Customer profitability: is the customer king - or cost? (CEO Insights).

Consumer products companies compete fiercely for the business of large retailers. Customer profitability analysis can ensure that those efforts deliver positive return on investment.

WHEN WAL-MART BECAME THE WORLD'S LARGEST COMPANY LAST year, the achievement reflected a decades-long trend in the U.S. economy away from manufacturing toward services. Yet there was an additional implication for consumer products companies that serve large retailers: Increasingly, such customers wield greater individual influence over the balance sheet.

It's no surprise, then, that corporate leaders of consumer products companies are more carefully scrutinizing their relationships with trade customers. In particular, they're weighing the cost to serve those customers against the resulting revenue. The goal is to uncover strategies for making each customer more valuable while ensuring a lasting, mutually beneficial relationship.

It's the latest incarnation of customer profitability, a concept that began to take hold a decade ago among financial services providers and other organizations that directly serve consumers. The idea is to provide higher levels of service to customers that deliver greater profits -- and upsell or even shed customers on the lower rungs of profitability. Although few have perfected it, the approach is becoming mainstream as executives recognize the value of a strong customer focus.

"The cost to retain existing customers is far lower than the cost to attract new ones," points out Kimberly Collins, Ph.D., a research director for Gartner in Stamford, Conn. "So smart companies are investing in ways to identify and better serve their most valuable customers."

Now, executives at consumer products companies are taking the same approach to their trade customers. They're developing strategies to analyze customer profitability to determine the total cost to serve each customer, identify ways to reduce those costs and take actions that ensure every customer relationship is as profitable as it can be.

The Cost to Serve

There are good reasons for this sharper focus on customer profitability. "During the past several years, consumer products companies have been increasing their trade spend, providing new services to trade customers and incurring greater costs to serve them," says Marc Shingles, customer profitability solution/practice leader for Cap Gemini Ernst & Young U.S. LLC (CCE&Y). "Much of this activity has been driven by competitive pressures as manufacturers strive to build more solid relationships with large retailers."

It started with services such as vendor-managed inventory. In exchange for point-of-sale data, manufacturers helped retailers optimize inventory levels and automate replenishment.

Manufacturers captured valuable information about consumer behavior, ensured that their products were always in stock and differentiated themselves from less sophisticated competitors. They also incurred tremendous cost. And as large retailers began requiring vendor-managed inventory of all manufacturers, the competitive advantage dwindled.

At LeapFrog Enterprises, a maker of interactive learning products, building relationships with its retail partners is critical to the company's growth -- net profits for the Emeryville, Calif., upstart increased a whopping 349 percent to $43 million last year, on a 69 percent sales increase to $532 million.

"We look at our partnerships with retailers over the long term," says Michael Wood, LeapFrog's founder and CEO. "We monitor on a weekly and sometimes a daily basis the sales of our major retail partners, their in-stock position, their margin, their inventory, their turns. We monitor our profitability and their profitability very closely, because the relationship has to be strong on both sides."

"The strength of that partnership determines how many opportunities our ultimate customers -- moms and dads and teachers and kids -- will have to buy LeapFrog products," Wood adds.

The better the relationship with the retail customer, the more likely the company is to understand the particulars behind the sale -- and the potential areas for savings. Consider the display-ready pallets many companies use. According to CGE&Y, end-of-aisle product displays were formerly an activity (and expense) of the retailer but are now assembled by the manufacturer in its distribution centers. This reduces cost and hassle for the retailer while ensuring prime shelf space for the manufacturer. But it also can involve millions of dollars in additional expenditure transferred from the retailer to the manufacturer.

Equally costly are customer-specific product configurations and marketing activities. Increasingly, retailers rely on manufacturers to deliver exclusive products that enable retailers to differentiate themselves. "Account-specific activities can involve significant cost," notes Shingles. "But most manufacturers don't include this cost in their brand P&L, and the return on this customer-related activity isn't measured."

Finally, large retailers are taking advantage of their size and influence to demand special services or flexibility from manufacturers. For example, they may order less-than-truckload shipments but still expect to pay full-truckload pricing.

Executives are realizing that instead of managing a portfolio of products, they need to manage a portfolio of customers. Notes Collins: "In a B2B scenario, every customer relationship is valuable. The cost to serve each customer is higher, and the prospect of losing a customer involves greater risk."

A Different Yardstick

All these factors point corporate leaders toward a pressing need to analyze and manage profitability by customer. Trouble is, most companies aren't very good at it, experts say. Service companies such as financial institutions are most effective, while manufacturers lag, reports Forrester Research, based in Cambridge, Mass. That's particularly true for manufacturers that sell through a direct sales force.

What's more, manufacturers haven't been able to map additional revenues to the increased cost to serve retailers -- that is, they haven't effectively measured what returns, if any, they have achieved on their service investments. In fact, according to Forrester, customers with identical revenue potential can vary widely in service cost.

"Intuitively, you may know that one customer is high-maintenance while another is highly profitable," says Shingles. "But one manufacturer we worked with found a 300 percent difference in ROI between two apparently similar trade customers" -- a situation the manufacturer wouldn't have recognized without thorough analysis. Profitability analysis for another manufacturer, he adds, revealed that "one customer delivered 35 percent less in gross sales than a large retail customer but contributed 9 percent more in profit."

Consumer products executives know that their companies have long been adept at measuring profit and loss by product, by brand and even by channel. Measuring by product or brand helps them understand product performance, develop new products and pricing, establish sales quotas and create product-oriented goals. Measuring by channel helps them understand how to most effectively reach customers, how to allocate revenue and where to invest resources.

Now, executives want their companies to apply that same level of discipline and expertise to measuring profitability by customer. "What's necessary is a multidimensional approach in which you measure profitability by product, channel and customer," advises Collins. "A focus on product or channel profitability might lead to the elimination of a product or channel used by your most profitable customers. If you lose these customers as a result, your profitability could actually decrease."

You've Got Profits

Still, it's not enough for leadership simply to know that a customer is profitable or not. "You need to determine why the customer is unprofitable," Collins says. "That way, you can identify ways to make them profitable, such as collaborating and integrating processes to reduce costs and streamline operations."

For example, Shingles recalls a manufacturer that was shipping virtually all its products display-ready. Yet customer profitability analysis revealed that for one retail customer only 30 percent of those shipments were being used for displays, while 70 percent ended up as regular shelf stock. The solution to this waste and added cost was to work with the retailers to learn which shipments would be displayed. "A simple code in the electronic data interchange (EDI) between the two companies, or better coordination among sales teams and order management, could enable the retailer to receive display-ready pallets only when necessary," he says. "The savings could then be reinvested in more value-added activities, such as in-store, consumer-oriented branding and marketing events."

Similarly, retailers routinely return products -- because the products are damaged, because they didn't sell or for other reasons. The manufacturer incurs the freight cost, along with the cost of quality inspections and determining what to do with the merchandise. "If, through comparative analysis, you determine that a retailer has excessive returns, you can work together to identify the reason for the returns and how to reduce them," Shingles says.

Some consumer products companies, particularly electronics manufacturers, can benefit from customer-specific pricing. Customer profitability analysis provides an objective, equitable way to set pricing -- in line with government regulations. Instead of basing pricing solely on volume, you can base it on volume plus profitability. Executives can also use customer profitability analysis to prioritize technology and process investments. If costs are associated with marketing activities, then maybe it makes sense to invest in a CRM system. If costs are associated with logistics, then perhaps you need a new ERP system, or maybe you should bring in a logistics expert to improve processes.

The cost savings that result from greater efficiencies can be reinvested in the relationship -- for example, toward activities such as trade spending for consumer-oriented promotions. "The goal isn't to use your knowledge of customer profitability to attack the customer with the information or make harsh demands that customers change their behavior," Shingles says. "Rather, it's to have a fact-based discussion about ways to work collaboratively to improve processes that benefit both parties, and reinvest the savings in more mutually valuable activities."

The New Standard

The next step beyond customer profitability is customer lifetime value. "You need to understand which customers have a large upside potential and which are maxed out," says Collins. "Some customers may be unprofitable today but have a high future value. So you want to invest in those relationships."

Such a forward-leaning stance isn't simply academic. Increasingly, experts say, Wall Street will expect organizations to map customer profitability to overall financial performance. "Companies will have to be able to take customer profitability, relate it to financial metrics and report on that to drive shareholder value," Collins predicts. After all, in today's economy, the customer is king -- but it's all about profits.

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Leaders of consumer products manufacturers increasingly recognize the need to measure customer profitability.

But few have enough information to fully understand the total cost to serve a particular customer -- or the total value that customer delivers.

Measuring customer profitability starts with looking at obvious direct costs such as trade promotional spending. But "it's imperative to also use activity- or process-based costing to identify costs for such things as inventory carrying costs and order processing," says Marc Shingles, customer profitability solution/practice leader for Cap Gemini Ernst & Young. Activity- or process-based costing breaks down business processes into specific activities and identifies the manufacturer's costs of the resources and materials used for those activities. "That gives you a more accurate picture of actual customer-specific costs incurred in the enterprise," he says.

Customer profitability analysis should include customer-allocated cost metrics for all enterprise activities, Shingles advises, including manufacturing, distribution, logistics, sales, trade marketing, order management, and administration and support. The capital investment in a sales office and equipment used to support a specific trade customer is an example of customer-specific overhead cost.

Just as important, you need to develop formal processes for capturing and managing customer-related cost information. "For example, a CRM solution can automate the collection of data in a consistent and accurate manner," says Shingles. "That enables you to avoid the need to manually gather data from various sources and then enter it into a spreadsheet for analysis" -- a time-consuming process that can result in inaccurate and outdated information. Bear in mind that the effectiveness of such automated processes often hinges on IT infrastructure that is integrated across teams and functions.

Beyond processes executives should promote a customer profitability mind-set through compensation and other incentives. For example, "a cross-functional customer team could be rewarded based on measurable return on investment in serving that customer," Shingles says. "Many consumer products companies already do that by brand."

Companies that measure profitability by customer have a distinct advantage over those that don't. "For starters, they can more intelligently manage their customer-facing processes," observes Shingles. "But even more important, they can identify and then strip costs out of processes that do not add strategic or economic value to the manufacturer/customer relationship, and reinvest in processes that are mutually valuable to the relationship. That leads directly to stronger customer relationships -- and profitable growth."

Top customer profitability pitfalls

Here are the 7 keys factors that keep companies from adopting and using customer profitability analysis.

(1) A lack of comprehensiveness. The majority of customer P&Ls lack enough detail to provide a true view of total cost and customer contribution. The most valuable customer profitability analysis captures data across all functions and includes customer-allocated cost metrics related to manufacturing, distribution, logistics, sales, trade marketing, order management, administration and support, and customer overhead.

(2) Manual vs. automated processes. Data for customer P&Ls are typically extracted manually from various sources and entered into a spreadsheet for review and analysis. This time-consuming process creates inconsistent data gathering and analysis and infrequent updates, making its use and value limited. In addition, customer cost and investment data need to be continually updated, as actuals come in to replace estimates. If this continuous feed of data isn't automated, it's very likely that it never will be updated.

(3) A lack of integrity and user buy-in. Manual and non-comprehensive processes create results that tend to lack integrity. Data quality compounds the issue, as critical data such as promotion cost/investment may be found only on salespeople's laptops. Data integrity issues cause business owners to second-guess analytical results -- and not use them to engage in a mutually beneficial and productive dialogue with their channel customers. Without sound data integrity, business owner buy-in is a challenge.

(4) Point-in-time and single use. This needs to be developed and automated for continuous use and measurement, vs. a one-time tactic for negotiation purposes or leverage.

(5) The process is overcomplicated. Customer P&Ls need not be fully loaded and reconciled to corporate financial reporting statements and systems. The focus should be on business use and reporting vs. financial use and reporting.

(6) The "80/20" fallacy. Promotional investment and spending are no longer representative of total investment and the cost of doing business with a customer. Years ago, an understanding of customer-specific trade promotion ROI would have provided manufacturers with 80 percent of the cost category of investment in a total customer profitability analysis. Today, size, complexity and individual customer requirements generate other significant costs and investments critical for accurate analysis, such as freight, inventory carrying cost, HR support investment, display-ready pallet cost, "nuisance fees" and so on.

(7) No linkage to strategy. As industries have rushed toward a solution, putting technology before strategy was a key shortfall. Companies must develop a transformation roadmap and plan for how they will use this type of analysis to affect their bottom line. How customer profitability analysis will be used is a key element to developing a strategy. An effective strategy and the use of customer profitability analysis should outline mutually beneficial (to manufacturer and customer), measurable and actionable uses and results. The manufacturer and the customer can engage in reinvestment dialogue, using the analysis to highlight mutually ineffective and inefficient activities -- such as returns, unsaleables. random-case picks and emergency orders -- that are driving cost and, therefore, investment that could be more effectively reallocated and reinvested toward mutually beneficial activities, such as consumer marketing, branding and retailer equity development.

For more details on how companies use customer profitability analysis to decrease costs and increase cash flow, contact Marc Shingles, Customer Profitability, Cap Gemini Emst & Young, at [e-mail].