Without considering external factors beyond the control of management, to maintain long-term and predictable profitability requires insight of the profitability of each customer, channel (route-to-customer) and product combination.
In the industrial and manufacturing sectors, businesses are generally mature and of such a scale that revenue growth often only correlates with GDP growth.
Unless these businesses can geographically expand, they need to constantly fine-tune their value chain through aggressive supply chain improvement programmes centered around customer profitability.
Unfortunately, industrial manufacturing companies often cannot meaningfully measure customer and product profitability because of their large and complex organisations and the inability to mine meaningful data from disparate systems.
The above notwithstanding, one only has to ask the right questions to start understanding how each customer contributes to business profitability. Managers will find these questions especially useful:
What does each individual customer contribute to earnings per share?
How do operations and logistics costs affect contribution by product, by geography and by customer?
What are the costs associated with increasing customer service levels?
Which product’s prices should be raised/lowered for which customers?
What products should be dropped from the product line-up?
Unfortunately, many accounting systems are unable to answer these simple questions as a matter of standard reporting. Compounding the issue is the fact that various business functions within the company have contradictory ideas about profitability. For example, Marketing may want to increase advertising budget in order to increase sales, while Finance argues that the company spends too much money on advertising and prefers instead to raise prices to increase profitability.
Within traditional full cost accounting there is little to determine which of the suggested courses of action will be effective because there is limited understanding of what’s going on by business, by customer, and by geography.
The good news is that when organisations adopt a detailed contribution approach to profitability analysis by customer and product segment a much clearer picture emerges.
The first step developing a profitability view on a major customer, for example, would be to identify those costs that are dedicated to serving the customer.
If the charge neither depends on unit volume, nor the resource dedicated to a specific customer, then the cost is placed in a ‘general contribution pool’.
This pool represents combined costs that are not credited to an individual customer or segment of customers meaning no individual customer is required to cover for costs within this pool. However, all customers together must generate a net margin that covers these costs.
The next step is to disaggregate costs into relevant segments and profitability levels, for example, route-to-market channels could be disaggregated into regions and finally into customers.
A tailored ‘operational income statement’ emerges as the analysis is further undertaken for each profitability level within the business. A detailed picture of the varying profitability margins for each customer segment emerges along the supply chain.
A further disaggregation into product would provide management with a strategic decision-making capability with which to identify, for instance, which customers or products to discard, opportunities to correct service levels or pricing levels.
This insight, combined with estimates of future growth for each individual customer or segment of customers, enables management to develop strategies that maximise long-term profitability in a predictable manner.
Most industrial and manufacturing companies use full cost accounting methods and systems that allocate fixed costs to individual products and customer segments. Costs shared by multiple segments are often allocated on the basis of subjective measures of activity, such as sales volumes. This method hides vital insight about the behavior of costs as a result of strategic changes within the businesses’ value chain and the controllability of costs.
The determination of a product’s (or customer’s) contribution should, in fact, be based on how revenues and expenses, therefore profitability, will change if the product (or customer) is discarded.
Once the true drivers of cost behavior at the each profitability level are understood, inefficiencies in discrete parts of the business’ value chain can be highlighted and controlled. Without this level of insight, various business functions will often hold conflicting ideas about how to improve business profitability.
Contributed by: Jan van Rooyen, Solutions Lead, Resolve Solution Partners