Improving Your Business: One Profitable Customer at a Time Part 2 - A process to improve profitability

[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. In Part 1 we outlined how a few customers can drive net profitability. This is Part 2 - a process to improve profitability. We hope you find it useful. -DPM]

  Improving Your Business: One Profitable Customer at a Time

  Part 2 - A process to improve profitability

 

Many managers seem to rely on intuition to determine if a customer is profitable or not. Sometimes the intuition is correct and sometimes it is not. Besides one's intuition not being correct, relying on intuition to determine customer profitability confuses the organization. Why? One's intuition varies greatly depending upon position in the organization and how the relationship is viewed. For example, for the sales vice president trying to make a sales goal, that unprofitable customer can be very attractive. For the technical director who must provide support to that same customer, the relationship appears very unappealing. There must be a process for assessing customer profitability and it needs to be used consistently throughout the organization. Here are some suggestions:

Define your core strengths 

 

Customer profitability centers on what a company does well and then matches these strengths with a customer group which values them. BMW is known for its ability to design and produce high quality cars with great road handling characteristics. As an organization, it understands this strength and seeks to cater to customers who seek cars that have excellent handling characteristics.

Take a hard look at your organization. What does it do exceptionally well? What differentiates it in the market? Ask this question of people throughout the organization. The responses may differ based upon who you talk to but you should hear some consistency about the core strengths of the business. Expand your analysis beyond internal perceptions; ask your better customers why they buy from your company. This is the first step in identifying where your organization needs to focus its efforts.

Study and Determine the characteristics of profitable and unprofitable customers.

 

Take the top 10% - your most profitable customers. Do these customers have similar characteristics (e.g., technical requirements, order size, etc.)? What types of products and services do they purchase? Are these customers more profitable because they are more loyal (sales and marketing expenses are less)? How do the characteristics of this customer group align with your company's strengths? You will likely see an alignment if you look closely enough.

We have worked with a company in the software industry with a long history of profitable growth. Its projects are typically long-term in nature and management takes customer selection very seriously. The company's disciplined customization and project management process includes a great deal of client collaboration. At the heart of the process is developing a good understanding of project objectives and the customer's customer. Key to the company's long success has been selecting clients whose approach fits the process and are good candidates for repeat business. The company avoids single project clients shopping solely based on price, since this approach does not fit well with their collaborative process.

After you have looked at your top customer group, repeat the process with less profitable customers. What are the common characteristics of these customers? They are likely very different than those more profitable customers.

Establish guidelines for evaluating customers.                                                          

 If you wish to move beyond simply talking about customer profitability, you must establish guidelines for evaluating customers. Guidelines could include:

• order size (orders in quantities the company is set up to handle)
• product mix (customer is not just cherry picking to get the lowest priced products or services. This is important if you offer loss leader products)
• technical support requirements (can the customer be effectively served?)
• growth potential (does this customer have the potential to grow?)
• how long will you let a customer receive special treatment on "potential" alone

As you can see from the above list, it is a combination of financial measures, buying practices and long-term potential. Do not worry about developing the "perfect" measure. The most important thing is to develop consistent parameters that make sense for your business. If you apply these criteria consistently, you will see a clear segmentation between your best and worst customer relationships.

Taking Action - One Customer at a Time

Now that you have defined the profile and characteristics of profitable customer relationships, begin putting the evaluation process into action. One of the first places to start is with prospective customers. Focus your energies and sales efforts on prospects consistent with your evaluation criteria. Prospects that do not fit most of your evaluation criteria are not likely to develop into long-term profitable customers. Make sure your sales team has a clear understanding of the types of prospects you are targeting.

As you attempt to improve profitability, focus on your top quartile relationships as these customers often represent one of your best growth opportunities. Map out clear strategies for retaining and growing these relationships. Learn more about your customers' businesses and how they serve their customers. This collaboration can uncover new opportunities and help you forge stronger relationships. As you eliminate the unprofitable relationships, this frees up time and other resources for your more profitable customers. This is an important principle of executing a successful fewer and deeper strategy.

 

Don't fire unprofitable customers. Modify the unprofitable behavior.

                                            

What can you do about unprofitable relationships? Be aggressive about changing those unprofitable relationships. Make certain the sales team understands that the customer must become more profitable within a given time.

Don't just fire customers, however. Often, it is we, the sellers,  who have encouraged or permitted "unprofitable behavior." These customers may offer profit potential - particularly if they fit many of your evaluation criteria. Look for differences in how you are serving these customers versus your more profitable segment.

You may be overlooking product or service opportunities that could enhance profitability, or you may be making inaccurate assumptions about client needs. One client's management team believed it was obligated to supply certain customers with unprofitable commodity products in order to sell more profitable, high margin product lines. Interviews with customers revealed otherwise. There were many alternatives for procuring commodity products and customers were primarily interested in the more innovative, higher value product lines. A subsequent change in product mix has boosted profitability significantly.

If a path to profitability cannot be found, use pricing as a way out of a relationship. Be sure to provide recommendations for alternative vendors. You never know when an unattractive customer can change and become desirable.

Many successful middle-market companies take pride in their premium, high touch service levels. Each customer usually receives the same products, services, and delivery regardless of profitability. This approach, combined with the size or buying practices of some customers, makes some relationships appear hopeless. If there is no clear path to profitability under your current product and services umbrella, consider offering alternative services for these customers. This may be a particularly viable alternative if you have a large segment of unprofitable customers with similar needs. Depending on your business, alternative services may entail different methods of selling (e.g. inside sales vs. more costly face-to-face), a different scope of service or different pricing structures. These changes can completely change the profitability picture for these customer relationships.

_______________________

The Mead Consulting Group has been helping clients identify and improve customer net profitability and execute strategies that drive profitable growth. For a free consultation, contact me at meaddp@meadconsultinggroup.com or (303)660-8135

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