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
