There has been, and there will be and increasing focus on managing corporate profitability over the next several years. The economic recovery in North America and Europe promises to pose a real challenge to business executives in maintaining margins. Managing product and customer profitability more intelligently have been leading-edge business topics the past several decades. While there have been some success stories highlighted in the business press and academics, I’ve found that “real world” results have been decidedly mixed, which is why these remain immature areas of business computing.
Of the two, product (and service) profitability is more advanced. In part this is because it’s a refinement of cost accounting, which has been around since the 19th century. It also reflects the refinements made to activity-based costing (ABC) and other marginal costing approaches and software over the past decade.
ABC and other marginal costing techniques came about several decades ago because it became clear that using “standard costing” often drove bad economic decisions, especially in complex manufacturing environments. Unfortunately, in its first iteration in the 1980s, ABC failed to live up to its hype and despite ongoing refinements to it; the initial letdown continues to hamper its adoption. Still, I expect upward cost pressures and a continued lack of pricing power will force corporations to focus on having a deeper and more economically accurate understanding of costs and cost drivers. I believe they increasingly will use ABC and related techniques (and software) to do this.
On the other hand, customer profitability management remains very immature in my judgment, because it is a much bigger challenge than product profitability. There are at least three reasons: the data needed to do the analysis is scattered across a company, the underlying analysis of these data is far more complex and companies do not (and cannot) control how customers behave. Addressing these three issues has not been easy. For this reason, companies have had a hard time managing the trade-off between volume and profitability intelligently.
For example, there’s the data challenge. Understanding which data are needed to do a good-enough analysis often involves a heavy dose of trial-and-error. The analysis that’s required can be complex: not only is product/service costing itself challenging but companies need to understand and define who the customer is. That is, is the relevant “customer” an individual purchasing agent, the business unit in which they work, a subsidiary or the whole company? Is it a person’s account, or all of their accounts? Are “they” an individual or a family? Does this definition always apply or does it change with the circumstances of the analysis? And then there’s the time element. Should “customer” profitability be calculated based on a month, quarter, year or multiple years of records? Should the assessment also include some measure of future revenue and profit potential? And once you’ve decided on which sorts of data are necessary to create the analysis, you then have to get it all in one logical place consistently.
Even after an organization has arrived at some measure of customer profitability, it’s not clear whether the conclusions are actionable. For example, analysis of retail banks famously conclude that 10% (or some such small number) of customers account for more than 100% of the profits. In other words, they have customers that range from highly profitable to heavily loss-making. Knowing this, what is management supposed to do? Generally, it’s a good idea to lose money-losing customers, but if they’re a highly profitable customer somewhere else in the business, antagonizing them will be a bad idea. Similarly, if they are relatively young and encouraging loyalty will pay big dividends in the long run, losing them may be the wrong approach.
Despite the formidable challenges in implementing and using profitability management, the payoff for developing this discipline in a corporation will pay off, not just in terms of profitability but also in helping define a more sustainably successful strategy and being able to adapt more rapidly (and more profitably) to changing market conditions.
Managing product and customer profitability will continue to be a focus of senior managers over the next several years because this business cycle, held back by the deleveraging headwinds in the world economy, will force corporations to (in that hackneyed phrase) work smarter, not harder. The payoff from better profitability analysis can also be significant. Because it’s a skill not easily copied (it’s as much about techniques and their application, not simply installing software and following some high-level “best practices”), companies that are able to achieve results will have a sustainable competitive advantage.
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Robert D. Kugel CFA - SVP Research