us deloittereview customer profitability jul09
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issue 5 | 2009
Cmmer rce rer
How proftableare yourcustomers… really?
By Ed Johnson, MikE siMonEtto,
JuliE MEEhan and RanJit singh
> illustRation By Ralph voltz
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4 ARTICLE T ITLE
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How proftable are yourcustomers … really?By Ed Johnson, MikE siMonEtto, JuliE MEEhan and RanJit singh
> illustRation By Ralph voltz
With thousands of golf courses needing to be
mowed, watered and fertilized, the U.S. West
Coast looked like the perfect new market for
one Midwest-based lawn care products manufac-
turer. Initial forays into the region yielded strong
sales, high market penetration, and a 26 percent
gross margin. So why was the company’s bottom
line still stagnating? Because the cost of freight
to the West Coast, which the company provided
free as a standard industry practice, was not
being factored into the company’s profitability
metrics. When it was, leaders realized that the
company was actuall y losing six to eight per-
cent on every West Coast transaction. If it had
not looked more closely at these customers’ real
profitability before finalizing plans to expand its
West Coast operations, the company could have
literally grown i ts way into bankruptcy.
No company can aord a awed understanding o customer proftability, least
o all in a recession when the margin or error (as well as proft) is whisper-
thin. The ip side is that improvements in this area can be a very eective way o
bolstering the bottom line — and companies can oten make those improvements
with only a modest initial investment. In act, because employees tend to be more
accepting o change in a downturn, now may be a good time to invest in changes
that can not only deliver a badly needed revenue boost, but help your company
better take advantage o the eventual recovery.
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6 How pRofITAbLE ARE youR CusTomERs … REALLy?
Pocketing the Profits
A customer proftability analysis, done right, tells you not just which custom-
ers are proftable, but why certain customers are more or less proftable than
others. At a strategic level, this inormation can help guide decisions on everything
rom growth initiatives to marketplace segmentation. And, tactically, the inorma-
tion can suggest a variety o ways to improve proftability, such as lowering the
cost to serve, improving the sales orce’s bargaining position, and developing more
eective prices and promotions.
However, many com-
panies that believe they
understand customer
proftability are actually
working with the wrong
inormation. Most use
aggregate measures o
proftability, typically
gross margin, that ail
to account or costs that are difcult to measure or that can’t be attributed to indi-
vidual transactions (such as marketing expenses or distribution costs).
Even when these costs are considered, they’re oten computed at an aggregate
level using metrics that ignore the nuances o serving particular customers, seg-
ments or other populations o interest. One $10 billion U.S. retailer, or example,
subtracted a at “cost-to-serve” percentage rom each transaction’s gross margin to
calculate the transaction’s proftability. But because the same percentage was ap-
plied to all stores regardless o their efciency, this metric ignored important varia-
tions in store selling costs. Adjusting the calculation to reect individual stores’
cost to serve gave leaders better inormation on which to base a number o deci-
sions, such as whether to close a certain store or where to place a regional ofce.
In act, when it comes to specifcs, more is always better. That’s why compa-
nies should analyze proftability on a transaction-by-transaction basis, looking not
just at every customer but at every transaction each customer completes. But the
drill-down shouldn’t stop there. To gain true actionable insight, companies needto examine each transaction’s proftability based on its “pocket margin” — the
undamental metric on which all higher-level proftability metrics are based.
Pocket margin reers to the amount let in a company’s “pocket” ater all o the
costs related to a transaction, as well as the cost o goods sold, are subtracted rom
the list price. These costs can range rom the obvious, such as o-invoice discounts
and promotions, to the easily overlooked, such as costs associated with reight,
Pocket margin refers to theamount left in a company’s
“pocket” after a l l of the costs
related to a transact ion, as wel l
as the cost of goods sol d, are
subtracted from the l i st pr ice.
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7How pRofITAbLE ARE youR CusTomERs … REALLy?
warehousing and other activities that may be generally classifed as “overhead.”
The costs incurred at each point in a transaction are oten graphically represented
in a “price waterall,” a bar chart that depicts the impact o each successive cost-to-
serve element on the list price (Figure 1).
Unlike measures that gloss over dierences among customers or omit cost-to-
serve elements, pocket margin gives a company a clear view o how much revenue
each transaction generates, how much it costs the company to generate that rev-
enue, and — crucially — when and why those costs are incurred. And because
pocket margin is measured or every transaction, metrics based on pocket margin
can provide insight into costs and revenues at any desired level o detail, rom in-
dividual clients all the way up to broad marketplace segments.
L i s t P r i c e
$700
$600
$500
$400
$300
$200
$100
$0
C u s t o m e r S p e c i f i c D i s c o u n t
I n v o i c e P r i c e
C r e d i t R e b a t e
C r e d i t P a y t e r m s
N e g o t i a t e d N e t P r i c e
O t h e r P r o m o t i o n a l A d j u s t m e
n t s
N e t P r i c e
C u s t o m e r S p e c i f i c C
o s t
M e r c h a n d i s i n g C
o s t
C u s t o m e r W a r e h o u s e C
o s t
C r o s s d o c k C
o s t
M a r k e t i n g C
o s t
P r o m o t i o n s
P o c k e t P r i c e
C O G S F i x e d
C O G S V a r i a
b l e
P o c k e t M a r g i n
Figure 1. An illustrative price waterall. A price waterall portrays the progression rom
list price to pocket margin or a specifc “slice” o the business — such as a customeror customer segment — based on cost-to-serve data collected at the transaction level.
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what your customers won’t tell you (but Pocket margin can)
Metrics based on pocket margin can give companies a wealth o insight into
what they spend to make how much rom whom — and how they might
be able to improve the outcome. Here are some o the ways we’ve seen it work.
One obvious use o customer proftability metrics is to identiy the customers who
cost more to serve than they generate in revenue. Once a company knows who
those money losers are, it can either try to transorm them into proftable buyers or
attempt to ush them out o the business altogether.
Best Buy, the U.S. consumer electronics retailer, took just such an approach in
its eorts to boost the bottom line. As described in the Wall Street Journal , the com-
pany used customer proftability analyses to dierentiate between “angels” — cus-
tomers who buy high-defnition televisions, portable electronic devices, and other
items at ull retail price — and “devils” — customers who only buy sale items or
loss leaders, return a large raction o their purchases, and generally “wreak enor-
mous economic havoc” on margins, according to then-CEO Brad Anderson. The
company then made changes designed to attract more business rom angels, such
as stocking more merchandise and enhancing customer service, and to discourage
sales to devils, such as removing them rom marketing lists. The company also
took steps to reduce the negative impact o the devils it couldn’t shed, such as
enorcing a 15 percent restocking ee on returned merchandise.1
“Yu’re spedig t much t serve me”
Many times, relationships with large customers that are presumed to be pro-
itable actually have special terms, unusual shipping conditions, or other “belowthe radar” idiosyncrasies that erode proftability until those idiosyncrasies are ad-
dressed. Price waterall inormation can help companies identiy such accounts by
agging “outlier” customers whose cost to serve in certain areas is disproportion-
ately high or whose pocket margin across transactions is consistently lower than
average. The company can then look more closely at those customers to uncover
and address the reasons or their atypical proftability profle.
“Yu’re lsig mey me”
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In one extreme case, a $9 billion global manuacturer discovered that one o its
largest customers was arbitrarily reducing the invoice amount every time orders
were not flled 100 percent correctly. These unilateral adjustments had gone un-
noticed until the company delved into the details o the relationship to build a
price waterall. Not wanting to make waves with what was assumed to be its most
proftable customer, the company’s accounts payable sta had been crediting the
dierence to an “outstanding clarifcations” expense account that was not included
in the calculation o the customer’s specifc proftability metrics. (In act, when the
adjustments were actored in, the customer turned out not to be the company’s
most proftable buyer ater all.) The company is considering ways to address thisissue in its uture negotiations with the customer, on the principle that such penal-
ties should be agreed upon by both sides beore being imposed.
“I’m i the wrg segmet”
Companies oten segment their customers along demographic lines or accord-
ing to how much revenue each customer generates or the business. But while
these approaches are suitable or some purposes, such as marketing and product
development, segmenting customers according to proftability can be much more
useul in managing margins. Examining the dierences between customers at di-
erent levels o proftability can give companies valuable insights into what their
more proftable customers look like — what they buy, how they buy, what it costs
to serve them — and guide eorts to change their less proftable relationships to
better ft a proftable mold.
A revised segmentation approach based on customers’ overall value to the busi-
ness helped the lawn care manuacturer mentioned previously ocus its plans or
making the West Coast proftable. The company drew heavily upon its improved
understanding o customer proftability to create its new segmentation scheme,
which also considered actors such as location (“How badly do we want to establish
a presence in this area?”) and customer brand (e.g., “Is this customer Pebble Beach
or a no-name public course?”). The company then evaluated the probable impact o
various pricing and service changes on each segment’s proftability. For some seg-
ments, the company decided that going against industry tradition by charging its
customers or reight — in exchange or more requent sales visits, extended war-
ranty terms, and other concessions that customers valued but cost the company less
to provide — would be the most easible way to boost profts. For other segments,
the company decided to continue to oer ree reight, but charge higher prices or
adjust the terms o service to compensate.
Another company, an international beverage distributor, used customer proft-
ability data to refne a segmentation approach that classifed customers into “large”
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10 How pRofITAbLE ARE youR CusTomERs … REALLy?
and “small” buyers based on each customer’s contribution to revenue. Ater di-
viding each category into proftable and unproftable sub-segments, the company
discovered that the drivers o proftability diered markedly between its large and
small customer groups. Large customers’ proftability depended on product mix,
while small customers’ proftability depended on the cost o sales visits. This in-
sight helped the company understand that it would need to use dierent tactics
with each segment to increase overall proftability. It launched a tailored, two-
pronged improvement eort aimed at changing the product mix among large
customers and reducing sales costs among small customers, which is expected to
increase profts by $10 million annually — an improvement o more than one per-cent in proft driven by relatively small changes.
fixing the mix
“33 percent more in every bottle!”
That’s the offer that played havoc with
profits at the international beverage
distributor described in the main text.
On the surface, the issue seemed simple
enough: Unprofitable large customers
were buying too much of the company’s
low-margin value brand and too l ittle of its high-margin premium
brand. Leaders were mystified, however, as to why many large
customers had only recently switched to this unprofitable buying
pattern after a long history of acceptable profitabil ity.
A review of the company’s promotional efforts solved the puzzle. In
a bid to boost sales of its value brand, the company had increased
its serving size by more than 30 percent while keeping its price
almost the same. But while volume of the super-sized value brand
did indeed rise, the net effect was to reduce overall profits due to
extensive cannibalization of the premium brand.
How could the company direct its large customers back toward a
more profitable balance? A detailed analysis of transaction-level
data helped leaders tailor its tactics to suit specific markets. By
examining historical purchase patterns, the company discoveredthat the super-sized value product actually was driving new volume
in certain areas of the country. In other regions, however, cost-con-
scious customers were merely “trading down” to the value brand.
The eventual fix involved first adjusting prices on a region-by-re-
gion basis to drive customers’ product mix back to profitabil ity, and
then using the introduction of a new product to reset all relative
prices and restore volume to the premium brand.
Photo: rune thorstein
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“Yu shuld be chargig me mre fr …”
Price isn’t all that matters to most customers. Many also have defnite preer-
ences about aspects o the transaction process that aect your cost to serve, such as
how oten they place orders or the way products are shipped. It’s not unusual or
salespeople, especially in a business-to-business context, to oblige such requests
gratis or or a nominal ee. They may be worried about preserving the customer
relationship, or they simply may not know how much extra to charge to cover any
additional costs. By clariying the impact o customer requests on individual cost-
to-serve elements, a customer proftability analysis can help your company avoid
leaking margin through such missteps, giving salespeople the inormation theyneed to negotiate more proftable prices and terms o service.
By the same token, a detailed breakdown o costs to serve can help you identiy
opportunities to improve profts by changing buying behavior in ways that are
relatively unimportant to the customer, but drive large cost-to-serve savings or
you. Companies may need to make concessions on price or other actors to gain cus-
tomers’ acceptance or such changes. Here again, a cost-to-serve analysis can guide
negotiations by quantiying the impact o various price and service adjustments on
proft. For example, the international beverage distributor mentioned previously
is planning to cut sales costs by reducing the requency o sales visits to some o
its less proftable small customers. To oset the impact o asking customers to
consolidate their purchases, the company may consider lowering prices, extending
credit terms, or other steps that would accommodate customers’ needs while still
delivering a net proft increase to the company.
To execute tactics like these, a company needs two types o inormation. First,
it needs to identiy the elements that go into the cost to serve, determine the im-pact o any changes on pocket margin, and assess the easibility o making those
changes. It’s essential, too, to get this inormation to the people in a position to
use it — with technology that gives salespeople instant, dynamic access to price
waterall inormation, or instance.
Second, a company needs to understand what its customers value about their
relationship with the business and how much they’re willing to pay — or what
concessions they might demand — or any changes. Sometimes, a salesperson may
be able to make this call based on his or her personal knowledge o a customer. A
“voice o the customer” survey, supplemented by interviews as necessary, can also
help clariy customers’ priorities. Business-to-consumer companies oten conduct
market research or just this reason. And i asking one’s actual customers isn’t prac-
tical, publicly available industry and marketplace data can oten serve as a proxy.
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13How pRofITAbLE ARE youR CusTomERs … RE ALLy?
products are eective “hooks.” That’s where a historical view o customer proft-
ability can help. By examining customers’ transaction histories, a company can
determine which products are likely to drive proftable add-on sales. Conversely,
a company can also use historical customer proftability data to identiy product/
price combinations that tend to encourage unproftable “cherry-picking” by cus-
tomers that pay no dividend in uture loyalty.
One major U.S. boutique retailer drew on historical customer proftability in-
ormation to reclassiy its products into our categories — “invest,” “develop,”
“preserve,” and “harvest” — that reected the role o each product in driving mar-
gins and revenue. The new classifcation model allowed the company to improveits pricing, promotion and store layout eorts in several ways. For instance, the
company realized that some “hot” products that were being heavily promoted dur-
ing the holiday season were actually items that appealed primarily to “cherry-
pickers” and hence did not drive proftable long-term customer relationships. The
company thereore de-emphasized those products by moving them closer to the
back o its holiday circulars. The analysis also helped the company’s merchants
develop bundles o products or promotion in ways that had been demonstrated
to drive customer loyalty and proftability (such as by oering discounts on acces-
sories instead o rebates in the orm o git cards). All o these insights helped align
the strategy or managing each product more closely to its actual contribution to
company perormance.
why you can’t afford noT to act now
A widespread myth about establishing a pocket price-based view o customer
proftability is that it’s expensive, impractical and time-consuming — cer-
tainly not something most companies can aord to do in a downturn. It’s true
that making improvements can require a certain amount o upront investment.
But many companies we’ve worked with fnd that even a modest investment can
yield substantial returns. A company can start small, ocusing frst on a portion o
revenues or a single product line, business unit or location, and then expand the
eort as resources permit.
In act, a pilot project can be both a useul proo o concept and also yieldincreases in proftability that can help und urther improvements. One global
chemical company, not wanting to put all o its eggs in one basket, ran a pilot pro-
gram at three o its poorest-perorming business units, reasoning that they would
be more willing to try something new than would better-perorming divisions.
During the pilot, the participating business units made many minor adjustments
— including “fring” customers, rationalizing products and oerings, and raising
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14 How pRofITAbLE ARE youR CusTomERs … REALLy?
prices in certain segments — that increased their profts by $165 million within
12 months. This amount represented a greater than 1000 percent return on ini-
tial investment, surprising even the initial project sponsors and yielding more
than enough cash to und the project’s subsequent global rollout. As an additional
welcome surprise, the company discovered that many customers that had initially
been “fred” or unproftability returned to buy rom the company again under
more proftable terms, showing that a company that knows how to sell its value to
customers, and has the data to know when to hold the line, can aord to take bold
steps with customers to improve their value to the business.
Contrary to popular belie, a company doesn’t need activity based costing ora customer loyalty program to gather detailed cost-to-serve data, assign costs to
individual transactions, or create a customer transaction history. Most companies
routinely collect much o the inormation needed to analyze customer proftability
or other purposes. A
little digging in the
right places — sales-
person time and ex-
pense reports, reight
systems, marketing
budgets, documenta-
tion o payment and collection terms — can allow them to piece together enough
inormation or at least a rudimentary customer proftability analysis. Even inor-
mation that was never explicitly collected can sometimes be derived rom primary
data. For instance, one retailer that originally thought that its lack o a loyalty card
program would preclude a customer proftability analysis was able to constructcustomer purchase histories by combing individual transactions or linkages be-
tween credit card numbers, phone numbers and e-mail addresses customers gave as
part o their warranty inormation.
How long does it take or a company to beneft rom customer proftability
improvements? In our experience, many companies start to see results in as little
as 8 to 12 weeks, oten as a result o relatively simple changes. One automotive
manuacturer, struggling to fnd a silver lining in a down economy, realized that
signifcant proft-enhancing opportunities could exist in the hundreds o thou-
sands o parts the company sold in the atermarket. During a 12-week analysis o
the market and o supplier costs, the company ound that many parts were over-
priced, reducing the competitiveness o the dealers that sold them, while others
were underpriced and losing money or each sale. The company quickly adjusted
these prices to more appropriate levels while the analysis was still underway and
experienced a signifcant revenue lit in the very next reporting period.
So consider v iewing the recess ion,
not as a barr ier, but as a catalyst
for transformation in the way youtreat customer prof i tabi l i ty.
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15How pRofITAbLE ARE youR CusTomERs … REALLy?
Finally, one o the strongest arguments or starting now is that a recession can
make it easier to push through organizational changes that might be difcult to
make in times o growth. Your customers, your sales orce, and your operations
people are probably much more willing to accept tough decisions today than they
might be in a strong economy. Their greater receptivity can not only speed adop-
tion o new processes and procedures, but allow you to make much more sweeping
changes than might be easible in better times.
So consider viewing the recession not as a barrier, but as a catalyst or trans-
ormation in the way you treat customer proftability. Start with the low-hanging
ruit, think about ways to reinvest the benefts, and aim high with respect to orga-nizational change. The sooner you begin, the aster you’ll start to understand how
proftable your customers really are — and the better equipped you’ll be to pursue
renewed growth when the economy recovers.
Ed Johnson is a manager in Deloitte Consulting LLP, specializing in customer and market strategy.
Mike Simonetto is a principal with Deloitte Consulting LLP, and leader o the Pricing and Proftability
Management practice.
Julie Meehan and Ranjit Singh are senior managers in Deloitte Consulting LLP, specializing in customer
and market strategy.
Endnotes
Gary McWilliams, “Analyzing Customers, Best Buy Decides Not All Are Welcome,”1. The Wall Street Journal , November
8, 2004,