Customer Contribution Ranking
The new Gross Margin
“Eliminate the middleman and save!” I cringe every time I hear the phrase. Those of us in wholesale distribution know nothing could be further from the truth. Yet, this message constantly bombards our customers and suppliers. Distributor professionals more than ever need to understand our costs and recognize the complex inter-workings of our business. Our margins are under attack, and our business is getting more complicated. Back in the 1970s when many of us began our careers, life was simpler. National deals, supply contracts, buyers groups and amalgamated purchasing didn’t exist. The technology didn’t exist for our customers to easily compare prices. And the technology didn’t exist for us to compare our customers.
Today, distributor business system technology allows us to glean the data required to compare the true profit picture of our customer base. Viewed for the first time, the results may be surreal. Experienced sales managers will argue the results in total disbelief. The best of salespeople will question their very existence when their star account falls below the suitable profit line (or maybe into the loss category).
Customer contribution rankings allow us to evaluate whether a customer is an income generator or just an exercise. Thomas Jefferson wrote, “All men are created equal,” but all customers are not created equal. Since time immemorial, gross margin percentage reigned supreme as a customer measurement. We considered a customer with a gross margin of 31% to be “better” than a customer with 28%. Only a couple of years ago, a successful sales manager went on record as saying, “Give me a portfolio of small customers with high GM percentages. Those big guys always drive the gross margin percentage down.” Some of us may even have rewarded salesmen for bringing in high gross margin percentage accounts.
Times they are a changin’… Bob Dylan
Armed with a customer contribution ranking showing true profitability, we find that gross margin percentage doesn’t really tell the story. Trust me: When your staff hears this, there will be cries of heresy. Paradigms take time to break down. More importantly, when you prove these long standing-beliefs invalid, new ideas develop. Without the proper caution, the new ideas can drive unfortunate behavior. Together let’s explore some of the options available to us.
The Customer Contribution Ranking has five basic categories:
- Customers who generate significant revenue.
- Customers who generate some revenue.
- Customers who are break even.
- Customers who generate small negative revenue.
- Customers who generate major negative revenue.
You can further develop the list t to show the percent of total sales each customer turns into revenue. This provides strong new data for planning.
Beware the brave hearted among your ranks who will want to dash forward to “ax” the customers who generate loss. Distributors often make the mistake of first addressing the customers who generate major loss. Intuitively, this sounds great, but without experience and expertise, this can be tricky and mean. The easiest customers to work with are the middle-level customers. Can we somehow bring the profit contribution of the break even and small loss customers into the black?
There are two areas to explore to make this happen:
- Can we modify our practices to streamline dealings with the customer?
- Can we modify the habits of customers to make them easier to deal with?
There are many ways we can streamline our own practices to improve the profitability of a customer. Many distributors deliver orders on a daily basis. This equates to many man hours over the course of a year. By assigning a specific delivery day (i.e. Friday) and sending smaller rush orders via UPS, you develop an operational savings. Mailing a number of invoices in a single envelope is another example of streamlining the process.
Modifying the habits of customers provides another opportunity for moving a customer into the black. When one distributor did a customer profit analysis, they were surprised to find a favorite customer in the loss category. Keep in mind; this was a favorite customer with high gross margin percentage. Further, this customer was committed to the distributor. They purchased literally everything possible from the distributor’s company. Yet, they were not profitable. The salesperson assigned to the account found the whole thing impossible to believe and discounted the whole process until he saw all the facts.
As we reviewed the situation, we found that this customer did not use a purchasing department. Instead, their engineers and technicians phoned in orders as they discovered the need. Technical folks channeled literally dozens of calls per day to the distributor’s inside sales people. Each of these calls resulted in a very small order, a separate box, a separate shipping document and a separate invoice. Results? Huge transaction costs.
We did a number of discovery meetings with the customer. It became apparent that their own process was costing them plenty, too. Remember, they had a gigantic number of packages to receive – their own receiving department called the daily shipments “Santa’s Sleigh” because it contained so many small packages with a single part enclosed. The answer: Develop a system for consolidating orders and doing a daily fax order with all of the needs the customer generates. We did this with ease by setting up a daily order sheet near the fax machine. Engineers added their needs to the list, faxing and invoicing on a daily basis. We handled emergency stuff and expedited orders via phone, but the use of a fax order allowed a low-skill customer service rep to enter their purchases rather than a senior inside salesperson. And, as many have already determined, you can use a fax order to “fill in” during slack times.
What about the most profitable guys?
Use of the data can also improve customer segmentation. Now we know who the good guys are. We have set processes in place to further endear ourselves to them. We put the best of our salespeople, inside sales, technical support and customer service directly in their service. We use this information to establish targets. Newly published research indicates that organizations that are excellent targeters are 47% more effective in reaching their financial goals. One of the first steps in establishing successful targets lies in determining what types of customers are the most profitable. Without the information we described above, determining the right targets is only a guess.
Certain types of customers will prove to provide strong return on investment regardless of their size. With further investigation, you can answer the question, “what kinds of customers provide you with the best overall targets?” For instance, some distributors have been pleasantly surprised to find that they had multiple opportunities to pursue large, untouched segments of customers based on the data from a dozen or so similar accounts that all scored near the top of their customer contribution ranking based on percentage of return.
But, should we fire our money losing customers?
A question that inevitably comes up when organizations begin exploring their customers by profit contribution is; should I fire the negative profit customers? I can still recall the damage done when one young branch manager called a special meeting of his negative profit customers. He personally invited a group of 20 or more customers into a conference room where he explained that their business had been a drag to his ability to make money and said they were no longer welcome in his business.
What he didn’t take into consideration was customers change and customers talk. After the smoke cleared, the competition had a field day with the statement. To this day (and it has been several years), the distributor organization still smarts from some of the repercussions.
What should he have done with these customers? When I was a kid growing up in small town America, the saying was, “There is more than one way to skin a cat.” There is a right way and a wrong way to work with the negative income customers. Evaluate the customer.
Is it negative value because you have only a fraction of their business? If so, invest in growing your volume. Do other customers with similar businesses fall well above the profit contribution line? If so, explore the critical differences. Sometimes, the difference between profit and loss comes from sloppy habits within your own organization.
If there is no chance of improving volume (and turning the profitability corner), the suggestion is raising their price. A higher price equates to immediate lower loss and, ultimately, the customer may take his/her loss-producing business to a competitor (which isn’t a bad thing either). If things change, you can still go back hat in hand and work on getting the business. Other cost-cutting measures for this customer would be:
- Remove any discount terms.
- Set a minimum order size.
- Charge for deliveries.
- Remove any sales support.
- Begin charging for technical support.
- Assign this class of customer to the lowest skill customer service rep.
All of these allow you to better channel your resources to the best of customers. If the customer continues to do business with you in your new stripped down service, you may find your next analysis shows the customer in the black.
This is a process, not a silver bullet. And, it is a slow process to boot. Changes in customer ranking take multiple years to come to fruition. Contrasting customer profit contribution over multiple years allows you to re-engineer your own business. Subsequent iterations of the customer contribution rank will provide metrics for growth and profitability.
A couple of closing thoughts
The right information leads to better decisions. I often assist organizations in setting strategies for counter sales. As we discuss strategy, distributor managers will state that their counter traffic is a great money maker because its gross margin tracks five or six points higher in gross margin percentage. The statement should be, “Our counter is designed so that business flows with little or not employee involvement” or “our counter opens the door to other profitable business.” Gross margin doesn’t tell the story. Understanding the contribution of every customer does tell the story. Don’t be surprised if you find a need to revamp the way you run your counter.
In discussions with the manufacturing partners of distribution, I hear a common complaint. Distributors want more margin than they deserve. We discuss PAR reports. We share analogies, yet the same story keeps cropping up. Distributor councils meet and talk about fair margin. The manufacturer asks, “What is a fair margin for this new type of business?” The answer that comes back is always the same as the current margin. If we are to redesign the way we do business in the future, both parties need to understand the cost of everything. Gross margin was a good discussion point in 1977, but is it still the best measure in 2007? Understanding the contribution of individual customers leads to understanding what you will need to service each customer segment. Understanding customer activity cost of everything leads to good decisions. This is good for distributors and good for our manufacturer partners.
Frank Hurtte (email@example.com) is a consultant to distribution, the sales channel and manufacturer’s agents at River Heights Consulting. He has 28 years of real world experience and is available as a speaker and executive coach. River Heights has developed “a baker’s dozen of strategies to move customers into the profit zone.” It is available, for the asking. Send us a quick email.