A few good customers can drive your growth

[Editor's note: During the downturn that started in late 2007, most companies did an excellent job of reducing expenses and improving cash flow. However, we have observed in the last 18 months a disturbing trend. In the drive to improve the top line, companies are beginning to lose focus on the importance of "profitable growth." We decided to run a series on profitable customer growth. We hope you find it useful. -DPM]

Improving Your Business: One Profitable Customer at a Time

Part 1 - A Few good customers can drive your growth

Over the last few years there has been increased focus on the strategy of "fewer and deeper" as a strategy for growth. The logic of this strategy is straightforward-focus your resources on a fewer number of customers with whom you can have a deeper relationship and this will cause increased growth. Please note that we are not advocating extreme customer concentration, as this leads to excessive risk and can be a discounter of value when a business looks to sell. In this series of articles, we will address how to improve business results dramatically by gaining a deeper understanding of most profitable customers.

Selecting the Right Customers

In most businesses, a relatively small number of customers generate the bulk of the revenue (typically 20% of customers generate as much as 80% of revenue). One recent client derived 98% of their revenue from only 25% of their customers. This client assumed that the remaining 75% of the clients represent high margin business and thus, a greater share of profitability. Unfortunately, for this client and many similar companies, this usually is not the case. According to this study of retail banking performed by KPMG, 140 to 170% of profits can come from 20% of customers while 80% of losses can be attributed to only 20% of customers.

Research completed over the past fifteen years by The Mead Consulting Group, with data from over 1900 companies ranging from $4 Million to over $5 Billion in revenue, shows a similar pattern. The Table below illustrates an extreme example. In one company as few as 2% of the customers generated 800% of the profits, while the losses are generated by fewer than 10% of the customers. The balance of the 88% of the customers, remaining in this example, is about breakeven.

Tier	# Customers	% of Total Customers	Net Profits (Loss)	% of Net Profits (Loss)
Tier 1	19	2.0%	$8,648,185	801.5%
Tier 2	845	88.1%	($43,160)	(4.0%)
Tier 3	95	9.9%	($7,526,025)	(697.5%)
Total	959	100.0%	$1,079,000	100.0%

   

Below, we will address the costs of unprofitable customer relationships and suggest strategies you can put in place in your business to improve profitability and begin to implement a "fewer and deeper" strategy for growth.

The Cost of Unprofitable Customers

There are several reasons why managers pursue unprofitable customers. One of the biggest we have found is the passion that many middle-market company managers and business owners have for selling. These managers often place a premium on attracting new customers and generating top line revenue growth. This passion for the top line may be rooted in a fear of not having enough customers should there be a business downturn. This approach can lead companies in a wrong and unprofitable direction. If managers do not focus efforts on the right (profitable) customers, the same passion that was a driver in building the business can become a downright anchor, dragging down profitability.

An in-depth analysis of one client company revealed net profit would be two and a half times higher without 65% of its customers! This client provided a striking example of the cost of unprofitable customers. This manufacturing company provided excellent service and, as a result, continued to expand its number of customers over the years. Each year they added customers and seldom, if ever, lost a customer. Unfortunately, 65% of their customers made up a paltry 5% of total revenue. To make matters worse, these small customers were the most frequent buyers of the company's most unprofitable product lines. A detailed analysis revealed the company's net profit would be two and half times higher without 65% of its customers! We did not advocate "firing" these customers but rather provided a procedd to improve profitability which we will cover in the next article in this series.

Some of the failure to focus on more profitable customers comes from inadequate accounting. Companies, large and small, struggle with how to measure customer net profitability accurately. In many companies, management may know how much gross profit they are generating from each customer. The problem often occurs in the costs that occur after gross margin. The resources it takes to sell, administer, and service customers makes the issue of real profitability more complicated. For example, consider the customer with a relatively small level of sales but a healthy gross margin in both percentage and absolute terms. This customer buys frequently (lots of invoices), has high service requirements (always orders at the last minute and expects overnight delivery), and stretches payment terms to 120 days. This may not be a truly profitable customer. On the other extreme, it could be a large customer who purchases a significant volume and has a gross margin that is relatively lower as a percentage of revenue. This customer purchases in larger quantities (fewer invoices), has reasonable service demands (does not order at the last minute), and pays in a reasonable amount of time. Which one is the more profitable and more desirable customer? This is a question that is too infrequently asked in many companies because such "below-the-line" costs are not known.

Opportunity cost - time with marginal customers versus time with high potential customers. Even if you are confident that you can accurately determine customer profitability, there is an additional factor to consider - opportunity cost. What is the opportunity cost of having a salesperson travel to see a marginal customer versus spending time with top priority customers and prospects? Costs such as these make the bottom quartile of your customer base even less profitable than you may realize. These relationships not only result in poor customer profitability, but can also be a detriment to other existing and prospective customer relationships. Executing a "fewer and deeper" strategy requires you to focus your resources on relationships that matter.

Next - Part 2 - A Process to Improve Profitability