Activity Based Costing (ABC) is best known for its appilcation in computing product costs, but firms also find it useful in determining the cost of serving customers and as a basis for evaluating the profitabilty of a specific customer or group of customers. Why is this important? Most managers agree that 80% of their profits come from the top 20% of their customers and most important, the bottom 20% of their customers are unprofitable. For example, to compete with Walmart,Best Buy works hard to attract profitable customers and equally hard to discourage the unprofitable customers which those that are price shopping and looking for discounts and promotions and comparing prices to Walmart. Best Buy studies demographic and sales data for each store location to identify profitable and unprofitable customers.
Customer profitabilty analysis idetifies customer service activities and cost drivers and determines the profitability of each customer or customer group. Here, customer service include all activities to complete the sale and satisfy the customer including advertising, sales calls, delivery, billing, collection, service calls, inquiries and other forms of customer service. Customer profitability analysis allow managers to: Identify most profitable customers
Manage each customer’s cost-to-serve
Introduce profitable new products and services
Discontinue unprofitable products, services or customers
Shift a costomer’s purchase mix toward higher-margin products and service lines Offer discounts to gain more volume with low costs-to-serve customers Choose types of after-sale services to provide
How to calculate Customer Profitability Analysis
The first step of CPA is to create a simple model of revenue by customer on the one hand, and total business unit costs and overheads on the other. Second, subtract the direct product and service costs from each customer (costs of good sold/cost of sales) to arrive at a gross margin per customer. Third, it should be possible to identify other costs specific to the customer such as a particular sales campaign or servicing and retention costs. Orders of magnitude will do rather than getting hung up on 100% accuracy. Be consistent if applying any proxy. Fourth, sort customers by net profit and draw a cumulative profitability curve staring with the most profitable to the least. This is an effective way to visualize the relative profitability of customers and it soon becomes apparent which customers are critical to the business. Fifth, before taking any decision on non-profitable customers, make sure that you have strong retention activities in place to secure your most valuable customers. Sixth, get behind the real reasons why some customers are unprofitable and determine the appropriate strategies and tactics to enhance the profitability of your customer portfolio. Thought about sacking customers, should be put to one side until you have gained a clear understanding of the reasons. As we’ve seen there are lots of reasons for being unprofitable, and it is important to think ahead to potential value over time, not just recent history. (Six step to Customer Profitability Analysis, 2007)
A good understanding of the profitabilty of a firm’s current and potential customers can help firms improve overall profits and become more competitive. This begins with an analysis of the cost to serve the customer. Customer Cost Analysis
Not all customers require similar activities either before or after sales. Examples of customer-specific activities include: Order processing costs
Billing, collection and payment processing costs
Account receivable and carrying costs
Customer service costs
Selling and marketing costs
Customer cost analysis is the process of identifying the activities and cost drivers related to servicing customers. Traditionally these costs are hidden in the customer support, marketing and sales function. Activity based costing can help managers to understand their costs to...
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