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ABC to manage customer mix


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ABC to manage customer mix

  1. 1. Harvard Business School 9-197-094 April 7, 1997 Using ABC To Manage Customer Mix and Relationships Organizations today are performing comprehensive activity-based cost analysis thatextends the domain of analysis beyond manufacturing and factory costs. They are getting below thegross margin line to items like marketing and selling expenses, and many administrative expenses.The analysis reveals that many demands for organizational resources arise not only from productsbut from customers and distribution or delivery channels. Activity-based costing enables managers toidentify the characteristics that cause some customers to be more expensive or less expensive to serve.The table below shows the characteristics of hidden cost (high cost-to-serve) and hidden profit (lowcost-to-serve) customers. High Cost-to-Serve Customers Low Cost-to-Serve Customers Order custom products Order standard products Small order quantities High order quantities Unpredictable order arrivals Predictable order arrivals Customized delivery Standard delivery Change delivery requirements No changes in delivery requirements Manual processing Electronic processing (EDI) Large amounts of pre-sales support Little to no pre-sales support (marketing, technical, and sales resources) (standard pricing and ordering) Large amounts of post-sales support No post-sales support (installation, training, warranty, field service) Require company to hold inventory Replenish as produced Pay slowly (high accounts receivable) Pay on time All companies can generally recognize customers that exhibit some or all of the high cost-to-serve characteristics. Occasionally companies are fortunate to enjoy low cost-to-serve customers aswell. The only downside from having a low cost-to-serve customer arises when the customer itselfrealizes that its behavior reduces costs to its supplier, and demands low prices (high discounts fromlist price) in exchange. Walmart, in particular, has from its inception leveraged its unique purchasingcharacteristics to negotiate exceptionally favorable terms with suppliers. Sam Walton, Walmart’sfounder and long-time CEO, would go to even giant multi-national companies like Procter & Gambleand AT&T with something like the following pitch (paraphrased extensively): We like your products and want to carry them in our store. But we don’t want a lot of variety; we want a large package and a small package (or a white phone and a gray phone) for each category we carry. Don’t send us a lot of marketing people, we’ve already made up our mind which of your products we want to carry. And we don’t want to have to place orders through your sales force. We will connect you to our point-of-sale terminals in all our stores. Your job is to monitor the rate of sales, and keep our distribution centers adequatelyRobert S. Kaplan prepared this technical note for class discussion.Copyright © 1997 by the President and Fellows of Harvard College. To order copies or request permission toreproduce materials, call 1-800-545-7685 or write Harvard Business School Publishing, Boston, MA 02163. Nopart of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted inany form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without thepermission of Harvard Business School. 1
  2. 2. 197-094 Using ABC To Manage Customer Mix and Relationships replenished based on consumer takeaway. Don’t bother us with special deals and promotions. We want standard products, continually replenished, at every day low prices. Marketing executives when first encountering this opportunity thought they had justexperienced heavenly bliss. They had never met a customer that would be so easy to support andserve. They were certainly prepared to offer an attractive discount to Mr. Walton for such a supplyarrangement. But they never got to offer their discount, since Mr. Walton had already decided whathe was prepared to pay, and this was far less than the marketing executives had ever contemplatedoffering. The executives objected, indicated their sincere interest in working with an enterprisinggrowing retailer but not prepared to offer goods at such a substantial discount, where their companymight lose money. Mr. Walton (again paraphrasing) would respond: The price I am prepared to pay is fair based on your costs of serving me. The high gross margins you are accustomed to earning on your products are necessary to pay for all the marketing, technical, selling, and administrative resources required by your normal customers. But you are not going to need these resources for me, the way I am prepared to work with you. I don’t want to pay for resources I don’t use. Collect revenues from your other customers. They should be the ones to pay for those resources, since they’re using those resources. In the end, as the supplying companies conducted their own ABC analyses, they could seethe truth of this claim. Companies can view their customers through the lens of a simple 2x2 diagram(see Exhibit 1). The vertical axis shows the net margin earned from sales to the customer. The netmargin equals net price, after all sales discounts and allowances, less manufacturing cost (asmeasured by an ABC product costing model, of course). The horizontal axis shows the cost of servingthe customer, including order-related costs plus the specific customer-sustaining marketing,technical, selling, and administrative expenses associated with serving each individual customer, asmeasured by an ABC customer costing model of these expenses. This diagram shows that companies can enjoy profitable customers in different ways. Acustomer such as Walmart would be at the lower left hand corner of the curve: demanding lowprices, so net margins will be low, but also working with its suppliers so that the cost-to-serve is alsolow. High cost-to-serve (hidden cost) customers can also be profitable (these would be located in theupper right hand corner of Exhibit 1), if the net margins earned on sales to these customers more thancompensate the company for the cost of all the resources deployed for these customers. In effect,Exhibit 1 provides an alternative to Porter’s admonition not to attempt to be simultaneous low costand differentiated. Perhaps, an ABC system enables a company to offer low cost service to Walmart-type customers, and special services to those customers who value unique functionality, features, andextensive customer service. The trick has always been to be profitable with both types of customers.A customer-based ABC model gives companies a new capability to offer and price out differentiatedservices to customers, based on their individual needs and preferences, so that they can be both alow-cost and a differentiated supplier and make money with both types of service. Increasingly,companies are going to menu-based pricing where the cost to the customer is determined not only bythe volume and mix of products purchased but also by the method of delivering to and serving thecustomer. The menu-based pricing is based on the cost-to-serve calculated by the company’s activity-based costing model. Occasionally, a company may count its blessings by observing that several of its customersare in the upper left hand quadrant: high margins and low cost-to-serve. These customers should becherished and protected. They could be vulnerable to competitive inroads. Managers should beprepared to offer modest discounts and incentives, or special services to retain the loyalty of these“hidden profit” customers if a competitor threatens. The most challenging set of customers are found in the lower right-hand corner: low marginsand high cost-to-serve. Companies can use the bill of activities in the net margin and cost-to-serveABC calculations to modify relationships with such customers and move them in a northwestdirection, towards break-even and profitability. For example, the bill of activities may reveal thatsome of the company’s internal processes are quite costly and inefficient and this is leading to highmanufacturing costs or high costs-to-serve. The first action should be to improve the performance ofthe processes now revealed to be critical; i.e., reduce the cost of activities associated with serving2
  3. 3. Using ABC To Manage Customer Mix and Relationships 197-094these customers. The bill of activities may also show that high cost-to-serve is caused by customerordering patters: unpredictability, changes, excessive frequency, customized products, non-standardlogistics and delivery requirements, large demands on technical and sales personnel. The companycan share this information with the customer, indicate the costs associated with such actions andencourage the customer to work with the company in a less costly manner; i.e., reduce the number ofactivities demanded by the customer. Both improvement of internal activities and business processesand better coordination between the company and its customers will have the effect of lowering thecost-to-serve, thereby moving the company in a westerly direction on Exhibit 1. Alternatively, if the customer is not able or willing to shift its buying and delivery patterns tolower operating costs, the company can take actions to augment its revenues, such as by modifyingits pricing arrangements: lowering the discounts it is prepared to grant, and pricing for specialservices and features. A McKinsey study revealed that managers are often unaware about the actualnet price they receive from customers.1 As a result, many discounts and allowances are not linked toactual performance by the customer, or to the economics of the relationship with the customer. The same study also revealed that the same or similar items sell for a wide variety of prices todifferent customers and different industry groups. Price bands (the difference between the highestand lowest priced transactions) of 60-70% with some in excess of 200% were reported. Perhaps theseprice variations could be justified by differences in the cost to serve the different customers in thedifferent industries. But, more likely, the variation in prices and discounts, as in the price waterfall, israndom, caused by the bargaining power or skill of the customer not by the economics of serving thedifferent customers.2 ABM can help the company identify when price variations are unrelated to theeconomics of its relation with the customer. As a specific example of an unmanaged discount policy, one supplier of plastics did ananalysis of the total ABC cost-to-serve (including manufacturing costs) versus discounts from listprices for several customers in the appliance industry (see Exhibit 2). The results showed thatdiscounts were unrelated to the costs-to-serve. Several customers, in the upper right hand quadrantof Exhibit 2, some large though others quite small, received high discounts even though they wereboth high cost-to-serve. Some companies, however, received low discounts even though they wererelatively low cost-to-serve. This evidence indicates that without an ABC model of cost-to-serve,many companies’ pricing and discounting policies will likely be unrelated to the cost of supplyingindividual customers. Marketing managers can use the information about the economics of thecustomer relationships, as revealed in Exhibits 1 or 2, to conduct fact-based discussions. They can linkdiscounts to specific customer actions that lower the company’s cost to serve. As managers repriceand manage discounts better on their product and service offerings, they move unprofitablecustomers northwards on Exhibit 1. Margins increase to compensate the company for high cost-to-serve customers.Applications to Distribution and Retailing Cost-to-serve pricing is now occurring in the vendor to supermarket retailing supply chain.In 1995, Procter & Gamble announced a new price incentive intended to influence the trade to adoptmore efficient practices in logistics and promotions. Wholesalers and retail distributors who partnerwith Procter & Gamble in eliminating inefficiencies in the distribution stream will pay lower priceson P&G products. The company’s director of industry affairs said:1 M. V. Marn and R. L. Rosiello, “Managing Price, Gaining Profit,” Harvard Business Review (September-October 1992), pp. 84-94.2 An alternative and more generous explanation is that companies may be exploiting the knowledge of thedemand elasticities of different customers. That is, they are granting concessions to high price-sensitivecustomers and no discounts to low price-sensitive customers. Such price discrimination, based on demand ratherthan cost characteristics, can be profitable if legal, and if the company can prevent customers receiving highdiscounts from communicating price information or transferring goods or services to the customers paying listprices. 3
  4. 4. 197-094 Using ABC To Manage Customer Mix and Relationships If customers will accept certain efficient operating principles, we will pass our internal savings on in the form of a lower list price. Primary features of the P&G initiatives are: • Efficient ordering and billing: Customers will be able to automate all orders and billing using EDI [electronic data interchange – the exchange of data directly between suppliers’ and customers’ computers], which will improve speed and accuracy, reducing the need for manual intervention. • Efficient delivery: Retailers will be rewarded for picking up backhaul loads on schedule and for unloading P&G deliveries in two hours or less. P&G will also begin using its Chep pallet pool system [pallets that it already is using for transport in the manufacturing process] for all its shipments except for a few paper items. • Efficient promotion: P&G will streamline its offerings of display-ready unit loads from its current level of more than 400 options down to 100 choices that reflect the companys biggest brands and best-selling stockkeeping units. • Comarketing: The company will build on its existing account-customized direct-mail marketing programs by offering a custom-published family magazine that can be configured and distributed to meet retailers marketing objectives. • Activity-based Costing: The company makes intensive use of ABC techniques to identify the per case cost of inefficient industry practices, and the amounts that can be saved by improving those practices. The company stated: One of the real objectives was to reduce complexities that we had built into our own systems. We were averaging 27,000 manual interventions monthly in our order and invoice process, or 31% of orders. We have now reduced that in one year to 5,000 per month or less than 6% or orders. Last year we were implementing something like 55 pricing changes per day with 100 brands. Those changes were in large part promotion-related. Multiply that by 17 different pricing brackets and the complexity was enormous. P&G expected that the total savings from the cost-cutting initiatives like value pricing andcontinuous replenishment could be as much as $50 million. According to an industry study, deliveryand receiving efficiencies represent more than $2.5 billion annually in potential cost savings to theindustry.3Managing Unprofitable Customers Pricing initiatives and process improvements, either by the company or jointly with itscustomers, are often successful in transforming customers from unprofitable to profitable, movingthem out of the lower-right hand quadrant of Exhibit 1. What about customers that remain in thislower-right hand quadrant? Should the company consider firing these unprofitable customers? Not yet! Some of the currently unprofitable customers in the lower right-hand quadrant of Exhibit 1may be relatively new to the company. Considerable expenses (now accurately traced to these newcustomers) may have been incurred to attract them as customers. And the customers may be testingits new supplier by only giving it a small portion of its total business, and that in relativelydemanding applications, so that it can assess how well the new supplier can perform. The company(the new supplier) hopes to grow these customers into long-term profitable relationships. For thesenew customers, the initial losses revealed by the cost-to-serve ABC model can be considered part of3 Supermarket News (September 4, 1995), page 1; U.S. Distribution Journal (October 15, 1995), page 10.4
  5. 5. Using ABC To Manage Customer Mix and Relationships 197-094the investment in obtaining new customers. This initial investment will, the company hopes, berepaid in higher volume and more profitable mix of business in subsequent years leading tosubstantial lifetime customer profitability.4 So companies will certainly not seek to fire new butunprofitable customers; they will want to track them to ensure that the such customers migrate in anorthwesterly direction on Exhibit 1 in subsequent periods, reaching profitability through somecombination of higher volumes, higher margins, and lower cost-to-serve, once the initial courtshipleading to the new customer acquisition has been fully consummated. Other unprofitable customers in the lower right-hand quadrant of Exhibit 1, may give thecompany benefits that can not be quantified by the ABC cost-to-serve model. For example, somecompanies are prestigious to have as customers because they are known to be demanding on theirsuppliers for quality and performance. In effect, as an on-going supplier to such prestigiouscustomers, the company has gained benefits that it can leverage with other customers. The lossesreported on Exhibit 1 by the ABC model then become interpreted as an element in the company’sadvertising or promotion costs. They represent the price of establishing the company’s reputationand credibility. As in any discretionary expense, of course, such losses should be monitored andmanaged. It would be even more desirable to establish reputation and credibility at a negative cost byfinding ways to transform the currently unprofitable relationship with the prestigious customer intoa profitable one. Another difficult-to-quantify benefit from certain customers is the opportunity for learning.Japanese companies, like Toyota, Nissan, and Honda, that established manufacturing presence in theUS have demanded performance from US-based suppliers that is comparable to what they enjoyfrom their Japanese-owned suppliers. Many US suppliers found it quite costly to meet the stringentrequirements for quality, delivery times, and flexibility from their new Japanese customers. If theywere to understand the full costs they are incurring to provide such stringent performance to thesecustomers, they likely would find these customers to be unprofitable, especially initially. Some ofthese losses could be rationalized by the company as using currently excess capacity that otherwisewould go unused. A much more compelling justification, however, is that the working relationshipswith such customers also provides a learning opportunity; the demanding customers are prepared towork with their new suppliers and show them how new management processes, equipment, andtechnology will enable them to satisfy the customers’ demands without incurring excessive costpenalties. Thus, the initial losses incurred in satisfying these customers demands can be viewed as thecost of education about new manufacturing and logistics processes that should be beneficiallydeployed to all of its customers in the future. Let us now summarize the customer component of Strategic ABM. We have analyzed the netmargins and cost-to-serve of all our customers. We rejoice with our profitable customers both thoselow cost-to-serve and those high cost-to-serve. We have established protective measures in casecompetitors attempt to win business from our most profitable customers (in the upper left-handquadrant of Exhibit 1). For many of those initially found to be unprofitable (lower right-handquadrant), we have transformed them to profitable customers by improving internal processes,negotiating improved ordering and delivery relationships, reducing discounts if not accompanied byreduced cost-to-serve, and establishing menu-based pricing for special services and features. Otherunprofitable customers were recently acquired. We will watch them for profitability progress insubsequent periods. Still others were important for our strategy either because they give us prestigeand reputation by our being identified as their suppliers, or because they help us to learn andimprove our internal processes. Suppose, however, that a customer falls into none of the above categories. Such a customer isnot profitable, resists all our attempts to transform the unprofitable relationship into a profitable one,is not a new customer, and the only thing we have learned from 10-15 years of working with thiscustomer is that we do not want another 10-15 years like the ones just experienced. Now we havereached the point of considering firing a customer. But we still do not have to contemplate such a4 See “The Right Measures,” Chapter 8 (pp. 217-253) of F. F. Reichheld, The Loyalty Effect (HBS Press:Boston, Mass., 1996). 5
  6. 6. 197-094 Using ABC To Manage Customer Mix and Relationshipsdrastic action. We can, perhaps, let the customer fire itself, by refusing to grant discounts, andreducing or eliminating marketing and technical support. What can the company do with its technical and marketing people formerly deployed forincorrigibly unprofitable customers? In the short run, these people are still on the payroll so theirexpenses still accrue to the company. The answer is obvious once one returns to the insights fromExhibit 1. Why not analyze the characteristics of the most profitable customers, the ones in the upperleft-hand quadrant: high margins and low cost-to-serve. Our company likely has excellent and valuedproducts and services for these customers. By understanding the characteristics of such customers –industry, location, size, strategy – we may be able to identify companies with similar characteristicswho are not existing customers. Our marketing, selling, and technical resources can be deployed tosuch potential customers in an attempt to win their business and loyalty. If successful, we maycapture a high lifetime profitability customer from a competitor who, lacking an ABC model of itsown, may not realize how profitable such a customer might be. Even better, if the competitor wishesto retaliate by capturing one of our existing customers, we have an excellent set of disgruntledcustomers – the ones who remain in the lower right-hand quadrant, currently unserved andundiscounted – who would be delighted to switch to a new supplier.Summary Managers follow strategic ABM principles by: • protecting existing highly profitable customers • repricing expensive services, based on cost-to-serve • discounting, if necessary to gain business with low cost-to-serve customers • negotiating win-win relationships that lower cost-to-serve with cooperative customers • being patient with currently unprofitable customers that are expected to become profitable in the future, or that provide other non-quantified benefits to the company • conceding permanent loss customers to competitors • attempting to capture high profit customers from competitors These actions should enable managers with good (ABC) instrumentation to dramaticallyimprove their profitability, especially in industries where their competitors do not understand theeconomics of customer relationships. Informed managers can act upon ABC information to reinforceexisting profitable customer relationships and transform unprofitable ones into profitability.6
  7. 7. 197-094 -7- Exhibit 1 Options for Managing Customers Types of Customers Customers that are Profits above the cost-plus diagonal are more Hi Costly to service, profitable but pay top dollar Passive: • Product is crucial • Good supplier match Net Margin Realized Price-sensitive and few special demands Aggressive: • Leverage their buying power • Low Price and lots of customized service and features Low Low Hi Cost to Serve Losses Profitability depends on whether and how much the net product margins recover the customer-specific costs.Source: Shapiro, Rangan, Moriarty and Ross, “Manage Customers for Profits (Not Just Sales)”; Harvard Business Review, Sep., Oct., 1987.
  8. 8. 197-094 -8-Exhibit 2 Discounting that is Unrelated to Cost-to-Serve Company B 60% Company G 50% Company C Total Company E Company H Discount 40% from Company D List 30% Company F Price Discounting Related 20% to Cost-to-Serve 10% Company A 0% 0.5 0.6 0.7 0.8 0.9 1.0 1.1 Total Cost to Serve (Product & Customer Costs (in $/Lb). <1 million pounds 1-2 million pounds 8-11 million pounds >20 million pounds