Customer Profitability Measurement and Management

Robert S. Kaplan
V.G. Narayanan
Harvard Business School
May 2001

Customer Relationship Management (CRM) is the hot topic in today’s management scene. Building upon recent investments in enterprise resource planning (ERP) systems and data warehouses, companies have installed CRM systems to track detailed data about individual customer transactions and relationships. Many companies have created long-term relationships with their customers. Toyota and other Japanese manufacturing companies have shown how to implement just-in-time and strategic alliances that improve the responsiveness of suppliers to customers needs and drive waste and inefficiency out of the supply chain system. And with the advent of new performance measurement and management systems, like the Balanced Scorecard, companies have increased the role for customer measures - such as customer satisfaction, acquisition, retention, loyalty, and account share - in their reporting and compensation systems. This has truly become the “age of the customer.”

Easy to overlook, however, in all the rhetoric and excitement about delighting customers is whether companies are actually making money with their customers. Many companies have customized their products and solutions, and increased their specialized services to increase customer satisfaction and exceed customers’ expectations. Measures of satisfaction and loyalty increase, but these increases are often accompanied with declining profits, especially when the increased functionality and services are not accompanied by increases in prices or order volumes. Our experience indicates that only a minority of a typical company’s customers is truly profitable.

Misaligned Incentives

Consider the situation faced in 1995 by Owens & Minor (O&M), a Fortune 500 company and one of the nation’s largest distributors of medical and surgical supplies. Sales had more than tripled in five years (325%) to nearly $3 billion, yet Selling, General, and Administrative expenses, thought by many to be a “fixed” or at least a “semi-fixed” cost, had increased even faster than sales (337%). Despite the tripling in sales, gross margins had declined by one percentage point and the company had just incurred its first loss in decades. Rather than SG&A costs being fixed or even variable, these costs had become “super-variable.” They had increased faster than sales revenue.

The experience of O&M is hardly unique. As companies expand operations and increase their market share, they capture business by meeting customers’ expectations for increased service. For many companies, increased service means:

• Smaller, more frequent deliveries
  
  
• Direct deliveries to the customer’s end-use location
  
  
• Managing more complex rebate and pricing schemes
  
  
• Maintaining information on customer usage
  
  
• Producing and stocking a greater variety of products
  
  
• Supporting more communication channels

All of these services create value and loyalty among customers, but none of these comes for free. O&M had to add extensive infra-structure to make the transition from its historic low-cost strategy to its new strategy of providing differentiated services to its customers. As Michael Porter has argued (M. Porter, Competitive Advantage (New York: Free Press, 1985)) companies can certainly succeed with either a low cost or a differentiated strategy. A low cost strategy requires the company to have the lowest cost structure in the industry so that it can be profitable even at the lowest prevailing prices. A company can succeed with a higher cost structure by providing products and services valued by customers. But for a differentiated strategy to succeed, the value created by the differentiation - measured by higher margins and higher sales volumes - has to exceed the cost of creating and delivering the differentiating functionality, features, and services.

In the case of Owens & Minor, the dominant form of pricing in its medical/ surgical distribution industry was cost-plus in which the customer paid the base manufacturer price plus a mark-up for the distributor, typically about 7%. No provision was made in the price for special services requested by customers. The consequences from this pricing policy were highly predictable.

First, customers soon found that the flat percentage mark-up on expensive, low-bulk items, such as cardiovascular sutures, greatly exceeded the cost of handling and distributing them. They ordered such items directly from the manufacturer, and paid the freight for their shipment. O&M was left handling low price, low margin, bulky items like boxes of diapers where the flat percentage mark-up was likely below the cost of storage, handling and distribution. Second, customers asked for special services such as breakpacks, small order sizes, and desktop delivery. Since these services were not priced, customers began to demand much higher quantities of them. After all, if supplies can be delivered in small quantities directly to the point of consumption, why have carton or pallet quantities arrive at a receiving dock and moved into a local storage area to be subsequently redistributed, using internal resources, to end-use customers. Thus the demand for specialized services that are provided at zero incremental price by the supplier can be enormous.

As customers’ demands for unpriced services increase, we can forecast two possible outcomes. First, the supplier incurs large losses in serving customers demanding large quantities of these special services. Or, second, to avoid the losses, the supplier decides not to supply the services requested by its customers. For example, O&M refused, because of lack of payment, to provide the stockless delivery - small quantities delivered directly to multiple locations at the customer’s site - requested by several of its customers. These outcomes are caused by misaligned incentives between suppliers and customers, leading to either excessive demand by customers or restricted supply by suppliers. The market between supplier and customer has broken down, leading to frustration and confrontation.

Such misalignment happens for other companies as well. A semiconductor manufacturer with nearly $2 billion in annual sales found its profitability eroding. It had increased the scope of its product line to accommodate customers’ specialized requests, and expanded the services it offered, such as express (overnight) delivery of small shipments, consignment warehousing, special packaging and labeling, and electronic data interchange (EDI). While EDI is normally thought to be a cost-reducing alternative, the manufacturer found that customer error rates were more than 50% when submitting EDI orders, requiring extensive error correction and data validation processes. The company had no understanding of how the costs of the special products and services varied among its individual customers; consequently it had no basis for recovering these costs.

Customer Profitability: The Key for Aligning Incentives

The breakdown in relationships between suppliers and customers occurs when the supplier does not measure and manage customer profitability. If suppliers understood individual customer profitability and the drivers of customer profitability, they could take a variety of actions to transform unprofitable relationships into profitable ones. And such actions benefit customers as well as suppliers. Often the excessive demand for unpriced services by customers masks higher costs that customers themselves are incurring. The customers, focused only on lowering the prices of purchased goods and services, fail to measure their total cost of acquiring products and services. Also, suppliers with profitable relationships do not balk at providing services valued by the customers. Valid pricing, based on the cost-to-serve, provides a critical parameter for mediating conflicts between suppliers and customers.

Why do companies typically not understand their cost of serving individual customers and individual customer profitability? The primary reason is that financial reporting provides no requirement or incentive for companies to assign their operating expenses to customers. Companies are not allowed to assign selling, general, and administrative expenses, considered period costs, to products or customers. So calculating the cost-to-serve for individual customers and the assignment of relevant SG&A expenses to customers requires extensive extra computations. And, until recently, companies did not have accurate, machine readable, and easily accessible data about the demands and ordering patters of individual customers. So data were not available, information processing was expensive, and the competitive needs for accurate information about customer profitability were not great.

For example, O&M, as a distributor, did no manufacturing and therefore had no need for a cost system that assigned operating expenses to inventory for financial reporting purposes. Like most service organizations, O&M managed expenses through department budgets and periodic variance reports, which compared actual to budgeted expenses. Its largest operating expense was the price paid to manufacturers for the items it stocked and re-sold to customers.

Today, of course, the environment has changed. Companies have proliferated the number of products made and customers served, and have experienced enormous diversity in customer behavior. And the money spent on marketing, selling, distribution and administrative expenses has escalated to keep up with the diverse demands from products and customers. While such recent increases in the scale and scope of customers would seem to make calculation of individual customer profitability even more difficult and expensive, the information technology advances described in the opening paragraph have come to the rescue. Contemporary hardware and software advances can now track transactions from thousands or even millions of customers.

But raw data alone would be of little use unless they can be aggregated in an economically meaningful manner. Activity-based costing (ABC), and associated software, provides the conceptual framework for linking customer transactional data from ERP and CRM systems with financial information, so that calculating individual customer profitability data becomes a straightforward exercise. The ABC cost hierarchy of order-related, channel and customer-specific costs (such as customer management and maintenance, accounts receivable, and specialized inventory) gives companies a clear and accurate picture of the gross margins and cost-to-serve components that aggregate into individual customer profitability. The processes for building and interpreting an ABC model of product and customer profitability are well known and documented so we do not have to provide a primer in this article. (See R. S. Kaplan and R. Cooper, Cost & Effect: Using Integrated Cost Systems to Drive Profitability and Performance (Boston: HBS Press, 1998))

The output from the ABC analysis is often portrayed as a whale curve (see chart at right), plotting cumulative profitability versus customers. While cumulative sales usually follow the normal 20-80 rule (20% of the customers provide 80% of the sales), the whale curve for cumulative profitability typically reveals that the most profitable 20% of customers generate between 150 and 300% of total profits. The middle 70% of customers about break even, and the least profitable 10% of customers lose 50 - 200% of total profits, leaving the company with its 100% of total profits. And, often, some of the largest customers turn out to be the most unprofitable. A company can not lose large amounts of money with small customers. It doesn’t do enough business with a small customer to incur large (absolute) losses. Only a large customer, working in a particularly perverse way can be a large loss customer. Large customers tend to be either the most profitable or the least profitable in the entire customer base. It’s unusual for a large customer to be in the middle of the total profitability rankings.

It is not hard to identify the behavior that causes some customers to be low-cost-to serve, and likely to fall on the profitable (left-hand) side of the whale curve, or the behavior of the high-cost-to-serve customers who, if not fully priced, end up on the falling (right-hand) side of the whale curve. The Table below indicates several dimensions that lead to diversity in costs-to-serve individual customers:

Understanding customer profitability is especially valuable for service companies, such as financial institutions and telecommunication companies, that offer a full line of services to customers. Often an entry product, such as a checking account or a commercial loan, operates at breakeven or loss levels. The product and its pricing are justified as a “strategic product” since it enables the institution to leverage its relationship with the customer by selling more profitable, financial products and services. (When companies call a product strategic, it is a sure sign that the product is unprofitable.) But many companies lack the ability to track all the services used by individual customers, much less the profitability of each product/service used by an individual customer.

In fact, for service companies, customer profitability is far more important than product profitability because the costs of providing a service product are usually determined by customer behavior. Take the example of a standard product like a checking account. One customer may make very few deposits, withdrawals or balanced and service requests, and use only electronic channels - ATM and internet. Such a customer imposes low demands on the bank’s resources. A second customer, however, may manage her checking account balance very closely, keeping only the minimum amount on hand, and make many in-person branch withdrawals and deposits. This customer’s checking account may be highly unprofitable under current pricing arrangements. Service companies need to identify the differential profitability of individual customers, even those using standard products. The customer almost completely determines the quantity of demands for the organization’s operating activities so, unlike manufacturing companies, the variation in demand for organizational resources is much more customer-driven than product-driven. Customer balances or sales volume are poor proxies for profitability. Small-balance customers can be quite profitable and large-balance customers can be highly unprofitable. And to complete the picture, financial service companies need to integrate information about the transfer price of funds and the cost of risk (e.g., loan loss provisions and reserves, and risk-adjusted cost of equity) when calculating individual customer profitability.

Transforming Customer Relationships: Role for Activity-Based Pricing

Once a company sees the whale curve of customer profitability, the opportunities for action are generally obvious. Managers can choose from several actions to transform unprofitable customers into profitable ones. The actions generally fall within three categories:

1. Process improvements
   
   
2. Pricing decisions
   
   
3. Relationship management

Process improvements

Suppliers should first look internally to see where they can improve their own processes to lower the costs to serve. If most customers are migrating to smaller order sizes, companies should strive to reduce batch-related costs, such as setup and order handling, so that customer preferences can be accommodated at lower cost and without raising overall prices. Electronic systems greatly lower the cost of processing large quantities of small orders. If customers like variety, manufacturing companies can introduce modular designs and use information technology to enhance the linkages from design to manufacturing so that greater variety and customization can be offered without cost penalties.

Activity-Based Pricing

The real opportunity for mediating conflicts between suppliers and customers, and for transforming unprofitable to profitable relationships, arises from pricing individual orders and transactions. Customized pricing policies should be at the heart of any strategy to manage customer profitability. By understanding the (activity-based) cost of providing services, companies can establish prices that motivate more efficient behavior of both suppliers and customers, mediate the demand for services between suppliers and customers, and transform unprofitable relationships into profitable ones. Valid cost and pricing information motivates customers to shift their ordering, shipping and distribution patterns in ways that lower total supply chain costs to the benefit of both suppliers and customers.

The prices of special services can be set simply to recover the cost-to-serve, allowing the customer to choose the menu of services it wishes and the supplier to recover its cost of serving. Alternatively, the supplier may choose to earn a margin on special services – an inherent feature of becoming a differentiated supplier. It would then price its specialized services above the costs of providing the service. For example, the supplier could price the service up to the point of the costs saved or costs avoided by the customer from the special service. Suppliers could even try to estimate the value created (revenue enhancements) from the special service and price up to that created value. Some companies, to be described later, have gone further, estimating a second ABC model - of the customer’s internal costs and profits - to be explicit about how far above this floor the price can be and still provide a net benefit to the customer.

Activity-based pricing improves the fit between suppliers and customers and has the potential to enhance the profits for both across the supply chain. Such pricing educates customers about how their behavior affects the costs of its suppliers. But, often, the customer also learns about its own costs from such activity-based pricing. For example, a large US consumer goods manufacturer analyzed its warehousing costs. It was spending $2.8 million dollars on an activity, pick, stage and load cases. With an annual activity volume of about 70 million cases, its average cost per case was slightly above $0.04 . A more careful activity analysis revealed that it was performing several different types of distribution options for its customers. The cost analysis is summarized below:

Two of the options, full pallet (63%) and layer and case (34%) represented 97% of the orders and the cost driver rates for these two options were $0.015 and $ 0.080 respectively. The company, however, had been using a standard price for all of its customers to recover the average cost of $0.042 per case. One large retailer had been requesting 60% of its deliveries with the layer and case option, with only 40% using the standard full pallet option. The manufacturer could now see that the cost to serve this important customer averaged $0.054 per case, well above the price being charged.

The company shared the data with the customer, indicating that it would be pleased to continue doing the layer and case option, but that it would now price deliveries based on the type of packaging requested. The customer proceeded to do its own ABC analysis to examine its activity costs and discovered, unexpectedly, that handling costs of deliveries with the layer and case option were higher because of more breakage and special handling. The customer agreed to shift to 100% full pallet shipments. The ABC analysis produced a win-win solution in which both the company and its customer realized significant cost savings.

In a similar example, another grocery chain had asked its pet food supplier to package dog food in 10 kg. paper bags, thought to be efficient and cheap for bulk handling and sales. The manufacturer incurred extra costs to package, store, and ship the product in this form but wanted to be responsive to an important customer’s request. A subsequent ABC analysis by the retailer revealed that receiving the product in this form was enormously expensive. The fork-lift trucks used to transport the bags often pierced through the paper package, spilling dog food all over the food. Apart from the cost of spoilage, the store required two persons, on a regular basis, to sweep up the spilled dog food. Both manufacturer and retailer quickly agreed on a more expensive and robust package for the product, one that required far less handling and product loss.

By estimating an ABC model for their customers, companies can often convince customers of the benefits of the relationship even when selling at higher prices. The DeLuxe Corporation, the world’s largest check printer, had 18,000 financial service and small business companies as customers. The company had been providing customized services to each customer, without pricing for the customization. The company’s cost-to-serve had escalated so that it was almost comparable to its manufacturing cost-to-produce. Its customers were resistant to price increases, and alternative payment mechanisms (credit and debit cards, online payments) had reduced the demand for DeLuxe’s products. The company initiated process cost reductions, especially by opening up an electronic channel to shift customers from paper to automated ordering, but needed to convince its customers to shift to this new lower-cost (to DeLuxe) channel.
Deluxe quantified the savings to its customers (banks) by computing what it called a Deluxe Partner Index. This index had three components:

• Cost to produce: the price paid by the bank to Deluxe for the check order
  
  
• Cost to serve: the cost incurred by the bank in activities to sell, process, and fulfill orders from its customers
  
  
• Revenue: the cash received by the bank from selling products supplied by Deluxe.

Deluxe could prove, with this index, that even when paying higher prices, the customers who used the lower cost electronic ordering channels made more money sourcing checks from Deluxe than by purchasing checks from competing check printers. (P.B.B. Turney, "Deluxe Corporation (E): Supply Chain Management," Darden Case UVA-G-0553)

Kanthal, the Swedish heating wire manufacturer (R. S. Kaplan, “Kanthal (A),” HBS Case 9-190-007), also encountered a difficult situation that it resolved by working with its customers’ own cost structure. Kanthal’s US subsidiary learned that the General Electric Appliance Division (GEAD) was one of its most unprofitable customers. A customer order that normally cost about $150 to process, cost more that $600 from GEAD because of many order changes, rescheduling, and expediting. Kanthal faced the dilemma of how a small ($25 million annual sales) subsidiary of a Swedish-based company could negotiate changes in the terms of trade with the large subsidiary (nearly $5 billion in sales at the time) of a giant, sophisticated US multinational corporation. The president of Kanthal’s US subsidiary took an open book policy to its large customer and suggested that the many change orders were not only a cost to Kanthal but also a cost to GEAD. After a quick internal study, GEAD managers concurred. With Kanthal not charging for all the change orders, GEAD had failed to notice how many of them it requested and was unaware of the high costs it incurred from such changes. The two companies soon signed the largest contract in Kanthal’s history, incorporating one activity-based pricing feature – a surcharge for any change made to an existing order, and an ABM action – minimum order size.

Suppliers who are first to exploit the opportunities for activity-based pricing gain clear short-term advantages, as indicated by the above examples. They recover costs that their competitors are absorbing, and change customers’ behavior to lower the cost of serving them. Moreover, they can gain additional market share by offering lower prices to customers who wish just the basic level of services, and shed customers who are not willing to change their behavior to allow a minimum level of supplier profitability. The question is whether such short-term benefits are sustainable. What happens to industry profitability if all suppliers move to activity-based pricing?

Analytic research indicates that industry profitability will increase for two reasons, when all suppliers move to activity-based pricing. (J. Larsen and V. G. Narayanan, "Menu Based Pricing" Harvard Business School working paper (2000)) First, when customers change their behavior and consume only services that they really value - and pay for, all suppliers benefit. Second, if suppliers follow different strategies and exploit different resources for competitive advantage, activity-based pricing leads to a better fit between suppliers and their customers. Consider, for example, a simple example with two possible suppliers: a job shop and a mass production factory. Without activity-based pricing, the job shop and the mass production factory will compete on the same terms for the same customers, provide customizations for free, and erode each other's profitability. With activity-based pricing, the job shop, which is more efficient in handling jobs involving a high level of customization, will offer lower prices to customers that require a high level of customization. Correspondingly, a mass production factory will be less expensive for high-volume standard orders. Activity-based pricing provides an efficient matching between suppliers and customers, and total industry profitability increases.

Managing Customer Relationships

Before taking any action - including pricing - with unprofitable customers, companies should expand the customer profitability measurement to encompass all the relationships that each customer has with the company. In a bank, for example, a customer may, in addition to a standard checking account, have a savings account, a credit card, a mortgage, and a personal loan. Bank managers need to understand the profitability of the total relationship between the bank and its customer, and act based on total relationship profitability, not just the profitability with a single product. While such total profitability calculations were difficult and expensive using legacy computer systems, modern ERP and CRM systems can identify and link all customer relationships together. For a commercial bank, a standard corporate loan may breakeven or lose money (after an appropriate risk-adjusted cost of capital is applied). The loan, however, is the entry-level product that establishes a relationship between the bank and its customer. The bank may make enough profit on other banking relationships - trust services, corporate money management, and investment and merchant banking services - to produce a highly profitable total relationship. But a marginal borrower who uses no other commercial or merchant banking services is a prime candidate for repricing, aggressive marketing activities, or deletion (if all other attempts to generate a profitable relationship fail).

At one commercial bank, the loan officer tried to fire an unprofitable customer, who had only a single banking relationship and did not use its banking facility intensively. The officer shared the economics of the unprofitable relationship with the customer and suggested that it seek other financial institutions for its borrowing needs. The customer, however, wanted to retain its relationship with the bank and offered to find ways to increase the bank’s profitability on this account. The CFO offered to travel to New York for periodic meetings, rather than have the loan officer visit its Midwestern headquarters. It would also do more banking business so that the relationship could be transformed into a profitable one for the bank. (“Manufacturers Hanover Corporation: Customer Profitability Report,” HBS Case # 9-191-068.)

The Balanced Scorecard (BSC) provides a comprehensive framework for managing customer relationships. (R. S. Kaplan and D. P. Norton, The Balanced Scorecard: Translating Strategy into Action (Boston: HBS Press, 1996)) The BSC’s customer perspective typically includes outcome measures for targeted (strategic) customers. Such measures include customer acquisition, satisfaction, retention, account share, and market share. But the customer perspective should also measure whether loyal, satisfied customers are profitable customers. Companies do not want their loyal, satisfied customers - those receiving lots of attention, service and features - to be unprofitable customers, appearing on the right-hand downward-sloping side of the customer profitability whale curve.

Companies can combine their BSC and ABC insights, as shown in Figure 2, at right. They can celebrate the targeted, profitable customers of the northwest quadrant. Untargeted, unprofitable customers in the southeast quadrant are good candidates to be "de-marketed" and referred to competitors. Profitable, untargeted customers (southwest quadrant) should be retained but watched to make sure they don't drift into unprofitability. Managers can then focus their pricing, process improvement, and relationship management actions on the unprofitable, targeted customers in the northeast quadrant. The BSC defines targeted vs. untargeted customers; the ABC model gives managers insights about where opportunities exist to transform attractive, but money-losing customers into long-term profitable relationships.

Life Cycle Profitability

Many service companies invest considerable resources in marketing campaigns to attract new customers. If not knowledgeable about the characteristics of what makes a profitable customer, such companies may spend a great deal of money to attract a general set of customers, 75 percent of whom end up being unprofitable. By knowing the characteristics of profitable customers, companies can direct their marketing efforts to specific segments that are most likely to yield profitable customers.

Once acquired, because of the high cost of acquiring new customers, and the time required to establish a broad and deep relationship (such as across multiple product offerings), even attractive new customers may be initially unprofitable. Service companies need to distinguish the economics of newly-acquired customers from those who have been customers for many years. Thus, in addition to recognizing cross-sectional variation of demands by customers - across multiple products and services, companies must also forecast the longitudinal variation of customers over time to calculate their total life-cycle profitability.

Custom Research Inc. (CRI), a marketing research company, provides an interesting example of how to manage lifetime customer relationships. CRI, with about $10 million in sales in 1990, had experienced rapid growth in clients, but no increase in profits. A simple analysis revealed that 6 percent of its clients generated 29% of sales and virtually all its profits. At the unprofitable end were 70 percent of clients who required extensive sales and research employee time, but whose annual billings with CRI were below breakeven levels.

CRI took some immediate actions to terminate relationships with clients who would not give CRI a higher share of their market research expenditures. CRI did not want to work with clients who could not give them at least $100 thousand in annual billings. In effect, CRI – a service organization - instituted a minimum order size with all its clients. The company estimated that it needed only about 25 percent more business from two dozen existing clients to compensate for firing about 100 unprofitable clients over the next two years. Second, CRI established strict policies for screening new clients. Before, it took any client who came in through the door (or over the phone), using standard hourly pricing rules. Now all initial inquiries are routed to a single manager who screens new customer leads, using the responses to six standard questions, and rejects those she estimates will fall short of CRI’s profitability goals. Typically only 10 percent of inquiries pass this initial screen.

A second manager then does in-depth research on the potential clients. Those that pass this screen are welcomed to CRI’s “freshman class” and assigned to an existing account team. The account team – charged with growing the business from all existing accounts - works closely with the freshman client to migrate it to a higher level of business. After a year, the account teams determine which of the freshmen are allowed to be promoted to sophomores. Those not promoted are let go; it’s either up or out. A sophomore is expected to show real growth in sales and profits by year two. Sophomores are expected to double sales in the second year. Clients who graduate from the sophomore class get the royal treatment. Within 4-5 years of launching this approach, CRI had 36 clients who provided 86 percent of sales and 96 percent of profits (unlike the normal customer profitability whale curve, CRI had few unprofitable customers – perhaps only in its freshman class). From 1990 to 1995, CRI reduced its number of customers by 50 percent, yet revenue increased by 60 percent and operating profits were more than 300 percent higher. CRI could devote intensive attention to its established client base, knowing that the revenues per customer more than compensated them for the extensive research and support provided.

Companies with thousands, or even millions of customers may not be able to replicate CRI’s comprehensive screening, mentoring, and graduation of individual customers. For them, tools such as activity-based costing and lifetime customer profile analysis help to automate the calculation of lifetime profitability. (See “The Right Measures,” Chapter 8 of F. F. Reichheld, The Loyalty Effect (HBS Press: Boston, Mass., 1996): 217-253) But the message from understanding the lifetime customer profitability concept may be more qualitative than quantitative. Companies can be more tolerant of unprofitable customers when they are newly acquired than when they have been customers for ten or more years. No one envisions a lifetime unprofitable relationship when a new customer is acquired. Companies, however, need the discipline of at least annual profitability reviews to detect when customers remain or have recently fallen into the unprofitable category. They can then use activity-based pricing, process improvements, and customer behavioral changes to transform unprofitable relationships into profitable ones. These should be attempted before following the Custom Research discipline of firing customers with little potential for long-term profitability.

Barriers to Implementation

Owens & Minor encountered several barriers as it attempted to implement its new activity-based pricing scheme with targeted customers. First, its customers’ internal budgeting, transfer pricing, and incentive programs were based on the historical cost-plus pricing scheme. Departmental budgets and purchasing managers’ incentive schemes incorporated distributors’ fixed percentage markup fees. The customers were perplexed about how to accommodate the new fee structure, based on cost-to-serve. As a transitional device, O&M offered to do the accounting for its customers, assigning the distributor fee back to products ordered so that the new pricing scheme would be transparent and compatible with customers’ existing systems. Over time, however, customers would need to modify their internal systems so that departments and purchasing managers would understand clearly the impact of their actions on ordering costs.

Also, customers would have to eliminate or reassign personnel, equipment, and warehousing space to realize the gains from the new value-added services supplied by O&M. Otherwise, customers would pay for the services twice; once when they paid O&M for the cost of services provided, and a second time by continuing to supply resources which were now being bypassed by O&M’s new ordering and delivery services. It’s one thing to estimate the cost saving from new supplier-customer relationship; it’s quite another thing to eliminate resources no longer needed to capture the savings. Many companies are good at estimating opportunities for cost saving, but fall short on taking unpopular actions to realize the potential cost savings. Further, O&M and its customers would have to invest in electronic technologies, such as EDI, for streamlined ordering and processing. This is an additional front-end investment to be repaid by future cost savings (by eliminating resources for manual order processing no longer needed).

To overcome these barriers, O&M introduced its new pricing services gradually, working in cooperation with targeted customers. It offered customers the option to experiment with activity-based pricing, while still receiving other deliveries under the traditional cost-plus contract. O&M institutionalized its new approach with a new CostTrack system, a menu of services encompassing activity-based costing, pricing, and management. The system became a valuable marketing tool, enabling it to sign up important new customers. In April 2001, Owens & Minor announced a three year distribution agreement with the largest ($17 billion in annual purchases) supply cost management company in US healthcare. The agreement allows customers to use the CostTrack activity-based management system to “separate the cost of the process of distribution from the cost of the product.” In conjunction with CostTrack, O&M introduced a new supply chain management information tool that enables customers to track trends in lines per order and other factors so that they can learn how to reduce CostTrack distribution fees and save money throughout their supply chain. The activity-based pricing discipline within CostTrack is giving Owens & Minor a distinctive competitive advantage in its highly competitive marketplace. While other distributors are now trying to adopt the new approach, O&M enjoys a several year headstart in the knowledge, internal systems, and customer relationships of operating with activity-based pricing.

Some companies, even after they have gained the insights from an activity-based cost analysis of customer profitability, fall into a pitfall that O&M avoided. They wait for competitors to move first, not wishing to upset existing industry pricing policies. These companies lose the first-mover advantages of cherry picking the most attractive customers. First movers get the customers who want specialized services and are willing to pay premium prices. Existing competitors don’t want to supply the services because they are unpriced, and they want to avoid the higher costs of supplying them. First movers also steal customers who don’t use the special services, but are paying for them through the average cost plus markup used by existing suppliers. The innovating firm can offer attractive discounts to low cost-to-serve customers that existing competitors find difficult to match because of their inability to distinguish and capture the benefits from being a supplier to such customers.

Consider also a potential problem from initial implementation of activity-based pricing. The company loses the business from some high cost-to-serve customers, who don’t want to pay for the services they demand. Other customers switch to more efficient distribution channels and ordering patters. In either case, the supplier now has excessive selling, distribution, and administrative resources. These were needed and supplied under the old way of doing business but they are no longer needed with the new customer mix and ordering and distribution processes. The supplier must identify the excess resources and redeploy them to more productive uses (or eliminate them altogether) to capture the savings from the reduced demands for selling, administrative, and distribution activities.

Finally, suppliers must change the incentive compensation schemes used for their own sales force. Conventional compensation schemes based on the top line - total sales volume - must be replaced by schemes based on the profitability of products, customers and orders. Salespersons can best decide, with their local knowledge of customers and competitors, when to take unprofitable orders - yielding no commission to them from that transaction - in the expectation of establishing or maintaining a long-term relationship yielding many profitable orders (and commissions) in the future.

Advances in information systems and innovations in costing have given companies new capabilities for measuring and managing individual customer profitability. Implementing activity-based pricing and redefining customer relationships based on sound economics provide managers with powerful tools for greatly enhancing their long-term profitability.

For Additional information contact Rainmakers at 847/251-3327