It’s natural to assume that your large customers, who unquestionably are the source of most of your revenue, also deliver the major part of your profit. The Pareto Principle suggests that 80% of your profits come from 20% of your customers and assumes that the 20% are represented by the largest customers.

But is this based on fact? Let’s look at some of the typical attributes and behaviour of a company’s larger customers and see if they point to increased or decreased profitability.

• High sales volume – increases revenue 
• High sales volume – benefits of economies of scale 
• Value on client list for marketing 
• Discounted selling prices 
• Extended payment terms 
• Requests for product customisation 
• Requests for marketing contributions 
• Requirement to deliver to multiple locations as opposed to single central warehouse 
• In a services business do your large customers always demand your best resources and do you charge appropriately for them? 
• Senior Management Time 

The Pareto Principle also suggests that 80% of your profits come from 20% of your products; but do you know which 20% that is?

Also do you know what the effect on your business would be if you lost one of your large customers? Could you adjust your production capacity and overheads in line with the reduced level of business?

There are dramatic benefits to be gained from certain strategic customers. As the Harvard Business Review writes:

“World-class best customers like Toyota, Tesco and Wal-Mart are famous for actually pushing their suppliers to be more innovative. Toyota made its quality reputation sending its lean manufacturing experts into its suppliers' production lines to advise them on product design and process improvement. Tesco has worked closely with local suppliers on sustainable agriculture and fresher food packaging. And, of course, Wal-Mart has hugely committed to working with suppliers on more innovative ways to maximize energy efficiencies and minimize carbon footprints.”

So how do you make sense of the data you have in your transaction systems and use this to help assess the relative profitability of your customers and your products?

Your Enterprise Performance Management system may be providing you with an analysis of your revenue by "customer" and "product" but any understanding of the relative contribution to gross or net contribution is likely to be based on the application of standard margins.

In order to improve the analysis of customer profitability we need to look at how we can allocate the various elements of the Income Statement by customer.

The approach will vary based on the nature of the income or cost lines, the available driver data which can be used to allocate the costs and the objective of the analysis. Income can be based on invoiced sales net of any settlement discounts. If overriding discounts are offered based on total sales volume these should also be taken into account. The cost of sales can be based on standard costs; if customised products are produced for customers ensure that the customisation costs are included in the cost of sale.

This will give us the gross contribution by customer but to understand the true profitability of a customer we need to look at how we can allocate overheads. In some cases we may be able to directly attribute costs, for example where we have a dedicated sales team for the customer, but in most cases we will need to capture information on the activities which are undertaken relating to a particular customer. We then need to measure the cost of the activities. For example we could analyse the costs of invoicing and credit control and allocate these costs to customers as a cost per invoice raised. 

There are two ways of thinking of the allocation of costs and these are based on two different ways of looking at the contribution of a particular customer. The costs incurred at a given level of activity could be allocated across customers based on some appropriate activity measure or the incremental revenue and costs of the business relating to a specific customer or group of customers could be analysed. The latter would be the analysis you would want if you were considering the implications of losing a customer or acquiring a new customer.

In a future blog I’ll look at the approaches in more detail but feel free to contact me if you’d like to discuss an approach which could help you to better understand your customers’ profitability.