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 |
|||
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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