I was in a suburb of Detroit, presenting to a sales force. The subject was “Modeling the Profitability of Relationships.” The presentation went well until I relayed to a Sales Manager that the type of customer she was targeting was unprofitable and I would never sign them. It turns out she was not the only Sales Manager with the belief that “every customer is a good customer.”
This situation is not uncommon and usually happens when business managers focus on revenues, and not profitability; or when your sales force is compensated based on activity and not profitability.
Characteristics of an unprofitable relationship may include –
-Customer/ Client requires preferential pricing/concessions, i.e. discounts. Organizations negotiate special pricing or fixed rate pricing with a vendor in exchange for exclusivity;
-Customer/Client requires high touch, i.e. a dedicated customer service in exchange for exclusivity;
-Customer/ Client requires the vendor to advance cash as part of the product or service to be purchased; and/or,
-Customer/Client is a slow payer of outstanding invoices. It is possible to have a very profitable relationship that is financially disruptive to cash flow.
An approach that has worked for me in the past, to identify non-profitable relationships includes the following steps –
Understand Your Business
-Asses your cost structure – Are processes within your organization as efficient as possible? Are inputs priced competitively? Inefficiencies have a cost, i.e. a non-value added cost. Customers/clients will not pay for inefficient processes that increase the cost of your product or service. Alternatively, you will be forced to assume the cost through lower profit margins.
-Assess your target return – What is your profit requirement? For every $1 of revenue, do you expect to earn $0.50, $0.25, or $0.05? You should calculate an acceptable range – “My target is between $0.35/dollar and $0.15/dollar of revenue. If I am earning any less, it is not worth my time.”
-Assess the price for similar products in the market, from competitors. Is your price above or below the average of competitors in the market? Do not look to be the lowest price or the highest price. Neither place is sustainable.
After this stage, you should have a good understanding of your economics. If you found that [costs + your target profit] would require a price point higher than your competitors, it may be an indication that either profit aspirations are too high or your cost structure is too high.
Once you fully understand the business economics, analyze your customer/client. It is very important to start your analysis only after you have fully understood your business economics.
Understand Your Customers or Clients – Prepare a spread sheet with client information. For every customer/client, compare the expectations you had when the relationship was established, i.e. revenue, profit and profit margin; as well as your original target pricing. Now calculate revenue earned, profit earned and the profit margin for each of your customers/clients. What is your current pricing? Review this data over a set period, i.e. three years. One year is too short a period.
Based on the data pulled, group the customers/clients into three categories – the relationships that exceeded expectations with superior returns; the relationships that met expectations; and the relationships that performed below expectations with dismal returns. Understand the reasons why certain customers/clients exceeded expectations. Can relationships that met or fell below expectations be modified, to closely resemble the relationship with the highest returns? Basic adjustments include –
-Customer/ Client requires preferential pricing/concessions – remove all discounts;
-Customer/Client requires high touch – additional usage of a help desk or service center, above an established level, should be priced accordingly;
-Customer/ Client requires the vendor to advance cash – establish an arrangement where costs are paid upfront; and for,
-Customers/Clients that are slow payers – establish a Collections Process, which rewards timely payment and penalizes late payers.
These simple modifications can make an unprofitable relationship profitable. However, you must be prepared that your customer/client may not wish to make these changes, and decide to seek an alternative service supplier.
Obtaining a customer that becomes unprofitable is a common situation. It only becomes an error of management if you do not perform this analysis periodically, or ignore the results.