CUSTOMER PROFITABILITY AND SERVICE LEVEL

Knowing the customers for the profitability they provide, it is possible to adjust the level of customer service.

All people involved with Logistics are aware of the potential that logistics services have as an instrument for differentiating a company. Greater frequency of deliveries, information about orders, greater availability of goods, extended delivery times, merchandising support, among others, are ways of creating value for the customer, of “expanding” increasingly undifferentiated products.

The emergence of new competitors, increased competition, customers with higher levels of demand, made this pursuit of differentiation more frantic, forcing companies to have more support staff, keep more stock, spend more on distribution, in short, increase its logistical costs.

On the other hand, it is undeniable that in recent years, the adoption of new technologies and modern management practices have made manufacturing more efficient, reducing production costs.

Thus, the increase in logistical costs and the reduction in manufacturing costs meant that, in percentage terms, the former began to have a much greater share of total costs. In other words, this means that the product has become cheaper but the service cost associated with the product has become more expensive.

We open another theme in this introduction, a theme related to our customers. Marketing specialists argue, with increasing vehemence, that the important thing is not to have profitable products but profitable customers and that keeping existing customers costs less than continually seeking new customers. In this sense, it is necessary to delight profitable customers, know their needs perfectly, provide them with individualized attention, personalized treatment, attributes that are increasingly valued among those that constitute the concept of customer service.

But do we know who the profitable customers are? Are they the ones who buy the most? Are they the least demanding? When it is said that it is cheaper to keep current customers, does this statement refer to all customers?

Two basic questions that conventional accounting has difficulties in answering are related to the two themes covered in this introduction: what are the costs of serving and what are profitable customers. It is possible that the survey of logistical costs is correct (how much is spent on transport, storage, etc.) but the difficulty arises when allocating these costs to who really should pay them, giving rise to the second difficulty: what the profitability of each customer.

Normally, the profitability of a customer is calculated considering only the gross margin, that is, the total revenue from sales to the customer minus the cost of products sold to that customer. However, as we saw in the first paragraphs, there are a series of other costs that are increasingly significant and that must be considered in order to correctly assess the profitability of a client. These are the costs of SERVING that customer. How much sales staff time does the customer require?, who deals directly with the customer, a key account or a less senior salesperson? What is the frequency of deliveries to this customer? When all these costs are perfectly identified, that is, when it is possible to calculate exactly the profitability customer by customer, this analysis can conclude that there is a reasonable number of customers that contribute negatively to the profitability of the company, just as there are customers that are necessary " protect them” from the attacks of competitors.

The purpose of this article is to show the importance of customer profitability analysis, motivating companies to implement cost systems based on logistical activities. Traditional cost systems do not provide the necessary information to define the level of service to be provided to different customer segments according to the profitability they provide to the company.

Throughout the article we will be using the term “customer” in a generic way, that is, customer can be a distribution channel, a market segment, a company or even individual customers.

THE INADEQUACY OF TRADITIONAL ACCOUNTING IN DEALING WITH LOGISTICS COSTS

For some years now, there has been an increase in the interest, within companies, of paying different attention to different types of costs not directly related to productive activities. The growing increase in administrative expenses, with sales and especially in logistical costs, made it clear that the amount of these costs, normally called indirect, had a strong impact on the profitability of the business. The possibility of practicing competitive prices came to depend on the exact understanding of such costs, where they were incurred and who should pay for them.

In traditional practice, indirect costs were apportioned according to the volume of sales to each customer. So let's consider the example in Table 1, where hypothetically the company that had annual sales of 500.000 reais, has three customers A, B and C with sales of 200, 180 and 120 thousand reais, respectively. Let's also assume that the cost of goods sold to these three customers was respectively 85, 80 and 65 thousand reais. With these figures it is possible to calculate the gross contribution margin of each customer. Important information to complete the results account is that during the year the company spent 110 thousand reais on Marketing, Transport, Warehousing and other activities that appear in the table as Customer Service, to make sales to those customers.

To calculate the net contribution margin, what conventional accounting suggests is basically the following: As indirect costs (110) represent 22% of sales, each of the three customers is charged with 22% of what each one purchased , then calculating the net contribution margin of each customer (last line of the table).

What is observed in an analysis like this is that the contribution margin per customer is basically affected by the volume purchased and whether the items purchased are more expensive or cheaper. Basically, customers are distinguished by having purchased products that bring the company a higher or lower gross contribution margin. When distributing the costs of the sales structure and other logistical costs proportionally to the volume purchased, we are not considering the sales effort, order processing times, the number of orders that each customer placed, the need, for example, for special packaging that customer A requires, the daily deliveries required by customer B, etc. If the activities that make up this 22% were better analyzed, the final numbers (by client) could be different.

Costs derived from customer service are independent of the volume of sales to customers. When the real profitability of each customer is calculated considering the costs of serving each customer, it is possible to conclude that there are customers who really contribute to profit while there are others who represent a reduction in profit. Figure 1 seeks to illustrate this fact.

This curve that everyone knows as the ABC Curve or Pareto Analysis shows something interesting: it's not just that 20% of customers represent approximately 80% of profit; what is dramatic is to see that close to 100% (the definitive profit), there is a huge percentage of customers who either represent very little profit or, what is worse, contribute to a reduction in profit.

Next, the article will show the advantages of differentiating customers according to the profitability they provide.

Strategic Opportunities from Customer Profitability Analysis

From the analysis of customer profitability, companies now have a series of strategic opportunities:

• Better serve existing and highly profitable customers; At the beginning of the article we asked if it was necessary to please/delight all customers. Demagogically, someone could answer yes, that all customers deserve to be treated well, that we have to spend all our efforts to serve them in the best possible way, etc., etc. Most companies, however, know that this is impossible. It's unfeasible, it's too expensive. But when you discover that 20% of customers represent 80% of profit, it is obviously natural to pay special attention to these customers. What do banks do with their special customers? What about the super specials? .Thus, it is necessary to get rid of the idea that providing good service means offering the same level of service to all customers. Customers must be segmented according to the economic value they represent for the company and, in each segment, identify the attributes most valued by customers in the segment and define the level of service attribute by attribute. For example, consider the attribute “availability of merchandise”. In all surveys we conducted, regardless of customer segments, this is the attribute most valued by customers. Having availability means having stocks, it means saying “we don't have” less often. The cost of having stock is inversely proportional to the cost of saying “we don't have it” (the cost of shortages). For certain customers (the most valuable ones), saying “we don't have” is more problematic than for other customers. So a 95% availability rate might be good for certain customers, but it might mean dissatisfaction for your most valuable customers. Such customers should deserve an index of, for example, 98%, an index that may be unfeasible for other customers due to the cost it represents. The segmented analysis of customers, based on the profitability criterion, would make it possible to identify, for each segment, the adequate level of availability. And the same goes for other attributes such as delivery frequency, special packaging, delivery flexibility, etc.
• Know the cost of customer service and then be able to charge for the level of service provided. Customer service is not social assistance. You have to charge for the service. When this cost is not known, injustice can be committed by charging people/clients who do not use it. Customers who demand a large number of activities cannot be subsidized by those other customers who do not. If a company keeps its focus only on product cost, the effort it makes to meet customer requirements will be anonymously diluted among all of them, preventing it from making fair pricing decisions. A non-exhaustive list of logistical costs of serving a particular customer might include:

– Cost of taking orders (sales visits, commissions)
– Order processing cost
– Special packaging cost
– Cost of holding inventory for the customer
– Cost of dedicated storage space
– Material handling cost
– Shipping cost/special deliveries
– Costs with documentation/communications
– Costs with returns/returns

• Offer discounts, if necessary, on operations with customers who can be served at reduced costs. Of course, on many occasions there are less demanding customers, and it is possible to serve them with a low-cost service. Such customers may want to negotiate more advantageous prices. If the company has not analyzed its customers according to profitability, not granting a discount could mean the loss of sales which, due to the lack of information provided by the analysis, may appear to be unprofitable. Here it is worth mentioning an example taken from the negotiations of Sam Walton, founder of Wal-Mart, with his suppliers. Walton was considered tough in negotiations because he invariably asked for much greater discounts than his suppliers were willing to give him. “Be reasonable Mr. Walton; the price that Mr. is willing to pay barely covers the cost of products. We have a whole marketing structure that needs to be paid for”, that's what the suppliers more or less said. Walton retorted by recommending that they charge the marketing structure from those who used it, which was not his case because he did not want the presence of salespeople, he did not want promotions, he wanted a high volume of few models and he would give them online information about the sale of products from so they didn't have to stop by stores to pick up orders.• Negotiate win-win relationships between suppliers and buyers.. Successful partnerships are those in which suppliers know perfectly well how much it costs to serve a customer and how much would be lost if they stopped serving it. A good example took place in Rio de Janeiro in a partnership between Kibon and the Zona Sul Supermarket chain for night reception of products. Neither Kibon made night deliveries nor Zona Sul was prepared to receive such deliveries. When they jointly studied the advantages of receiving the product at night, they realized that they outweighed the costs that such a service initially entailed for both parties. The stores in the South Zone are located in a residential area with a lot of traffic, it was difficult to park trucks in a convenient place for delivery, the situation worsened in the summer, which led to fines for vehicles, products (ice cream) that already arrived at stores in terrible conditions, lack of product during the morning (greater concentration of sales) and even non-delivery when the truck driver gave up on finding a place to park and had other deliveries to make. When the two companies did their analysis and realized that sales of Kibon products were decreasing dramatically, both the supplier concluded that it was not a good thing to lose that customer and the buyer also concluded that he did not want to stop selling Kibon products.
• Try to attract customers who provide big profits for competitors. We did our customer profitability analysis and identified our profitable customers. Let's analyze its characteristics: size, volume of purchases, location, sector, operating strategy, etc. Aren't there companies with these same characteristics that are not yet our customers? Why not consider attracting a high-profit customer from one of our competitors who, because they haven't done the same type of analysis we did, still don't have protection mechanisms to keep that customer, don't provide them with the service they deserve? And if this competitor wants to take revenge for the fact that we stole a customer from him, we have an “interesting” set of dissatisfied customers (because we no longer offer discounts or service) who would certainly like to change providers.

Concluding this item in which we show some advantages of identifying profitable customers, Kaplan and Cooper¹, ​​two of the main authors on issues related to cost accounting, list some characteristics of customers with high and low costs to serve:

AND WHAT TO DO WITH UNPROFITABLE CLIENTS?

The analysis of customer profitability reveals the existence of customers who are cheap to serve and customers who are expensive but who are or can be profitable because they are willing to pay for what they receive. But what about customers who don't fall into any of these categories? Those that have been causing us losses for some time and with which we don't want to spend another years losing money. What to do with them? How to get rid of these accounts? Perhaps it is not necessary to make drastic decisions. It is possible that customers themselves will leave us if we refuse to give them discounts or if we reduce or eliminate marketing support or technical support.

A fundamental question to answer here is: What to do with the structure that served those customers? It must be remembered that the fact of ceasing to serve a customer does not necessarily imply a reduction in costs. What can the company do with its technical and marketing people who used to serve those customers that no longer exist? These people continue to cost. If these costs cannot be avoided, there are some alternatives to use the service structure efficiently:

1. a) Improve the service and profitability of valued customers. The strategy for these customers is to try to propose a relationship that distances them from alternative suppliers. At the same time, opportunities could be seen to increase the volume of business while keeping costs under control. Remember that just as we may want to attract profitable customers from our competitors, we must protect those that are profitable to us.
2. b) Identify ways to reduce the cost of service for those customers who are expensive to serve but are willing to pay for what they receive. The idea is not to reduce the service. Can deliveries be consolidated? If new customers were gained in the same area, could deliveries be cheaper? Isn't there a cheaper way to receive/process orders? c) Increase sales volume, without a commensurate increase in serving costs, for those price sensitive customers who are cheap to serve. Efforts could be directed towards achieving a more profitable mix in their purchases from such customers. And what to do with those customers who take advantage of their purchasing potential, who demand a low price and who ask for a series of “perks”. We could perhaps call them mercenaries. It is necessary to see if there is any reason or any concrete indicator that shows that in the medium and long term it is worth keeping them. Is there any indication that we can increase margins or reduce the level of service provided to them? Do we need them for volume reasons even if their contribution margin is low?

If the answers to these questions are all negative, it seems that there is no alternative but to stop answering them. Kaplan and Cooper in their book “Coste & Effect”, already referenced, alert to three possible reasons that a supplier could still keep unprofitable customers:

• Relatively new customers. It is possible that the company spent a lot of money to attract them. Furthermore, it is possible that they are proving the new supplier by giving it only a small portion of the total business and that this is exactly the case with more demanding operations in order to examine the capability of the new supplier. Thus, these initial losses should not be attributed to the high cost of serving that new customer, but part of the investment necessary to get that new customer. Over time it is possible that this new customer will become profitable.
• Customers who give prestige. Meeting their requirements can be good publicity and those possible losses can be offset by attracting new customers.
• Customers who provide learning. This is a benefit that is difficult to quantify. Japanese companies such as Toyota, Nissan, and Honda demanded performance from their North American and European suppliers comparable to the conditions they took a long time to achieve from their Japanese suppliers. Many North American suppliers came to the conclusion that it would be very expensive to meet the strict requirements of quality, deadlines and flexibility of the new Japanese customers and, therefore, at first, they were not profitable customers. Part of this loss could be offset by using the idle capacity they had, which in the short and medium term would not be occupied. However, they took into account the possibility of learning; discerning customers are willing to work with their new suppliers and teach them how new management processes, equipment and technologies will allow them to satisfy customer demands without incurring excessive cost penalties. Thus, the initial loss resulting from serving such demanding customers can be considered as the cost of training in new manufacturing and logistics processes that can be used in a beneficial way for all its customers in the future.

HOW TO PERFORM CUSTOMER PROFITABILITY ANALYSIS?

If traditional accounting does not help to calculate profitability per customer, the question then becomes: which system does?

The answer was given at the beginning of the article. This is the Activity-Based Costing System (ABC). This system considers that the resources available to the company (its structure to provide services) carry out the activities that are demanded by customers. This way of thinking allows cost allocation to occur in two stages, as shown in Figure 2.

Instead of talking about overhead or indirect costs (the people who receive orders, transport, carry out maintenance, make deliveries, visit customers), let's say that these people constitute our resources to provide logistical services.

What the model tells us: Activity-Based Costing starts by identifying the activities that must be performed to serve customers. For simplicity, the figure considered only four activities that consume resources. Some of these features can work across multiple activities.

• A seller, for example, can receive orders and also dedicate part of his time to serving customers, making visits, etc.
  • A person who checks inventory (a pool of costs) within the order-taking activity may spend some time preparing shipments or informing customers about the status of orders (part of what is called customer care).

Then a study is carried out to identify how much each activity consumes resources. If, for example, the drivers' time is all dedicated to making deliveries, then in the “deliveries” activity, we will put everything we spend with drivers. If a certain resource, say a Supervisor, dedicates 20% of his time to the “Order Receiving” activity and 80% to the “Shipment Preparation” activity, let's put 20% of what we spend on him in the first activity and 80% in the second and so on.

The most laborious step, because it requires a more accurate information system than the one traditionally used, is now to identify how much each customer consumes from each of the activities. There are software available to collect/work the data that the ABC system requires. It is an investment that will bring competitive information as a return, especially for those companies that want to improve their customer service strategies, offering a level of service compatible with the profitability provided by different types of customers.