sets of data, the dollar amounts can be recast as a percentage of revenues.

31. Common-Sized Profit Statements
Pharmacy margin is high, but some costs seem out of line.
Potential Savings?

32. End of Chapter 6