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How to Grade Customer Profitability

Oct. 1, 2006
I love it when I hear an order desk guy say, Every customer is the same, or, I treat them all special. Really? Then why do some customers get special

I love it when I hear an order desk guy say, “Every customer is the same,” or, “I treat them all special.” Really? Then why do some customers get special pricing? All customers are not the same. Some are more valuable than others. Your “A” customers contribute to the bottom line; “B” customers aren't particularly profitable, but they contribute to volume purchasing and help with economies of scale; “C” customers are ones that you might be better off without. But how do you differentiate?

Complete this exercise with your team. Gather your team together and ask each member to list the company's top 10 customers on a sheet of paper. More often than not, volume will be the criteria used to determine status on the list. Some will go the extra mile and rank customers by gross-profit dollars. It's good to know where the mind set is currently.

A couple of weeks later, gather everyone again and ask them to list the top 10 most profitable customers. There may be a few raised eyebrows and whispered suggestions that your memory isn't too sharp. Many people will think that you asked the same question and the list will be identical. If this is the case, it may be time for a quick discussion about the relationship between sales and net profit.

If you want to drive net-profit improvement through the organization, then everyone needs to become part of the mission. By identifying your company's most profitable customers,your sales teams can make better decisions on allocating company resources. You may think they don't have the authority to allocate company resources. I beg to differ. When a customer requests an item that needs to be transferred in from another location, the order taker is about to make a decision. The outcome of that decision can directly affect your bottom line. Is this customer worthy of the transfer? Are they a positive contributor to the bottom line, or do they string you out on payment? Chances are you have not armed your order takers with the customer information necessary to make good net-profit decisions.

As discussed in previous articles, distributors tend to utilize only a fraction of their distribution software packages. Understanding the reporting capabilities and manipulating data can increase your return on this substantial investment. The customer profitability analysis report is simply a spreadsheet using data that your system captures on a daily basis. The magic occurs when you share the data with, and develop policies for, your front-line decision makers.

This report will rank your customers by contribution to net profit. It's important to only look at customers who have done business with your company for at least 12 months. New customers should always be treated “special” until they prove themselves less than worthy. Here are the columns on the spreadsheet:

  1. Customer Name

  2. Annual Gross Sales

  3. Annual Cost of Goods Sold (COGS)

  4. Annual Gross Margin Dollars

  5. Annual Number of Orders Processed for Customer

  6. Cost of Processing an Order (COPO)

  7. Annual Cost of Processing Customer Orders

  8. Contribution to Net Profit

The first question usually occurs with the sixth column. How do we determine the cost of processing an order? There are fancy ways to do it, usually involving additional software and cost accounting, and there is an easy way to do it. The more precise way to determine the actual cost of processing an order is to use something called activity based costing (ABC). Using ABC tools, a cost is attached to each function associated with processing the order. Sometimes conflicts occur between departments as to their relative value in the process, but you will eventually get down to a fairly precise number.

For those of you more interested in getting a solid ballpark number, here is a quick method. Divide your annual operating expenses by the number of orders the company processed last year. Granted, a few extraneous costs, such as the new delivery truck, will get lumped into the year's operating expenses. Precision is not all that critical here. Depending on your vertical market, most distributors tend to come in between $35 and $65 per order. Plug the number into your spreadsheet as a constant.

The rest of the math in the spreadsheet is fairly simple. (See spreadsheet above.) Multiply column five (number of orders) by column six (COPO) to get your answer for column seven (annual cost to process customer's orders). Column eight (contribution to net) is determined by subtracting column seven (annual cost to process customer's orders) from column four (annual gross margin dollars). This contribution to net profit will either be positive or negative. Sort the spreadsheet by column eight (contribution to net profit) in descending order. The result is a ranking of your customers by contribution to your net profit.

Once you create your ranking, you may need to take for a few deep breaths. This is not the time to panic. One of the more troubling observations for first-time viewers is that a majority of your customers fall below the zero line. Stated another way, their contribution to net is a negative number. It isn't quite as bad as the old 80/20 rule, but most distributors find that 70 percent to 75 percent of their customers are in the negative territory. So what now? Do you cut off everyone below the line? Of course not. The majority of these folks help with volume purchasing and give you economies of scale. Your next task is to determine your threshold for pain.

About a quarter of the way up from the bottom of the list, I like to draw a red line and refer to those customers below the red line as bloodsuckers or bottom feeders. Behind closed doors you may be able to come up with more colorful names. Any customer below this line is a candidate for termination. Firing a customer is not something that most distributors relish. It's kind of against our sales code of conduct. It really isn't the customer's fault though. We have done it to ourselves. In the name of customer service, we have given company resources to those not deserving of our gifts. If you need more convincing that this bottom group is taking you for a ride, just compare an accounts receivable aging report with your list. There is a strong correlation between slow pay and negative contribution to net.

Let's get back to this exercise's goal. We are trying to drive decision making based on contribution to net profit. The key to getting the most from the extracted information is to share it with your front-line decision makers. Additionally, you need to set policies that help align resource expenditures with the customers that help contribute to your financial success.

“C” customers

The first group to tackle is the bloodsucker group. Let's refer to them as group “C.” You give everything; they give nothing. The sad part is you just learned this. They have known for years. They take pride in their ability to beat you up on price, run you all over town, and string out your money. You clearly need to level the playing field when it comes to this group.

The first thing to do is quit being their bank. Convert the slow payers to cash on delivery (COD). If you have cash discounts, get rid of them. This goes for all customers, but that is for another discussion. Now that your company is out of the finance business, it's time to raise prices. These folks won a prize. Give them all list price. Sound too harsh? Au contraire, it's time these folks paid their way. Will some of them leave you? Absolutely. Give them a road map to your competitor's place. Let them be someone else's worst customer. The funny ones are the customers who stay. This is one of those moments when you rethink your whole pricing strategy.

Now take a look at the services you provide. Does your company provide free deliveries to this group? Do you have minimum orders? Are you transferring product at your own expense? Have I hit a nerve yet? Good. There's a finite amount of resources in the company. Don't waste them on customers who are not contributing. A good strategy is to require minimum orders for both credit purchases and delivered product. Do not order special products for “C” customers. They can buy what you have on the shelf. Above all, do not transfer product at your own expense.

Finally, quit spending sales dollars on “C” customers. Stop calling on them. Remove commissions on these customers, and make them house accounts. By removing the commissions, you remove the favorite word in the sales vocabulary used to describe an under-performing customer — potential.

“B” customers

The middle group, let's call them “B” customers, is a different animal. They do have a negative contribution to net profit, but I wouldn't want to lose them. As mentioned earlier, they provide your company with the volume to purchase more efficiently and allow you to enjoy certain economies of scale. Some slight adjustments to how you handle this customer group will allow many of them to rise to positive contribution.

Most of these customers have a decent gross-profit volume. The real trouble occurs in the frequency of order. You may find yourself processing several low-dollar orders in a single day. If you could get them to consolidate orders to once a day, they would slide up the profitability scale. This type of discussion will need to come from someone senior in the organization. They can speak in terms of reduction in the clerical costs of purchase-order generation and payment processing.

Another strategy is to look at how your company handles special orders and transfers for this customer group. Ask this customer to bear the cost of expedited handling. In addition, consider suggesting the customer accept a substitute rather than ordering in a special item. Make sure your company gets a high margin on special orders because you spend company resources to bring them in. Be strict with your return policies and be mindful of internal costs.

Finally, look at modest price increases. This is where a matrix-pricing guru can come in handy. Look for subtle increases to less popular items. You should be able to raise your overall margin by 1 percent to 2 percent.

“A” customers

Now analyze your best customers. Let's call them “A” customers. These are the folks that make a positive contribution to net profit. You should love them, and you should tell them how much you appreciate their business. I'm serious here. If you lose one of these customers, it will often be an expensive loss. You will throw all kinds of deals at them to woo them back. Unfortunately, the cash impact of these deals will be felt for many years to come. Don't lose them in the first place.

Get close to the “A” customers. Don't leave the relationship to your sales manager or salesperson. At least once a year, meet with the owner of each of these companies. Talk about what you are doing for them. They need to be reminded. Incidentally, this is an excellent use of sports tickets or that golf club membership. People still do business with people they know, like and trust.

Is it easier to get new customers or sell deeper into your existing customer base? Nothing fancy here. You already have them on the books; sell them more product categories. It's always a blow to the ego when a long-standing customer says, “I didn't know you carried that.” Most sales managers I know would love to be able to analyze each customer and figure out what you are not selling them. The problem is that the task is just too daunting because there are too many customers to really look at. Why not use the ranking report to help?

Why would you want to sell more into companies that produce a negative contribution to net profit? Doesn't make a whole lot of sense to me. Focus on selling deeper into group “A.” I was presenting this idea at a private seminar recently. Fortunately, the sales manager was in the room, and a grin spread across his face. At the break, he shared with me that he had been told to create a sales-opportunity analysis for all of the company's customers. He was really sweating this assignment, and I just cut his workload dramatically. It's better to work smarter than harder.

Profitability analysis report

The customer profitability analysis report is one of the most powerful tools in any distributor's arsenal. From an inventory management perspective, you win in several ways. A big part of inventory management is the allocation of resources, but you have a finite amount of cash to invest in inventory.

As a good asset manager, you are charged with investing resources where you will receive maximum customer benefit and a strong financial return. When using this customer ranking, it's easy to see where to invest your money. You need to make sure that your “A” customers are satisfied. One of the scarier outcomes of this analysis may be realizing how many inventory dollars you waste on group “C.” Some companies carry entire product lines for “C” customers.

After all is said and done, the biggest win comes from educating the front-line decision makers. At a customer-service level, they have the ability to make a tremendous impact on your company's bottom line.

One of the final challenges is to make sure everyone knows who the “A,” “B” and “C” customers are. This is where software can help. Some of the more sophisticated programs can actually have the customer code appear in a different color during the order-entry process. Some user-defined fields in the customer record can help, but they are not always seen.

One distributor came up with a simple code of adding asterisks to the end of the customer name in the database. The asterisk codes also appeared on the pick tickets, so the material-handling team knew which tickets were priority. Customers with three stars were given special treatment. The key is to find a communication vehicle that works for you.

Understanding customer profitability will go a long way toward improving your bottom line. This simple data extraction will provide several avenues to look for cash. Don't be afraid to lose some of your “C” customers. You have already given them enough of your money. We'll explore additional power reports in the coming months. As always, I am here to help you get started. Good luck.

Jason Bader is a partner with The Distribution Team Inc., a consulting firm that works with wholesale distributors to improve their net profit through effective inventory management. Visit the firm's Web site at Badercan be reached at (503)282-2333; e-mail: [email protected].

Annual ReportCustomer Name Sales $ COGS $ Gross Margin # of Orders COPO Annual COPO Contribution to Net Profit XYZ $5,000 $3,000 $2,000 10 40 $400 $1,600 ABC $4,000 $2,000 $2,000 20 40 $800 $1,200 HGS $7,000 $4,000 $3,000 50 40 $2,000 $1,000 TBS $5,000 $3,800 $1,200 30 40 $1,200 $ — VGT $8,000 $5,400 $2,600 70 40 $2,800 $(200) BLM $7,000 $4,900 $2,100 60 40 $2,400 $(300) ACM $9,000 $7,000 $2,000 60 40 $2,400 $(400) FIR $9,000 $7,500 $2,500 75 40 $3,000 $(500) DOG $5,000 $4,000 $1,000 40 40 $1,600 $(600) BUM $6,000 $4,500 $1,500 60 40 $2,400 $(900)

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