According to Mae West, “There are no good girls gone wrong, just bad girls found out.“

“Good” profitable customers rarely become unprofitable. It’s more likely that they were unprofitable from the onset. Gross margin has been the traditional method of identifying “good” and “bad” customers. For example, if your overhead costs are 30% of gross revenue, a good customer is anyone with a gross margin over 30%. Conversely, bad customers have gross margins of 30% or less. This simple method has become simplistic. Customers rarely consume overhead costs equally. “Good” customers consume less activity than “bad” customers.

Activity Based Costing (ABC) has become the best method to identify profitable and unprofitable customers. ABC customer profitability analysis is based on the simple principle “customers consume activities”. It is not uncommon to find with ABC that 80% of overhead activity cost is consumed by 20% of your customers.

Consider this ABC customer profitability example. Large retail customers typically demand low purchase prices. If you sell to someone like Wal-Mart, their gross margin percent may be several points lower than your smaller customers. ABC analysis often exposes, however, that large retailers consume less than 30% of the overhead activities. As a result, while your Wal-Mart gross margin may only be 25%, an ABC “bill of activity” may show that their pre-tax profit contribution is actually 10%, not a loss of 5% (25% – 30%). Walking away from business opportunities with large retailers is very dangerous without first performing ABC customer profitability analysis.

Hold onto your “good” customers. But what should you do with “bad” customers found out? ABC helps you convert unprofitable customers to “good”:

• Look at yourself first.Identify and begin to eliminate non-value activities. In other words, you may be the reason they’re unprofitable!
• Create cost consequences.Don’t charge every customer for the overhead cost of expediting, changing orders or past due collections. Change your pricing policy. Tell customers, “We’ll be happy to expedite your order, but there is a charge for that.” Cost consequences improve the behavior of “bad” customers.
• Share your Bill of Activity.Review your Bill of Activity with large volume, unprofitable customers. Without showing them your cost, discuss the unnecessary activities you are both performing. Use your Bill of Activity to define an improved method of doing business with them. By helping your customers improve their process, both of your P&L’s will improve.

ABC will help you identify the good, bad and ugly customers. Using ABC, ask yourself three questions:

• “Is this a profitable customer?“Yes or No
• “Is this customer strategically important?“Yes or No
• “Is this a high volume customer?“Yes or No

A customer with three Yes’s is clearly “good”. No to question #1 followed by two Yes’s is “bad”. And a customer with three No’s is “ugly”. Make 2001 a “good” year for your organization. Implement an ABC customer profitability analysis.

Does your organization need to perform an ABC Customer Profitability analysis in 2001?

If yes, ICMS can help you with planning, training, onsite coaching or software. Send an e-mail totompryor@icms.net and ask us for a free implementation plan.