More distributors are using customer profitability ranking (CPR) reports to analyze their account bases and uncover which customers sap profit from their businesses. Using CPR reports to turn bad accounts into stars is similar in concept to the alchemists of the Middle Ages who supposedly had mystical powers to turn base metals such as lead into pure gold.
These days, there's nothing magic about analyzing the buying habits and profitability of all your customers. In fact, if you do it right, you can turn a few “lead accounts” into pure gold. Let's first look at losing accounts. As much as 60 percent of all active accounts contribute minor to unbelievable losses for a company. The bottom 1 percent of a company's accounts will typically cost it 20 percent of all existing operating profit. As a group, these accounts are a big contributor to the smallest 40 percent of all company transactions that yield less than 5 percent of the gross margin dollars. However, these unprofitable customers chew up 40 percent or more of all a company's transactional activity costs.
These “super-loser accounts” are often big-name or big-potential accounts, each of which is applying its own perverse purchasing philosophy to the unsuspecting distributor. A few of these losers may be using their size to cherry-pick a company's service capability and not pay for it. But the vast majority of super-loser accounts unknowingly pursue purchasing assumptions and processes that cause big transactional costs for both parties.
How could your company use a list of the five to 10 super losers per branch (profit centers)? I know distributors that have used these CPR lists to explain to branch managers and sales reps how activity-based costing attaches a cost to each of the key elements of service required by customers. The sidebar “Analyzing Customer Profitability” on page 47 offers a formula that will help you develop a CPR report.
When they first look at CPR reports, most managers don't believe how profitable the top 1 percent of their accounts are. On the flip side, they don't see the extreme unprofitability of the bottom 1 percent, either. The top 1 percent of the most-profitable accounts can account for 35 percent to 50 percent of a profit center's annual operating profit. These accounts will sport a profit rate as a percent of sales three to four times the return on sales of the branch.
The super losers are also surprises, because their order activity — one to 10 orders a day — is usually considered good. In fact, because they order so often, they are usually buddies with someone at the branch. The allocation of managerial and sales time for these customers is way out of line with the profit they produce, but managers and sales reps don't want to believe they have been naïvely misdirecting their time. In fact, when they first get a CPR report telling them their favorite accounts are not profitable, their first defensive response is to attack the activity-based costing assumptions used to generate the reports in an attempt to minimize the losses for the “heavy-lead” accounts. However, three big truths hold sway.
The only way an account can be at the top of the report is to have huge annual margin dollars and relatively few transactions. These are strong winners no matter what cost shifting and activity-cost assumptions are tried.
The only way an account can be at the bottom of a CPR report is to have huge transactional activity and relatively low margin dollar contribution. They remain super losers no matter what new cost assumptions are used. In fact, when more detailed analysis is used for big losers, they are often found to be even worse due to nonmoving, special stock, remote delivery costs, etc.
If anyone wants to use incremental cost assumptions, the rest of the overhead costs assigned to the accounts in dispute must be reassigned to all other accounts. This makes the super losers even bigger losers.
The second line of defensive reasoning is that all of the company's operating costs are fixed, so any incremental margin gains or losses directly impact the profit line. With this logic, if a company drove away a loser that had (for example) $2,000 in margin and $17,000 in hypothetical transaction costs, the company would take an immediate $2,000 hit to the operating profit line and would have $15,000 of idle, can't be redeployed overhead.
The rebuttal to this argument is that a distributor can persuade some customers to rethink how they buy to not only lower its transactional costs but also the customer's total procurement costs to buy. Say a distributor chose to selectively drive away 2 percent of its gross margin dollars to free 10 percent of its transactional activity. That company could shift it resources to serve other customers that will offer more profitable sales growth.
An important element of the concept of turning “lead” accounts into ones that shine like gold is deciding who to manage the process. Ask yourself three questions:
Which employee can get an audience with the head honchos at losing accounts?
Can this person convince them to change their inefficient purchasing ways?
Is there someone in the company who could develop some innovative service or process accommodations that could help the customer become a winner?
This person needs to have a title that will get them in the door and be fluent with both total selling and purchasing costs. In addition, this person must have experience in developing and managing existing buy-sell processes as well as new ones that are win-win. They also need to have the conversational and problem-solving skills that can eventually convince customers to change their flawed, often unspoken purchasing assumptions. It takes great skill and tact to help customers see the “hidden costs” of their flawed ways that have been creating unnecessary high costs for both parties.
Your sales reps are out of the running for this assignment. At large accounts, they tend to call on full-time purchasing people who don't have the clout to examine and change purchasing beliefs, policies or procedures. They just execute what has always been and deny any problems. Even if your sales rep could get into a meeting with a head honcho, they would be going over their key contact (often a friend at the account) to discuss eliminating cost in their purchasing department's transactional activity cost. They may not be comfortable doing that.
Some branch managers can succeed with big losers who are happy to change to help the branch. But, most branch managers don't have the education, experience and confidence to do an artful job with the rest, so they avoid them. The designated alchemist is usually the CEO by default. An unusual but effective alternative answer is to retain an outside consultant with experience in customer turnarounds and train an employee to turn losing accounts into winners. They would work together with customers at one or more branches and then develop guidelines that show other employees how to do it with other customers. At some point, the trainee can fly solo and take care of all super losers, once they have developed regular CPR reports on all customers at all locations.
It's not an easy process. You may have to play hardball with about 20 percent of the super losers who are cherry-picking your stock at one of your branches. Once you have determined that cherry-picking is the game and that the customer has no intention of changing, then the answer is to make changes in pricing and terms to make the customer profitable. The cherry-pickers may threaten to stop all buying, but they usually resume their activity on the new terms because the company still has, after all, the unique cherries that the customer needs.
Every customer, super losers included, intuitively wants to buy their goods at the lowest total-procurement cost. Most actually want the supplier to make at least a minimal profit. The problem is that all accounts are not clear about their total-procurement cost and how well they are really measuring and achieving it. You need to help them change from unintentional lose-lose practices to win-win ones.
Roughly 80 percent of super-loser accounts can be converted into gold ones with great “alchemy” skills. Many of these customers can even buy more volume than before if you sit down with them to rethink how you're doing business together.
The remaining 20 percent, who are either cherry-pickers or total hard heads, will bluff and bluster but often comply with new pricing and terms. The ones that do leave will paralyze another competitor that doesn't know its transactional economics.
When you get rid of these profit-sapping customers, you will free up personnel, time and capital to serve the rest of your account base. If your firm would like to relieve operational stress, better serve the accounts that matter, grow personnel productivity and operational profitability, and win new business from old accounts, the answer is to turn your lead accounts into gold with customer profitability analysis.
The author is president of Merrifield Consulting Group Inc., Chapel Hill, N.C. He is well-known throughout the distribution world and has given hundreds of presentations to trade associations and many of the world's largest corporations. His Web site at www.merrifield.com offers a diverse array of articles, commentary and other resources on maximizing the effectiveness of independent distribution channels, high-performance service management and the impact of electronic commerce on distribution channels. You can reach him by phone at (919) 933-7474 or by e-mail at firstname.lastname@example.org.
Analyzing Customer Profitability
Ranking all of your accounts by profit contribution isn't an exact science because of the problems of allocating fixed, semi-variable, and even variable costs. Although you can never do a perfect ranking of accounts from best to worst, you can get a rough idea with the following formula. If you need additional information, check out my article “Measure profitability and act,” available at www.merrifield.com/articles/2_3.asp. Use the following equation for each customer:
Gross Profit (12) - [Invoices (12) × Average Cost per Invoice] = Estimated Operating Profit Contribution
Calculate the total gross profit for an account for 12 months (or however many months of trailing history you might have). From the gross profit, subtract the product of the number of invoices billed to the account for the same period (12 months in this case) multiplied by the average cost per invoice.
The cost per invoice is simplistically calculated by taking the entire operating cost of running the business for the year and dividing it by the grand total of invoices for the same period.
The next step is to have your computer rank all of the accounts from high to low by their estimated profit contribution while also putting in cumulative percentage columns for customers and profit. It's not a perfect science, but you will learn from the analysis. Sometimes good managers must act wisely with imperfect information. They do their initial analysis crudely and quickly, and then refine further rounds of analysis as needed.