A customer profitability analysis provides valuable information to your team

BY JASON BADER
Inventory management specialist

When we look at the breadth of our customer base, are they really all equal? I love it when I hear an order desk guy say that every customer is the same or I treat them all special. Really? Then why do we have different prices for some? The fact of the matter is that not all customers are the same. Some are more valuable to us than others. Assuming that this is basically true, how do distributors differentiate the good ones from the bad ones?

Here is a great exercise to do with your team. Gather everyone together and ask them each to list the company’s top 10 customers on a sheet of paper. More often than not, volume will be the criteria they use to determine status on the list. Some will go the extra mile and rank the customers by gross profit dollars. It is good to know where the mindset is at the start.

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 just asked them the same question and their list will be identical. If this is the case, it may be time for a quick discussion about relationship between sales and net profit.

If you want to drive net profit improvement through the organization, everyone needs to become part of the mission. By understanding who our most profitable customers are, the sales teams can make better decisions on how to allocate company resources. 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 us out on payment? Chances are we have not armed our order taker with the customer information necessary to make a good net profit decision.

Simple steps to developing a customer profitability analysis report
As I have 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 is important that we are only looking at customers who have done business with us 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:

• Customer name
• Annual gross sales
• Annual cost of goods sold
• Annual gross margin dollars
• Annual number of orders processed for customer
• Cost of processing an order
• Annual cost of processing customer orders
• 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 something called Activity Based Costing. Using abc tools, a cost is attached to each function that is associated with processing the order. Sometimes conflicts can 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 who are more interested in the 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. Are there a few extraneous costs, like the twin-engine floating delivery truck at the end of the dock, that get lumped in? Sure. As you will see, precision is not all that critical here. Depending on your vertical market, most distributors come in between $35 and $65 per order. Plug the number in your spreadsheet as a constant.

The rest of the math in the spreadsheet is fairly simple. Multiply column fve (number of orders) by column six (cost of processing an order) 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 their contribution to your net profit.

Don’t panic if results aren’t as you expected
Once you have created your ranking, you may need to take a step back and allow 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% to 75% of their customers are in the negative territory. So what now? Do we just cut off everyone below the line? Of course not. The majority of these folks help us with volume purchasing and give us economies of scale. Our next task is to determine our threshold for pain.

About 25% of the way up from the bottom of the list, I like to draw a red line. I like to refer to them as bloodsuckers or bottom feeders. Behind closed doors you may be able to come up with more colorful names. Anyone below this line is candidate for termination. Firing a customer is not something that most distributors relish. It’s kind of against our sales code of conduct. The fact of the matter is that it really isn’t the fault of the customer. We have done it to ourselves. In the name of customer service, we have given away company resources to those who are not deserving of our gifts. If you need a little more convincing that this bottom group is taking you for a ride, just lay an accounts receivable aging report next to your list. There is a strong correlation between slow pay and negative contribution to net.

Set policies, share information
Let’s go back to the goal of this exercise. We are trying to drive decision making based on contribution to net profit. The key to getting the most out of the information we just extracted is to share this with our front-line decision makers. Additionally, we need to set some policies that help up align our resource expenditures with the customers that help contribute to our financial success.

The first group I would tackle is the bloodsucker. For ease of use, let’s refer to them as group C. We are giving everything, they are giving nothing. The sad part is that we just learned this. They have known for years. It is a sad fact that your worst customers know it. They take pride in their ability to beat you up on price, run you all over town, and string out your money. We clearly need to level the playing field when it comes to this group.

The first thing I would do is quit being their bank. Convert the slow payers to cod. If you have cash discounts, get rid of them. This goes for all customers, but that is for another discussion. Now that we are out of the finance business, it’s time to raise prices. These folks won a prize. Give them all list price. Whoa, Jason, you are being too harsh. Au contraire. It’s time these folks paid their way. Will some of them leave you? Absolutely. In fact, give them a road map to your competitor’s place. Let them be someone else’s worst customer. The funny ones are the customers that stay. This is one of those forehead-slapping moments where you rethink your whole pricing strategy.

Let’s take a look at the services we provide. Do we provide free deliveries to this group? Do we have minimum orders? Are we transferring product at our own expense? Have I hit a nerve yet? Good. We have a finite amount of resources in the company. We should not 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 in special products for C customers. They get to buy what we have on the shelf. Above all, we do not transfer product at our own expense.

One of the final suggestions is to quit spending sales dollars on them. For those of you with an outside sales force, quit calling on these customers. 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 underperforming customer -- potential.

This should get you started. Work through the process as a team and try to make policies that everyone can live with. Implementing changes will save you money each and every time your front line decision makers hit the enter key. In Part 2, I will take a look at solutions for the other customer groups. Good Luck.

 

Jason Bader is the newest member of The Distribution Team, Inc. The Distribution Team specializes in providing inventory management training, business operations consulting and technology utilization to the wholesale distribution industry. Bader brings over 20 years of experience working in the distribution field. He can be reached directly at 503/282-2333, e-mail jasonbader7801@yahoo.com, or at website www.thedistributionteam.com.