Activity-based management (ABM)

3.2. Customer profitability analysis

Customer profitability analysis combines customer cost and customer revenue analyses and provides information used to determine the value of customers. The information provided by customer profitability analysis helps to understand the customer's industry and its growing potential, customer reactions to changes in selling prices and sales terms, and customer life-time value.

Customer life-time value (CLV) is the net present value of all estimated future revenues from the customer.

For example, assume Friends Company estimates that its customer Motor, Inc. will produce profits of $60,000 per year for the next four years. Using an assumed discount rate of 7%, the CLV for Motor, Inc. is 3.387 x $60,000 = $203,220 (i.e. the factor of 3.387 can be obtained from the Present Value table; n = 4 and i = 7%).

Now let's calculate the net customer profit for the Friends Company's customers.

Friends Company
Customer Profitability Report
For the Year Ending December 31, 2009

 

AutoCo

Motor, Inc.

Fast Bike LLC

Total sales

$ 100,000

$ 360,000

$ 450,000

Less: Sales discounts

2,000

8,000

14,000

Net invoice amount

98,000

352,000

436,000

Less: Sales returns and allowances

12,000

15,000

65,000

Net sales

86,000

337,000

371,000

Cost of goods sold

56,000

260,000

302,000

Gross margin

30,000

77,000

69,000

Customer costs:

     

Order taking

175

400

1,100

Order processing (per order), total

126

288

792

Order processing (per item), total

4,375

7,600

8,250

Delivery (per order), total

840

1,920

5,280

Delivery (per mile), total

140

560

2,024

Expedited delivery

-

600

3,600

Customer visits

160

320

640

Monthly billing (1st statement)

6

6

6

Monthly billing (reminders), total

-

15

60

Sales returns

160

240

960

Restocking

300

510

1,200

Total customer cost

6,282

12,459

23,912

Net customer profit

$ 23,718

$ 64,541

$ 45,088

Looking at the table above, we can see that Motor, Inc. is the best customer out of the three. The reason Motor, Inc. is a more profitable customer for Friends Company than Fast Bike LLC is because Motor, Inc. has less favorable sales terms and returns fewer items. In addition, if we look at the customer cost analysis, Fast Bike LLC has more expedited orders than other customers, many returns, a few billing reminders (i.e. late payments), and higher delivery costs.

Therefore, even though Fast Bike LLC generates the highest net sales, it is not the most profitable customer for Friends Company. Friends Company should look into the reason for the high returns from Fast Bike LLC and its late payments (e.g. either a weak financial condition or dissatisfaction with the Friends Company's products or customer service). Finally, Friends Company should look into changing the delivery terms for Fast Bike LLC or negotiate the number of items per order: Fast Bike LLC orders relatively small number of items per order, which increases the number of orders, and thus, the delivery costs to the customer.

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