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Stewart Anderson

Six Sigma

Determining Customer Profitability

Measuring at the market-segment level can reveal the differences

Published: Tuesday, June 7, 2011 - 04:30

Not all customers are equally profitable. Different customers have different needs, and hence different costs to serve. The overall profitability of a business is a function of the profitability of individual customers and customer groups.

Many businesses measure customer satisfaction but they do not measure customer profitability. A profitable customer is a buyer who yields a revenue stream which exceeds by an acceptable amount the costs incurred to serve that customer. Customer profitability can be measured individually by customer, market segment, or channel. This article looks at an approach whereby customer profitability can be measured at the market segment level.

Unfortunately, most businesses are poorly equipped to understand how costs relate to specific customers. Traditional approaches to accounting allocate costs to individual products, but not to customers, who are the drivers of these costs. While the average costs in a business may decline as volume increases, there can still be significant profit leaks due to the higher costs involved to serve some customers.

In many firms, some costs are assigned to specific products or product groups sold to specific customers or customer groups. All other costs are allocated among all products and customers. For example, all sales and marketing expenses are usually averaged across product and customer groups alike. Because the true costs are rarely classified by customer group, the real costs to serve customers remain hidden from view. This means that some customers are being overcharged while some others are being subsidized.

In the matrix in figure 1, we correlate the costs to serve customers with the net margin realized. Quadrant 1 in the matrix is the preferred quadrant—here, one finds the most attractive customers (or segments) where the net margin realized is maximized with the least costs to serve. All other quadrants are less desirable.


Figure 1: Net margin realized

When customers or market segments are plotted on the matrix, those appearing in quadrants 2, 3, or 4 should be moved where possible toward quadrant 1. The general approach for dealing with customers or segments that are less attractive due to lower profitability is to improve their profitability through one of three approaches:
1. Reduce the costs to serve. This can be done by focusing lean techniques and other process-improvement methodologies onto the value-chain activities that serve the customer group or segment. In addition, products and services may be redesigned to drive out costs.
2. Increase the price to increase the total revenue obtained.
3. Improve the product mix offered to the customer or segment. Tightening the mix to eliminate unprofitable products can improve the profitability of a customer group or segment.

 

Where these approaches are not workable or prove ineffective, the firm should consider de-emphasizing the segment or customer group in marketing, or exit the segment or group altogether and focus resources only on the most attractive segments. However, as we will see below, this option is not without its pitfalls.


Figure 2: Customer group data 

Obviously, to calculate customer profitability one has to determine the costs to serve together with the segment revenues. This will require de-averaging costs according to how they are incurred by product groups and customer groups. How can this be done? Our preferred approach consists of the following steps:

Step 1: Define the firm’s market segments. Using a matrix similar to the one in figure 1, the firm’s product groups and customer groups are defined using appropriate criteria (e.g., customer type, industry, sales volume, use of the product) for defining the customer groups. Customer groups should consist of groups of buyers with relatively homogenous needs. In the matrix, where a product group and a customer group intersect, that is a segment.

Step 2: Determine the sales revenue for each segment. In many cases this can be determined from the firm’s sales records.
 
Step 3: Determine the costs to serve for each segment. This will require a detailed breakdown of costs and tagging them back to segments. Our preferred approach is to use activity-based costing to identify the activities that incur the costs to serve the segment, determine the capacity cost rates for each activity or process, and then identify the cost drivers for these activities. For example, if customer service and support activities are required to serve a segment, we identify the capacity-cost rate for this set of activities, and then identify the cost drivers that trigger the costs, such as customer service calls, field service visits, and warranty repairs. Then for each cost driver, we determine the duration in time these cost drivers incur, and together with their frequency multiplied by the capacity cost rate, determine the activity cost.

Step 4: Correlate the total segment revenues and costs to serve back to the firm’s financial statements. This check ensures that revenues and costs have been accurately captured and de-averaged. In addition, any unused capacity as a percent of total practical capacity is identified. This is important for identifying unused capacity that might be trimmed, or alternatively could be used to handle additional demand generated from refocusing actions that might be taken.

Step 5: Calculate the profitability of each segment and map on a profitability matrix.

Step 6: Take actions to improve the profitability of segments that do not lie in quadrant 1 of the matrix in figure 1. Actions taken should consider the structure of the segment. For example, it may not be possible to increase price in a segment where the price elasticity of the segment is low (inelastic). Where segment profitability is marginal and cannot be improved through the actions previously described, the firm may have to think about ceasing to serve the segment.

 

Exiting a segment, or discontinuing an unprofitable product, requires a careful think through because there will be a real impact on profitability, and not always in the direction a firm hopes. Firstly, when a firm chooses to exit a segment or discontinue an unprofitable product, the firm will decrease its total revenue due to the loss of sales revenue from the segment or product. In addition, costs may only be minimally reduced mainly due to less consumption of materials involved in the discontinued product. If the firm takes no other actions, the largest cost-bearing items such as direct labor will remain as part of the firm’s cost structure, even if the firm reallocates this labor to other activities. This in turn could cause segments and products which were previously highly profitable to now become less profitable since they are now bearing a larger portion of the firm’s cost structure. Thus, the overall profitability of the firm is worsened, not improved, in the short term.

Costs are only reduced when the resources which create those costs are reduced or eliminated, not reabsorbed elsewhere. Reallocating costs is not the same as reducing or eliminating them. A firm reduces or eliminates costs when it reduces or eliminates the key inputs it needs to create value and serve customers—inputs such as labor, materials and supplies, facilities, equipment, capital, and others. If an action cannot be shown to reduce a firm’s total costs (fixed and variable costs), then it is not a cost reducing action.

Manufacturing costs are sensitive to both scale and variety. As volume increases, manufacturing costs go down due to the spreading of costs over a larger volume of output. As product variety proliferates, costs increase due to the increasing complexity introduced within operations. Firms should try to seek the optimum where product line breadth and segment/customer group focus balances the effects on costs from scale and variety.

The approach has proven workable in a number of firms and has made transparent the profitability of segments and customer groups which otherwise were opaque. In addition, these firms were then able to take focused actions which improved their profit performance overall.

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About The Author

Stewart Anderson’s picture

Stewart Anderson

Stewart Anderson is a partner with Anderson Lyall Consulting Group, a Toronto-based consulting and advisory firm that helps firms develop their competitive advantage. Anderson’s background and expertise includes competitive strategy and value chain engineering. He has advised companies in the manufacturing, service, and contract manufacturing industries. Anderson is completing his bachelor of arts in economics and he is a certified trainer in lean manufacturing principles and techniques.