Customer profitability analytics are an effective way to drive improvements in gross and net margins. This article looks at how distributors can apply the information they have uncovered to improving profitability.
Part 1 of this series covered the basic concepts behind customer and transactional cost analysis and presented some key limitations.
Once a company has a relatively accurate picture of customer profitability, how can they put that information to use? The first step is to share it. Too often companies treat contribution profit data as if it’s a state secret and then wonder why they’ve failed to see any benefit from their investment in obtaining it.
Every salesperson and customer service rep should be conscious of the relative profitability of their customers. They don’t need to know the president’s salary or size of the annual rebate checks, but they should have an understanding of where the company makes money and where it doesn’t. Often, just communicating is enough to generate improvements. When inside sales reps learn that some of their high-maintenance “star” customers are actually big-time losers, they think differently the next time one of those customers asks for a discount. Replacing anecdote with data can have a profound impact.
Beyond providing visibility, customer profitability data can be used to drive margin improvements in three broad categories:
- Account profit improvement plans (PIPs)
- Pricing optimization
- Services and channel alignment
Profit Improvement Plans
Of the three levers, profit improvement plans, or PIPs, are the most tactical and lowest risk. Each sales rep creates a set of target accounts for profit improvement. The process is similar to growth targeting, but the goal is to grow bottom-line contribution dollars rather than top-line revenue dollars. The rep reviews the profitability of her assigned accounts, identifies a small number of customers that she feels are good candidates for improvement, sets improvement goals for each and develops action plans to reach the goals.
As with a growth target, the objective is dollar improvement, not percentage improvement. A large account with a slightly negative contribution percentage may be a better target than a medium-sized customer that’s underwater.
Customer profitability data can guide the rep’s planning. If the gross margin is lower than that of comparable customers, the rep can consider adjustments in pricing or improvements in product mix.
The rep should also look for errors or inconsistencies in pricing matrices or contracts used for the customer. A powerful tool is the product gap or “Swiss cheese” report, which identifies “holes” in the product bundle purchased by the customer. The tool returns excellent results because it is based on data from internal peers. For example: “The average rep in our company sells $5 in safety products for every $100 in supplies from paper mills. You get less than $1.”
Profitable customers are rarely positive on every single line. They usually buy a mix of high- and low-margin items. If a customer is cherry picking, it’s probably not selecting high-margin items. I recently went through this exercise for a “strategic” account with a national sales manager. After looking at the data, he sheepishly concluded that they only “buy the stuff where we made a pricing mistake.” The rep had a frank conversation with the customer in which he gave them a choice of an across-the-board price increase or an agreement to buy more product categories. They chose the latter.
If the profitability data indicate the problem is high transaction costs, the rep can look into reducing the cost to serve. This is often a win/win proposition for the customer, as there are always two sides to a transaction. If a customer’s behavior is costing the distributor more, it’s probably costing the customer more, as well. Armed with this information, a sales rep is perfectly placed to
explain the difference between price and cost.
Offering operational discounts in conjunction with price increases can be a great tactic. For example, a sales rep may implement a 1 percent price increase but give a 1 percent discount on orders transmitted by EDI or via an automatic replenishment system. Some companies implement a delivery fee that is waived on the first order of each week, thereby encouraging order consolidation.
If the profitability data show a high cost to sell, then the rep may have a lot of control over the situation. In some cases the account may have significant growth potential, so extra sales time represents a worthwhile investment. In others, however, the rep may be over-servicing the account, making just-in-case sales calls or failing to fully leverage other company resources.
The sales manager can be a powerful coach for these situations. Perhaps the rep is afraid to lose control of the account and feels he can’t trust customer service to take their orders or the quotations department to provide job bids. One of the most common dynamics is that reps simply overestimate their personal influence on their large, annuity accounts and underestimate the opportunity cost of their time. Swinging by the plant buyer twice a week may just seem prudent until they realize that a sales call costs $250 and the buyer would rather get some work done.
Plugging Pricing Leaks
Profit improvement plans are a great approach for making customer-specific pricing improvements quickly. But to get broader margin gains, distributors often take a more systematic approach, embarking on large-scale projects to optimize their pricing levels.
Most readers are probably familiar with some approaches for using transactional data to implement sensitivity pricing. A customer is said to be sensitive to a price if a small change has a big impact on demand. With thousands of customers buying thousands of products, it is not usually feasible to analyze the sensitivity for each item bought by each customer. Some distributors use the frequency or dollar value of purchases as a starting point. The idea is that a customer will be less sensitive on the price of a product that he buys infrequently or one that constitutes a small portion of his total spending.
Using current customer profitability as the basis for pricing changes is dangerous, because it can lock in the existing customer base. Good customers are rewarded, and bad ones are punished.
Prospects and developing customers are usually among the least profitable because they require intensive sales effort and are not yet buying their full potential. Raising their prices is probably not going to accelerate their development. The right starting point for a large-scale price level optimization is needs-based segmentation (which will be covered in Part 3 of this series), not current profitability.
Although it’s not great for setting price levels, current profitability is helpful for improving pricing processes. Think of this as finding and fixing pricing leaks: The plumbing is there; it just needs to be patched. It’s quite common to see far higher margin gains from fixing these process leaks than from more grandiose sensitivity pricing projects.
With contrition and gross margin at the transactional level, they can be analyzed by customer. They can also be analyzed by pricing category (e.g., matrix, contract, override) and order writer (e.g., Frank, Mary, Branch 17, telesales). This provides plenty of data with which to find the major leaks.
Some of the most common leaks are:
Mental margin caps – Sales and customer service reps limit themselves to some arbitrary markup. Addressing the root causes of this type of thinking can yield huge benefits.
Last price paid (LPP) ratchet – Systems often show the last price a customer paid for a product rather than the “right” price. As a result, pricing travels one way: down. The customer calls Larry on the order desk and begs for a lower price “just this one time.” Larry obliges and the new, lower price
is now displayed on the order entry screen. Next time the customer calls Curly and requests another discount, which Curly agrees to do. The downward LPP spiral can be a major pricing leak.
Overly broad categories – If a customer negotiates a deep discount for a single item or set of products, don’t automatically give him that level on everything he buys. Limit contracts to the specific categories, conditions and time frames quoted. Keep discounts as narrow as possible. It sounds obvious but it’s often fastest for a sales rep to apply a single factor across the board. Make it just as easy to quote the right price as it is to quote a low price.
Ignoring existing contract rules – There are far too many examples of distributors negotiating fair and reasonable agreements with customers, only to have the key conditions ignored from day one. A simple, periodic audit is often sufficient to end this unnecessary unilateral disarmament.
This is not an exhaustive list of pricing process leaks, but it provides some ideas for how to use data to find the biggest sources of margin loss.
Service and Channel Alignment
There is often an unstated assumption behind profitability improvement projects: The sales force is just not trying hard enough. Once they’ve gained new business by low-balling, they never go back and raise prices. If we leave them in control of pricing, everything will be a loss leader. Many distributor executives complain that reps seem to work for their customers more than their employer.
Of course reps will use low prices if that’s the only way they can win. But they don’t want to undercut themselves any more than the executives do. More gross margin dollars from customers generally means more commission dollars for them. Most sales professionals would love to sell value instead of price, but they often have no way of doing so. Price is the only differentiator when competing suppliers are equal in all other aspects. Nine times out of 10 the race to the bottom is driven by a lack of market access, not the sales force’s laziness, incompetence or disloyalty.
Market access refers to how well sales, marketing and service resources are aligned with customer needs and market opportunities. It indicates whether a distributor is selling what the customer is actually buying. It is likely to be the single most important factor in determining a company’s overall profitability and long-term growth.
Market access is a strategic opportunity that can’t be delegated to the sales force. Executives have to make the decisions about how the company sells and services different customer segments.
Part 3 of this series will focus on how to use customer profitability analysis to improve your company’s market access.
Steve Deist is a partner with Indian River Consulting Group, a firm focused on market access for distributors and manufacturers. Contact him at email@example.com.