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BU247 Lecture 11-12

Tues. June. 18. 2013

Thurs. June. 13.

Chapter 6 Measuring and Managing Customer Relationships

Companies, in addition to costs of production, also incur marketing, selling,
distribution, and administrative (MSDA) expenses

Most of these expenses are independent of the volume and mix of products that
the company produces, so that they cannot be traced through causal
relationships to products

Many of these expenses are incurred through multiple distribution channels.

Customers and channels differ considerably in their use of MSDA resources.

Companies must understand the cost of selling through various channels to

diverse segments Extend ABC to trace MSDA expenses directly to customer
orders and to individual customers.

Metrics such as gross margins and product-line profitability can appear in the
financial perspective of the Balanced Scorecard (BSC), while the process
perspective can include metrics related to the costs of production and
purchasing processes.

if the only info that managers have about customers is financial performance,
then they may take actions that improve financial performance in ST but
damage LT customer relationships need both financial and nonfinancial
metrics to manage their performance with customers.

To balance the pressure to meet/exceed customer expectations, companies must

measure the cost to serve each customer and the profits earned

Ability to accurately calculate metrics (like % unprofitable customers) =

important for ABC in BSC

Example of Madison Dairy Measuring Customer Profitability

Madison Dairy has annual revenues of
3 million, and its MSDA expenses are
900k (30% of revenues). Madison has
2 important customers, Carver and
Delta, with about the same sales
revenue. Gene (divisions controller)
allocated MSDA expenses to
customers as a % of sales revenue, leading to the data on the right:

Gene believed that carver was more profitable customer than Delta, because
Carver ordered few products in large quantities, placed the orders predictable,

BU247 Lecture 11-12

Tues. June. 18. 2013

Thurs. June. 13.

and required little sales/technical support. However, Delta placed many small
orders for special products, required expedited delivery, and used many
technical resources.

When Gene launched an ABC tudy of the companys MSDA costs, he developed
capacity cost rates for all resourcs in the support departments (ex: accounts
receivable department). He estimated time demands on various resources o
obtain/process orders, distribute orders, and serve customers.

Gene found that Carver was more profitable than calculated in his previous
report, which allocated MSDA costs as a fixed % of revenues.

Characteristics of High and Low Cost-to-Serve Customers

Companies can make money with high CTS customers/ lose money with low CTS
customers, but the info on MSDA costs incurred for each customer is vital for
effective mgmt. of customer relationship

BU247 Lecture 11-12

Tues. June. 18. 2013

Thurs. June. 13.

Reporting and Displaying Customer Profitability

80-20 rule: 80% of land is owned by 20% of the population 80% of a regions
income/wealth was earned or held by the top 20% this applies to companies
products and customers too

when companies rank products and customers from highest volume to lowest,
they find that their top-selling 20% of products/customers generate 80% of total

40-1 rule: lowest volume 40% of products/customers generates 1% of total


The 80-20 law applies to sales revenues, but not profits.

Whale curve: graph of cumulative profits vs. customers, constructed from an

ABC customer profitability analysis customers are ranked on x-axis from most
to least profitable.

The most profitable 20% customers generate about 180% of total profits
(peak above sea level) the hump of a cumulative profitability curve
generally gits 150-250% of total profits by 20-40% of most profitable

Middle 60% of customers is about break even

Least 20% profitable customers lose 80% of total profits some of the
largest customers fall on the far right-hand side of the curve because theyre
among the most unprofitable. This is because small customers dont do
enough business with the company to incur large losses. Only large
customers demand high discounts and make demands on technical, sales,
etc. resources.

Large customers are usually the most profitable or the most unprofitable,
rarely in middle.

High-profit customers, such as Carver, appear in the left section of the

profitability whale curve should be cherished and protected. Managers should

BU247 Lecture 11-12

Tues. June. 18. 2013

Thurs. June. 13.

offer discounts, incentives, and special services to retain the loyalty of these
valuable customers

Customers like Delta appear on the right tail of whale curve, dragging
profitability down to sea level with low margins and high cost to serve
unpredictable order patterns, small order quantities for customized products,
nonstandard delivery requirements, & demands on technical/sales personnel.

The opportunity for a company to identify its unprofitable customers and the
transform them into profitable ones is perhaps the most powerful benefit that
managers can receive from an ABC system.

Customers Costs in Service Companies

Service companies must focus on customer costs and profitability (more than
manufacturing companies do) because variation in demand for resources is
much more customer driven

Customer independent: manufacturing company producing standard products

can calculate production cost without regard to how their customers use them
only the costs of marketing, selling, order handling, delivery, and service of the
products may be customer specific

For service companies, customer behaviour determines quantity of demands for


Measuring revenues and costs at customer level provides the company with
more relevant info than at the product level certain customers demand more
than others

Increasing Customer Profitability

Manufacturing and service companies can make breakeven/loss customers into
profitable ones:
1) Improve processes used to produce, sell, deliver, and service the customer

Examine internal operations to see where they can improve to lower costs

Ex: if most customers are migrating to smaller order sizes, strive to reduce
costs of setup and order handling so that customer preferences can be
accommodated without raising overall price

2) Deploy menu-based pricing to allow customer to select features/services to

receive/pay for

BU247 Lecture 11-12

Tues. June. 18. 2013

Thurs. June. 13.

Activity based pricing establishes a base price for producing a standard

quantity for each standard product provide menu of options with
associated prices

Pricing surcharges can be imposed when designing special variants for

customers particular needs; discounts can be offered when customers
order patterns lowers cost of supplying it

Activity based pricing prices orders, not products

3) Enhance the customer relationship to improve margins and lower the cost to

Managing customer relationships persuade them to use greater scope of


Establish minimum order sizes from unprofitable customers

Before taking action with a customer who has an unprofitable effect on one
product line, managers should understand all relationships it has with that
customer, and act on the basis of total relationship profitability, not just
based on profitability of a single product

Some customers may be unprofitable because it is the start of the

relationship with the company. The company may have incurred high costs to
acquire the customer, and the customers initial purchases may have been
insufficient to cover its acquisition and maintenance costs. No action is
required at this point. The company expects and hopes that the customers
purchases will increase and become profitable, including recovering any
losses incurred in the start-up years. Companies can afford to be more
tolerant of newly acquired unprofitable customers than they can of
unprofitable customers they have served for 10+ years.

4) Use more discipline in granting discounts and allowances


Pricing waterfall: chart that shows many revenue leaks from list price
cause by special allowances/discounts to build customer loyalty

Each small discount seems like small concession to get the order, encourage
sales, and receive prompt payment but can actually lead to huge revenue
leaks from original list price

Companies fail to see revenue leaks because they record allowances in

different systems and make revenue deductions at different times of the year
in different accounts

The volume discount may be refunded to the customer only once it

BU247 Lecture 11-12

Tues. June. 18. 2013

Thurs. June. 13.

accumulates enough volume to qualify, and its not linked back to individual
transactions that qualified for volume discount

Good to offer discounts to the low cost-to-serve customers

See page 230 for an example of discounts that companies incur

Now, more common to calculate income for every quarter for every customer

Profitability depends on whether and how much the net product margins
recover customer-specific costs. Mapping customer profitability:

The y-axis = gross margins from all products sold to the customer net
revenues minus discounts/allowances minus all costs of production for that
customer in that period from ABC system; represents cost of actual
demands of resources to produce products for that customer

X-axis = sum of all MSDA costs to serve the customer and processing orders

Customers above the diagonal line are profitable. Below = unprofitable, as

gross margins do not cover all costs required to MSDA the customer.

Top right corner: can spend a lot on customers transportation, technical

support, and service because of high gross margins on products sold to this

Top left: price insensitive; demand few discounts, low cost to serve
customers best type!

Bottom left: company can make money with highly discounter customer, as
long as cost of servicing that customer is low large purchasing volumes
may > low prices

Bottom right: problem because theyre large customer who demand big

BU247 Lecture 11-12

Tues. June. 18. 2013

Thurs. June. 13.

discounts and lots of customized services and technical support right hand
edge of whale curve try to move these customer to breakeven point or
profitability through menu-based pricing, product mix rationalization,
elimination of discounts/allowances, and standardizing packaging/distribution

Worst case scenario fire a customer by encouraging it to buy from another


Salesperson Incentives
Instead of having to repair damages from unprofitable customers, it would be
better to avoid them in the first place these unwanted customer relationships
occur because salespeople have incentives to generate sales, not profit
because of commissions and minimum quotas

Companies base salespeoples rewards on revenues because its a simple

measure. Also, companies recently developed ability to trace MSDA costs they
used to only focus on revenue, not profit

Companies now use info from ERP (enterprise resource planning) and CRM
(customer relationship mgmt.) software systems, to base salesperson incentives
on order and customer profits & sales

Salespeople still accept breakeven/loss orders to penetrate a new account or

keep a loyal customer happy, but they accept this for future benefit,
understanding that it may not be a profitable order

Life-Cycle Profitability
By knowing the characteristics of profitable customers, companies can direct
their marketing efforts/resources to specific segments that are most likely to
yield profitable customers

Due to high acquisition costs and time required to establish a good relationship
(ex: multiple product offerings), even attractive new customers may initially be

To calculate total life-cycle profitability, companies must distinguish economics

of their new customers from old customers recognize cross-sectional variation
of demands, and forecast the longitudinal variation of customers over time

Customer lifetime value (CLV):


assumes that you can estimate retention rate (r): probability of retaining a

BU247 Lecture 11-12

Tues. June. 18. 2013

Thurs. June. 13.

margin (Mt): total net revenues (after deducting discounts, promotions,

allowances) minus all costs to produce, market, distribute, and sell to the
customer in year t

ct = any additional costs-to-serve (and retain) customer in year t

customer lifetime value strategy: service companies invest money into new
customers because they want to become the lifetime provider for these
customers as they get good jobs and become successful company should
track each customer
1) initial acquisition cost
2) profits/losses earned each year
3) any additional costs incurred to retain the customer each year
4) the duration of the relationship

Some banks have analytic systems that allow them to estimate these
parameters based on the demographic characteristics of a potential/new
customer guide the banks promotion strategies and campaigns to attract
customers with the highest expected lifetime value.

RBC uses an analytic model of a customers future profitability based on age,

tenure with the bank, number of products/services already used at the bank, etc.
The bank assigns a personal account representative to its estimated high
lifetime value customers, ensures that their phone calls get picked up quickly,
and provides them with ready access to credit at attractive terms.

Measuring Customer Performance with Nonfinancial Metrics

ST metrics of customer cost and profitability may cause a company to take
actions that work well to improve customer profitability metrics, but risk LT
relationship with the customer so companies must supplement their financial
measurements with nonfinancial measures of customer relationship

BU247 Lecture 11-12

Tues. June. 18. 2013

Thurs. June. 13.

Customer satisfaction: companies survey recent purchaser of companys


Writing customer surveys requires specialized expertise to get valid responses

from a high % of customers mail surveys, telephone interviews, and
personal interviews

Some customer satisfaction surveys become public info ranking companies

may rank companies in similar industries there are correlations between
rankings and future stock price

Customer loyalty: customers attitude toward a product/company doesnt

readily translate into desired behaviour of repeated/increased purchases. Loyal
customers are valuable because
1) Greater likelihood to repurchase lower costs of retaining them than to
acquire new people
2) Loyal customers persuade others to become new customers
3) Loyal customers are less likely to defect when competitors offer lower price
similar products
4) more willing to pay price premium to retain a known/trusted relationship with
5) willing to collaborate with supplier to improve performance and develop new

In competitive industries (many substitutes, low cost of switching), only

customers who give the company the highest satisfaction (5 out of 5) are
likely to repurchase the companys product somewhat satisfied people
may decent to competitor

Measure loyalty directly by actual repeat purchasing behaviour use %

growth of business with existing customers and account share, which
represents a companys % of a customers spending in its product/service
category (ex: what % of my closet is from Forever21)

Another measure = % customers from previous period who make at least one
purchase per year

Companies that can identify customers can readily measure customer

retention between periods

Companies that cannot identify individual customers to measure retention

often invest in loyalty programs that provide incentives to customers to

BU247 Lecture 11-12

Tues. June. 18. 2013

Thurs. June. 13.

reveal themselves when they make purchases discounts for frequent


Companies may view their customer satisfaction/loyalty along a five-stage


1) Satisfied customers: measure = how well their expectations are met per
transaction/LT relationship
2) Loyal customers: measure= customer devoting an increasing share of wallet
for repeat purchases
3) Committed customers: purchase frequently from supplier and tell others
about supplier
4) Apostle customers: committed customers who have credibility when they
recommend to others
5) Customer owners: take responsibility for continuing success of the
suppliers product or service

Companies want stages 3, 4, and 5 higher customer ,lifetime value

Net Promoter score (NPS): helps measure whether customers have moved
beyond stage 2 above

Some researchers find low correlations between customer satisfaction scores

and future revenue growth customers often remain with current supplier
because of inertia, high switching costs, or current lack of an alternative

Willingness to recommend: the variable most strongly correlated with

future growth/profit how likely is it that you would recommend this
company to a friend/colleague = best question

A score of 9 or 10 for question above means the customers are promoters


A score of 7-8 means the customers are passively satisfied

A score of 1-6 means the customers are detractors: can harm reputation
and brand value

NPS: % customers who are promoters the % that are detractors

Median NPS across 400 companies in 28 industries on 130k survey responses

(1999-2002) = 16%

BU247 Lecture 11-12

Tues. June. 18. 2013

Thurs. June. 13.

Quite a few companies have negative NPSs, and since 2002, the average
NPS has dropped < 10%

Power of NPS is that for customers to make recommendations, company

must do 2 things:
1) Product/service must offer superior value for the money and they feel
good about the relationship thy have with the company
2) Customers are confident that the company will treat their friends well if
theres a problem