focus on customer profitability

Focus On

CUSTOMER PROFITABILITY

After studying this focus unit, you should be able to meet the following learning objectives (LO).

1 Use activity-based costing

techniques to measure

customer profi tability.

Identify alternatives for

managing unprofi table

customer accounts.

2

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401

Terrence Gleason and Beth Wommack sat in the main conference room at Bradley Textile

Mills, chatting as they waited for the monthly sales staff meeting to begin. “I thought I was

going to be late,” Beth said. “Taylor Byrd from Sparrow Designs just called with another rush

order; I don’t know why they can’t plan any better. All their orders seem to be rush jobs.”

“Well, they generate almost $2 million in revenue for us, so we need to keep them

happy,” Terrence responded.

“I know, I know, but they take up so much of my time. I think I spend more time with

them than with all my other customers combined,” said Beth. “At least they’re really nice

to work with,” she added.

As the meeting began, Lindsay Stang, vice president for marketing and sales, announced

that the top brass at Bradley Textile Mills wanted a complete review of all sales accounts.

“Selling expenses have been growing rapidly—faster than sales—and management wants

to know where all those dollars are going. I told them it’s a cost of doing business and keep-

ing our customers happy,” Lindsay said. “Apparently, the chief fi nancial offi cer just returned

from a conference on customer profi tability. He claims we don’t really know which customers

are making money for us and which are costing us more than they generate in revenues.

There’s no point arguing with him. If we want to continue to get the fi nancial resources we

need, we’re going to have to demonstrate that our customers are profi table.”

The Pitch

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Customer Profi tability

Answering the following questions while you read this unit will guide your understanding of the key concepts found in the unit. The questions are linked to the learning objectives presented at the beginning of the focus unit.

1. What kinds of costs do companies incur in making sales to customers? LO 1

2. Why are selling costs pooled and allocated to customers rather than directly traced to customers? LO 1

3. How do you calculate customer net profi t? Customer profi t margin? LO 1

4. Give an example of customers who tend to drive up a company’s costs? Explain. LO 1

5. What can a company do if it has identifi ed customers who are unprofi table? LO 2

6. Why might a company decide to keep a customer who is unprofi table? LO 2

GUIDED UNIT PREPARATION

Many organizations believe that as long as the sales revenue a customer generates exceeds the cost of goods sold, that customer is profi table. That isn’t the case, however. Measuring customer profi tability in this way ignores all the selling and administrative costs incurred to provide customer service and support, such as warehousing, billing, and order processing. In this focus unit, you will learn how to measure customer profi tability more accurately.

In their book Killer Customers, Larry Selden and Geoffrey Colvin estimate that the top 20% of a company’s customers generates approximately 120% of the company’s profi ts, while the bottom 20% loses as much as 100%.1 This fi nd-ing highlights the importance of identifying the unprofi table customers and fi nd-ing ways to make them profi table. If unprofi table customers cannot be turned into profi table ones, the company should consider dropping them.

Identifying Unprofi table CustomersWhen asked if their companies have unprofi table customers, many managers claim they do not. When Bradley Textile Mills’ sales manager, Terrence Gleason, was asked this question, he quickly pulled out the customer profi tability report shown in Exhibit F5-1. “Granted, some of our customers are more profi table than others,” he replied, “but all 375 of our customers are profi table at some level.”

The problem with Gleason’s analysis was that the only expense it considered was the cost of goods sold. A business also incurs selling and administrative expenses. Recall from Chapter 4 that selling expenses are associated with the storage, sale, and delivery of products to the customer. Administrative expenses are associated with the general management of the business. When we examined activity-based costing in Chapter 7, these costs were not included in our analysis, since they are not considered product costs. However, in addition to covering the cost of the product, the revenue a customer generates should also cover the

402 Focus On Customer Profi tability

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selling costs associated with the purchase and provide enough margin to pay for administrative expenses and contribute to profi t.

What can managers do to get a better estimate of customer profi tability? One way is to allocate selling expenses to customers through activity-based costing (see Chapter 7) using the following steps:

1. Identify selling activities.

2. Develop activity cost pools.

3. Calculate activity cost pool rates.

4. Allocate selling costs to customers.

5. Calculate customer profi tability.

Let’s look at the selling costs incurred by Bradley Textile Mills. As Exhibit F5-2 shows, the company incurred $16,815,000 in selling costs last year. After iden-tifying all selling activities, Terrence Gleason’s group narrowed the list down to seven main activities. Then they developed seven cost pools and selected an activity driver for each. By dividing each cost pool by its annual driver activity, the company can determine the cost pool rates. For example, the company in-curs an annual cost of $3,200,000 to make 3,200 sales calls to current and potential customers. That is $1,000 per sales call ($3,200,000 4 3,200). Once

Customer Profi tability 403

EXHIBIT F5-1 Bradley Textile Mills’ customer profi tability.

BRADLEY TEXTILE MILLSCustomer Profi tability

(Based on Cost of Goods Sold)

Profi tability Rank Customer Revenues Cost of Sales Gross Profi ta Profi t Marginb

1 Morris & Morris $ 4,819,150 $ 3,585,455 $ 1,233,695 25.6%

2 Sparrow Designs 1,978,812 1,484,109 494,703 25.0%

3 Harps of London 168,600 126,450 42,150 25.0%

4 Gold’s Upholstery 482,000 361,982 120,018 24.9%

5 Unique Uniforms 2,098,915 1,580,483 518,432 24.7%

6 C&C Sports 1,540,951 1,163,418 377,533 24.5%

7 MedTogs 4,154,500 3,157,420 997,080 24.0%

8 Florstan 67,200 51,408 15,792 23.5%

.

.

.

368 House of Drew 879,520 835,544 43,976 5.0%

369 Mullins and Jones 164,826 157,244 7,582 4.6%

370 Potter Drapery 94,608 90,256 4,352 4.6%

371 Huffmeyer Mills 648,425 622,488 25,937 4.0%

372 Mooney Productions 540,895 520,340 20,555 3.8%

373 Dawson Shade 64,572 62,183 2,389 3.7%

374 Shadowbox Supply 267,400 262,052 5,348 2.0%

375 Ralston Fabrics 349,800 342,804 6,996 2.0%

Total $200,000,000 $172,000,000 $28,000,000 14.0%aRevenue – Cost of salesbGross profit

Revenues



Think About It F5.1

Why aren’t administrative costs included in these selling cost activity pools?

all the activity rates have been calculated, Gleason can use the information shown in Exhibit F5-2 to allocate selling costs to customers and calculate cus-tomer profi tability.

Two different calculations can be made to measure customer profi tability: customer net profi t and customer profi t margin. Customer net profi t starts with the revenues the customer generates and subtracts both the cost of goods sold associated with those revenues and the selling expenses allocated based on the customer-specifi c selling activities. This measure shows managers how many dollars a customer contributes to the company’s bottom line. Customer profi t margin divides customer net profi t by customer revenues to obtain the profi t percentage the customer generates for the company. The customer profi t margin allows managers to compare customers based on how much each dollar of rev-enue they generate goes to the bottom line, regardless of the customers’ absolute sales volume.

Customer net profit = Customer revenues – Cost of goods sold – Allocated selling expenses

Customer profit margin =

Customer net profit

Customer revenues

Let’s use Morris & Morris, Bradley’s most profi table customer according to Gleason’s analysis, to show how to measure customer profi tability. As Exhibit F5-1 shows, based solely on cost of goods sold, last year Morris & Morris pro-vided a 25.6% profi t margin. Exhibit F5-3 shows an activity-based profi tability analysis for this customer. Notice that Morris & Morris generates a customer net profi t of $1,045,895 on sales of $4,819,150, which translates to a 21.7% profi t margin. Even though the customer profi t margin is lower than Gleason fi rst thought, Morris & Morris is still a very profi table customer for Bradley Textile Mills.

Annual Driver Activity Cost Activities Annual Cost Activity Pool Rate

Sales calls $ 3,200,000 3,200 sales calls $1,000 per call

Internet orders 2,600,000 130,000 orders $20 per order

Catalog orders 2,925,000 45,000 orders $65 per order

Standard packing and shipping 5,000,000 50,000,000 yards $0.10 per yard

Support call center 480,000 960,000 minutes $0.50 per minute

Product returns 210,000 600 returns $350 per return

Express packing and shipping 2,400,000 800,000 yards $3.00 per yard

$16,815,000

EXHIBIT F5-2

Calculation of cost pool rates for selling activity.


How does that customer profi t margin compare to Bradley’s average cus-tomer profi t margin? We can calculate the average customer profi t margin using the numbers for the company as a whole (see Exhibit F5-1):

Revenues $200,000,000 Cost of goods sold 172,000,000

Gross margin 28,000,000 Selling expenses (Exhibit F5-2) 16,815,000

Customer net profi t $ 11,185,000

Customer profi t margin 5.6%

No wonder the chief fi nancial offi cer wants to review the accounts (see The Pitch). Administrative costs still need to be paid from the $11,185,000 net profi t, so Bradley’s net income is likely to be very low. With a customer profi t margin of 21.7%—well above the average customer margin—Morris & Morris is a real winner for Bradley.

A different picture emerges from an analysis of Bradley’s number two customer, Sparrow Designs. Gleason believes that Sparrow generates a 25% profi t margin, but an activity analysis of the resources Sparrow Designs consumes, presented in Exhibit F5-4, shows otherwise. Gleason may need to reconsider his plans for this cus-tomer. What he thought was a 25.0% profi t margin is really a 0.2% loss (($3,547) 4 $1,978,812). For every dollar in sales, Sparrow costs the company $1.02.

Sales $4,819,150

Cost of goods sold 3,585,455

Gross profi t 1,233,695

Selling costs

Sales calls 12 calls 3 $1,000 per call 12,000

Internet orders 1,000 orders 3 $20 per order 20,000

Catalog orders 10 orders 3 $65 per order 650

Packing and shipping 1,230,000 yards 3 $0.10 per yard 123,000

Call center support 100 minutes 3 $0.50 per minute 50

Product returns 6 returns 3 $350 per return 2,100

Express shipping 10,000 yards 3 $3.00 per yard 30,000

Customer net profi t $1,045,895

Customer profi t margin $1,045,895 4 $4,819,150 21.7%

EXHIBIT F5-3

Activity-based profi tability analysis for Morris & Morris.

EXHIBIT F5-4

Activity-based profi tability analysis for Sparrow Designs.

Sales $1,978,812

Cost of goods sold 1,484,109

Gross profi t 494,703

Selling costs

Sales calls 6 calls 3 $1,000 per call 6,000

Internet orders 0 orders 3 $20 per order 0

Catalog orders 230 orders 3 $65 per order 14,950

Packing and shipping 400,000 yards 3 $0.10 per yard 40,000

Call center support 3,000 minutes 3 $0.50 per minute 1,500

Product returns 28 returns 3 $350 per return 9,800

Express shipping 142,000 yards 3 $3.00 per yard 426,000

Customer net profi t ($3,547)

Customer profi t margin ($3,547) 4 $1,978,812 (0.2%)




Addressing Unprofi table CustomersNow that the managers of Bradley Textile Mills have a better understanding of each customer’s profi tability, they must decide what to do with the information. Recall from your study of activity-based management (Unit 7.3), that to the ex-tent possible, non-value-added activities should be eliminated. Because most of these activities are generated by the customer, we can assume that they have some value to the customer, but managers need to investigate other, less costly ways to deliver the service. Drastically reducing the activities would not be a viable option. Customers generally want good service, and developing a reputation for good customer service is one way for a company to differentiate itself from its competitors. Therefore, we cannot expect selling costs to be reduced to some nominal level. For purposes of this discussion, we will assume that Bradley Textile Mills is delivering customer service as effi ciently and effectively as possible.

Think About It F5.2

The customer profi tability analyses in Exhibits F5-3 and F5-4 assume that cost of goods sold is the only direct cost, and all selling expenses are indirect (that is, they need to be allocated). What selling expenses might be traced directly to the customer?

After following these same steps for each customer, Gleason obtained the customer profi tability analysis shown in Exhibit F5-5. Now he cannot claim that all Bradley’s customers are profi table.

EXHIBIT F5-5

Activity-based customer profi tability analysis for

Bradley Textile Mills.

Cost of Selling Customer Customer Customer Revenues Sales Costs Net Profi t Profi t Margin

Morris & Morris $4,819,150 $3,585,455 187,800 $1,045,895 21.7%

Sparrow Designs 1,978,812 1,484,109 498,250 ($3,547) 20.2%

Harps of London 168,600 126,450 8,100 34,050 20.2%

Gold’s Upholstery 482,000 361,982 44,835 75,183 15.6%

Unique Uniforms 2,098,915 1,580,483 65,015 453,417 21.6%

C&C Sports 1,540,951 1,163,418 57,030 320,503 20.8%

MedTogs 4,154,500 3,157,420 204,400 792,680 19.1%

Florstan 67,200 51,408 20,495 (4,703) 27.0%

.

.

.

House of Drew 879,520 835,544 32,625 11,351 1.3%

Mullins and Jones 164,826 157,244 1,560 6,022 3.7%

Potter Drapery 94,608 90,256 5,234 (882) 20.9%

Huffmeyer Mills 648,425 622,488 31,087 (5,150) 20.8%

Mooney Productions 540,895 520,340 207,800 (187,245) 234.6%

Dawson Shade 64,572 62,183 1,578 811 1.3%

Shadowbox Supply 267,400 262,052 37,337 (31,989) 212.0%

Ralston Fabrics 349,800 342,804 70,100 (63,104) 218.0%


At fi rst glance, it may appear that all unprofi table customers should be dropped, and that is exactly what some companies do. However, that is not the fi rst action a manager should take after identifying an unprofi table customer. Before any action is taken, managers should evaluate all the implications of the action for the affected customer, for other customers, and for the company.

Rather than drop an unprofi table customer, managers should fi rst identify the reason the customer is unprofi table and then work with the customer to re-turn to profi tability. Let’s look at Sparrow Designs again. Exhibit F5-4 shows the activities performed to support this customer. Does anything look out of the or-dinary to you? Do you see any opportunities for cost reduction? One that should jump out at you is express shipping, which consumes over 86% of Sparrow’s gross profi t. Perhaps Beth Wommack, Bradley’s customer service representative, can work with Sparrow’s managers to encourage them to order earlier or in larger quantities, to avoid the need for express shipping.

Another opportunity for improvement is order placement. Notice that Sparrow places all its orders through the catalog sales channel rather than the cheaper Internet sales channel. Again, Beth could educate Sparrow’s purchasing agents on the benefi ts of Internet ordering, which would reduce the cost to serve Sparrow while still meeting the company’s needs. That is what managers at Fidelity Invest-ments did when they discovered how frequently some unprofi table customers called Fidelity’s customer service representatives. Representatives instructed the customers in how to use the company’s website—a much cheaper delivery method for Fidelity. As customers became more comfortable with the technology, their satisfaction increased, and unprofi table customers turned into profi table ones.

Cell phone customers have long complained about dropped calls. Now, some of those customers may be complaining about another kind of dropped call. In 2007, Sprint Nextel dropped about 1,000 customers because of their excessive use of customer service. After reviewing the customers’ accounts over a 6- to 12-month period, Sprint concluded that they averaged 40 to 50 calls to customer service per month. At an average cost of $10 to $20 per call, canceling their accounts could have saved Sprint $400,000 to $1,000,000 per month—if the company reduced customer service personnel. What is more likely is that the freed-up resources were deployed to other customer service activities. While Sprint may not have realized any true savings as a result of dropping the customers, the company may have improved its customer service image by handling other customer calls in a more timely manner.

Sources: Barry Levine, “Sprint Saves Cash by Cutting Customers,” http://www.crm-daily.com/story.xhtml?story_id=100001VW8F08 (accessed July 16, 2007); Samar Srivastava, “Sprint Drops Clients over Excessive Iinquiries,” The Wall Street Journal, July 7, 2007; David Twiddy, “Sprint Nextel Defends Axing Customers,” http://www.crm-daily.com/story.xhtml?story_id=100001VW8BUC (accessed July 16, 2007).

In 2007, Sprint Nextel dropped about 1,000 customers because of their excessive use of

customer service.

Reality Check—Sprint drops more than a call




Customer profi tability can also be improved by raising the prices unprofi t-able customers pay. If customers are using a service, they should value it enough to pay for it. For example, Terrence Gleason might consider charging Sparrow for express shipping. The same could be required of customers who order in small quantities that require warehouse workers to select and pack individual items rather than ship a full case. Prices for such customers may be higher than for customers whose orders require less handling.

Raising prices for these customers is not a punishment for their unprofi tabil-ity; it is merely a refl ection of the cost of doing business with them. If the cus-tomer accepts the price increase or stops requiring costly activities, the company has turned an unprofi table customer into a profi table one. If the customer rejects the price increase and buys from a competitor, the company will be better off fi nancially. All other things held equal, either result will improve the company’s profi tability.

Perhaps not all customers can be returned to profi tability. If a customer re-mains unprofi table after efforts have been made to increase profi tability, man-agers may reluctantly decide to drop the customer. Doing so will increase the company’s overall profi tability, even though total sales revenue will decrease. Managers then will have more resources with which to serve profi table custom-ers, and overall sales may eventually increase.

Just as we saw in Chapter 7, however, the company cannot increase its profi t-ability simply by dropping a customer. To increase the company’s overall profi t-ability, the resources used to serve the unprofi table customer must be divested. If Bradley Textile Mills decides to eliminate some of its unprofi table customers but does not eliminate the resources (people and supplies) used to serve those customers, the remaining costs will be redistributed to other customers, reduc-ing their profi tability, even though there has been no change to Bradley’s overall profi tability.

Think About It F5.3

What kind of impact might product demand have on your strategy for improving customer profi tability?

F O C U S R E V I E W

KEY TERMSCustomer net profi t p. 404 Customer profi t margin p. 404

SELF STUDY QUESTIONS

1. LO 1 If you add up all a company’s customer profi t margins, the total will equal net income. True or False?

2. LO 1 Which of the following selling expenses would be traceable directly to a customer?

Commissions based on the sales amount

Invoice processing

Technical support

Returns processing

a.

b.

c.

d.


3. LO 2 The only way to recover the losses from an un-profi table customer is to stop selling to that customer. True or False?

4. LO 2 Which of the following will not increase a company’s net income, all other things held equal?

Reducing the resources dedicated to serving a customer

a.

Dropping a customer with a 2.5% customer profi t margin when the average customer profi t margin is 6%

Persuading a customer to accept an inexpensive activity rather than an expensive activity

All these actions will increase the company’s net income

b.

c.

d.

FOCUS 5 PRACTICE EXERCISECompass Directives prints road maps of major cities and distributes them to bookstores, convenience stores, and gas stations. Each map costs $1.30 to produce and is sold to retail outlets for $2.00. Sales to three of Compass’s best customers last month were as follows:

BookMasters 20,000 mapsPrice’s QuikStop 15,000 mapsFastLanes 12,000 maps

Jason Paul, Compass’s sales manager, has gathered the following information concerning the company’s sales support activities:

Total Annual Costs Annual Activity Level

Small-quantity bundling $400,000 50,000 bundlesOrder processing 840,000 200,000 ordersDisplay setup 238,000 1,000 setupsDisplay replenishment 110,000 20,000 replenishments

As part of the study, Paul also calculated the following data on monthly usage of sales support services by the top three customers:

Small Bundles Orders Display Setups Display Replenishments

BookMasters 400 400 25 100Price’s QuikStop 20 100 5 10FastLanes 10

RequiredCalculate an activity rate for each of the four sales support services.Calculate the customer net profi t and customer profi t margin for each of the top three customers.What actions could Paul suggest that BookMasters take to increase its profi tability?

1.2.3.

Focus Review 409

SELECTED FOCUS 5 ANSWERS

Think About It F5.1Administrative costs, which are related to running the entire business, include rent (or depreciation) on the corporate offi ce building, the president’s salary, and fi ling expenses for tax returns and other corporate documents. Though

customers benefi t from these organizational expenditures, allocating such costs to customers is not practical. You may recall that general overhead costs were treated the same way in Chapter 7.

Think About It F5.2Commissions on sales and shipping cost per unit are examples of direct selling expenses.

Think About It F5.3When demand for a company’s products and services is greater than the supply, managers are not likely to be con-cerned about dropping customers. In a highly competitive environment, however, managers must carefully weigh the implications of charging for services that were once con-sidered free. If customers can get the services they want

from another company, they may be quick to leave, and other customers may not replace them. Losing those cus-tomers could require more than simply cutting back on selling and administrative resources. If total sales decline as a result, it may require cutting back on production.



Self Study QuestionsFalse

A

False

B

1.

2.

3.

4.

After performing a profi tability analysis of all 375 customers, Terrence Gleason understood

that there was more to understanding a customer’s profi tability than gross margin. He real-

ized that some customers, such as Morris & Morris, remained profi table after considering

customer service costs. Others, such as Sparrow Designs, were unprofi table.

The Wrap-up

3. BookMasters consumes many more activities than the other two customers, even allowing for the number of units the company purchases throughout the year. Display setups, replenishment, and small-quantitybundling seem to be special services that BookMasters values more than other customers. Paul needs to fi nd out whether BookMasters values these services enough to pay a premium for them, or whether the level of service can be reduced without losing BookMasters’

business. To bring BookMasters’ requirements in line with those of other customers, Paul may want to es-tablish a standard order size. If BookMasters values small orders (probably because they eliminate excess inventory), Paul might consider adding a surcharge for this service. However, before Paul changes the pricing or order size, he should determine what services com-petitors offer and the impact that such changes would have on existing customers.

Focus 5 Practice Exercise1. Total Annual Costs Annual Activity Level Activity Rate

A B A 4 B

Small-quantity bundling $400,000 50,000 bundles $8.00 per bundle Order processing 840,000 200,000 orders $4.20 per order Display setup 238,000 1,000 setups $ 238 per setup Display replenishment 110,000 20,000 replenishments $5.50 per replenishment

BookMasters Price’s QuikStop FastLanes

Unit Price/ Revenue/ Revenue/ Revenue/ Cost Units (Cost) Units (Cost) Units (Cost)

Revenues $ 2.00 20,000 maps $ 40,000 15,000 maps $ 30,000 12,000 maps $ 24,000Cost of goods sold $ 1.30 20,000 maps (26,000) 15,000 maps (19,500) 12,000 maps (15,600)Small-quantity bundling $ 8.00 400 bundles (3,200) 20 bundles (160) 0 bundles 0Order processing $ 4.20 400 orders (1,680) 100 orders (420) 10 orders (42)Display setup $238.00 25 setups (5,950) 5 setups (1,190) 0 setups 0Display replenishment $ 5.50 100 replenishments (550) 10 replenishments (55) 0 replenishments 0Customer net profi t $ 2,620 $ 8,675 $ 8,358Customer profi t margin 6.55% 28.92% 34.83%

2.


Gleason examined the activities required to service the unprofi table customers to identify

ways to move them to profi tability. He encouraged Sparrow’s Taylor Byrd to begin using

Internet orders instead of catalog orders and to order with enough lead time to avoid

express shipping services. He also informed Byrd that should Sparrow continue to require

express shipping services, there would be an additional charge to cover the higher shipping

cost. Byrd’s initial reaction to these changes was favorable.

At this point, Gleason wasn’t ready to make drastic changes for all customers, how-

ever. He knew that alienating customers or changing the way the company provides

service could well have a detrimental effect on the company’s reputation for high-quality

products and excellent customer service. Gleason wanted to study the services Bradley

provides to customers and compare them to competitors’ services. He also wanted to

monitor Sparrow’s activities closely for a couple of months to see how the changes

affected customer profi tability. Only after he feels reasonably confi dent that he can

anticipate customers’ reactions will he make sweeping changes to Bradley’s selling

activities.

F O C U S S U M M A RY

In this focus unit you learned how to evaluate customer profi tability. Specifi cally, you should be able to meet the objectives set out at the beginning of this chapter:

1. Use activity-based costing techniques to measure customer profi tability.

To use activity-based costing techniques for measuring customer profi tability, a com-pany should follow these fi ve steps for allocating selling expenses to customers:

Step 1. Identify selling activities.

Step 2. Develop activity cost pools.

Step 3. Calculate activity cost pool rates.

Step 4. Allocate selling costs to customers.

Step 5. Calculate customer profi tability.

2. Identify alternatives for managing unprofi table customer accounts.

Companies that fi nd they have unprofi table customers might try to manage those accounts in the following ways:

• Reduce the customer’s use of selling activities.

• Add a service charge for certain selling activities or the excessive use of selling activities.

• Stop providing the service to the customer.

E X E R C I S E S

F5-1 Identify activities (LO 1) Place an “X” in the columns to indicate whether each of the following the activities would be included in a bank’s customer profi tability analysis.

Exercises 411



F5-2 Identify activity drivers (LO 1) Williams Enterprises is a small, locally owned provider of network services. Brian Williams, CEO, has considerable experience in the indus-try and knows that certain customers can run a company out of business. He has determined that the following customer activities are the major ones in which the company engages:

Establishing new customers and new ordersInstalling new systemsProcessing customer invoicesMaking service callsCustomer training

RequiredIdentify an activity driver for each of the major activities.

F5-3 Identify high-cost activities (Adapted from Robert S. Kaplan and V. G. Narayanan, “Measuring and Managing Customer Profi tability,” Journal of Cost Management, 15, no. 5 (September/October 2001): 5–15.) (LO 1) Customer profi tability is infl uenced by the activi-ties that customers consume. Indicate whether each activity listed in the following table would be associated with a high cost-to-serve customer or a low cost-to-serve customer.

a.b.c.d.e.

INCLUDED NOT INCLUDED

a. Opening a bank account

b. Supporting an online banking system

c. Developing a corporate logo

d. Preparing bank statements for mailing

e. Renting off-site document storage facilities (to preserve company data)

f. Hosting the board of directors’ annual meeting

g. Gathering information for federal bank auditors

h. Balancing transactions at the end of the day

i. Taking deposits at the drive-in window

j. Providing access to safety deposit boxes

HIGH COST-TO-SERVE

LOW COST-TO-SERVE

Orders custom products in small quantities

Uses standard delivery services

Frequently changes delivery requirements

Places orders using automated processing, such as EDI or the Internet

Requires little to no presales support

Requires installation and training

Requires frequent deliveries to accommo-date just-in-time inventory system

Pays slowly (high accounts receivable)


F5-4 Calculate customer net profi t and customer profi t margin (LO 1) Wingo Widgets makes and sells widgets to individual and corporate customers. Widgets cost $1.75 to make and are sold for $3.00 each. Individual customers typically require little service beyond order processing. Because widgets don’t differ much from one producer to the next, corporate customers demand additional services before they will commit to a purchase.

Wingo’s selling activities and cost pools are as follows:

Cost Pool Annual Cost Annual Driver Activity

Order processing $200,000 2,500 orders Telephone technical support 45,000 1,500 hours Product demonstrations 66,000 120 demonstrations Express deliveries 37,500 375 deliveries

$348,500

The following table compares the activity levels for the average individual customer and the average corporate customer:

Individual Corporate

Widgets purchased 1,000 10,000Orders 12 50Technical support hours 3 70Product demonstrations 0 8Express deliveries 1 15

RequiredCalculate the activity rate for each cost pool.Calculate the customer net profi t and customer profi t margin for the average individual customer and the average corporate customer.If Wingo wanted to drop one average corporate customer, how many average individual customers would need to be added to make up the lost net income?

F5-5 Calculate customer net profi t and customer profi t margin (LO 1) Stoner Excursions offers several services to customers. Susan Stoner realizes that some customers use more services than others, so the company has conducted a customer profi tability analysis that identifi ed the following cost pools and activity drivers:

Cost Pool Annual Cost Annual Driver Activity

Online reservations $ 240,000 40,000 online reservationsPhone reservations 980,000 98,000 phone reservationsTicket mailings 500,000 125,000 mailingsCourier deliveries 160,000 10,000 deliveries

$1,880,000

RequiredCalculate the activity rate for each cost pool.Two of Stoner’s customers have the following activity levels. Calculate the customer net profi t and customer profi t margin for each customer:

Customer A Customer B

Ticket purchases $172,500 $180,000Ticket cost $129,375 $135,000Online reservations 500 0Phone reservations 0 600Ticket mailings 500 120Courier deliveries 0 480

a.b.

c.

a.b.

Exercises 413



F5-6 Calculate the customer profi t margin; calculate the income effect of dropping customers (LO 1) Corley Communications performed a customer profi tability analysis and obtained the following results for its bottom fi ve customers:

Customer Sales Customer Net Profi t Customer Profi t Margin

Albert $ 425,000 $ 8,500 2.00%Brown $1,100,000 $16,500 1.50%Carter $1,000,000 $ 3,000 0.30%Dyson $ 675,000 ($ 1,350) (0.20%)English $ 560,000 ($ 4,480) (0.80%)

Chris Corley, vice president for marketing, believes that if these fi ve customers are dropped, the selling expenses required to serve them will be eliminated. Company revenues to-tal $15,000,000; the current average customer profi t margin is 6.8%, and net income is $220,000.

RequiredCalculate the total customer net profi t.What effect would dropping all fi ve customers have on the average customer profi t margin?What effect would dropping all fi ve customers have on net income?What action would you recommend? Why?

a.b.

c.d.

P R O B L E M S

F5-7 Customer profi tability (adapted from D. L. Searcy, “Using activity-based costing to assess channel/customer profi tability, Management Accounting Quarterly, 5, no. 2 (Winter 2004): 51–60) (LO 1, 2) Time Solutions, Inc., is an employment services fi rm that places both temporary and permanent workers with a variety of clients. Temporary placements account for 70% of Time Solutions’ revenue; permanent placements provide the remaining 30%. President Gia Johnson recently read an article that discussed the need to consider selling and administrative costs in determining customer profi tability—a practice that Time Solutions does not follow. Johnson is concerned that the company may be making poor choices in the selection of customers.

In the temporary market, Time Solutions advertises and searches for workers, hires them, and pays them for the hours they work. The company then bills customers for an amount that is higher than the workers’ pay plus taxes. Because the temporary market is very competitive, Time Solutions has had to reduce the rates charged to customers to keep their business.

After reviewing the year’s operations, Johnson has determined that the company’s cus-tomer service activities for the temporary business could be divided into three cost pools: fi lling work orders, hiring temporary employees, and processing payroll/billing customers. The following table shows the three cost pools and their annual capacity:

Cost Pool Total Cost Annual Capacity

Filling work orders $175,875 3,500 ordersHiring temporary employees $ 81,125 2,950 applicantsProcessing payroll/billing customers $ 43,000 215,000 hours worked

Time Solutions’ largest four customers account for about 42% of total sales, so Johnson has decided to analyze those customers’ accounts fi rst to determine how much they are contribut-ing to the bottom line. The gross margin the companies generate and the activities they use are as follows:


Chemical Company Trailer Manufacturer Newspaper Publisher Food Processor

Sales $466,733 $145,764 $122,604 $167,327

Cost of sales Wages 341,620 110,473 92,205 120,451 Taxes and fees 65,366 24,350 18,621 23,411

Total cost of sales 406,986 134,823 110,826 143,862

Gross margin $ 59,747 $ 10,941 $ 11,778 $ 23,465

Temps ordered 88 56 928 332Applicants 74 48 794 284Hours worked 47,370 15,115 13,000 22,765

RequiredCalculate the gross margin percentage for each customer.Determine the activity rates for each of the three cost pools.Determine the customer net profi t and customer profi t margin for each customer.What suggestions would you make for managing each customer’s profi tability?

F5-8 Customer profi tability (LO 1, 2) After attending a seminar on measuring cus-tomer profi tability, Mason Ford decided to examine Olson Optics’ customers to determine if the company truly knew how profi table its customers were.

Olson Optics already uses an activity-based costing system to determine the product cost of its two products: RF30 and LF45. Each RF30 sells for $15.00 and requires $7.05 in direct materials and $4.00 in direct labor. Each LF45 sells for $50.00 and requires $15.45 in direct materials and $14.00 in direct labor. The following table provides cost and activity information for manufacturing overhead for the two products.

a.b.c.d.

Based on what Ford learned at the seminar, he has gathered the following information about customer support activities.

Problems 415

Activity Cost Pool Cost Driver Selling Costs Driver Volume

Order entry Orders $200,000 40,000Customer support Support hours 150,000 5,000Sales calls Sales calls 250,000 2,000Express shipping Shipments 140,000 7,000

Total selling costs $740,000

Ford wants to apply his new profi tability analysis techniques to Infrared Technologies, a company he believes is representative of Olson’s average customer. Information about Infra-red’s account activity is as follows.

RF30 purchases 10,000 unitsLF45 purchases 3,000 unitsOrders placed 300Customer support 500 hoursSales calls 24Express shipments 250

Manufacturing Number of Activities

Activity Cost Pool Cost Driver Overhead Costs RF30 LF45 Total

Packing Cartons $ 200,000 500,000 300,000 800,000Setup Setup hours 450,000 10,000 27,500 37,500Assembly Spot welds 730,000 125,000 240,000 365,000Finishing Machine hours 300,000 25,000 75,000 100,000 Total manufacturing overhead costs $1,680,000 Units produced 600,000 200,000



RequiredCalculate the activity-based product cost for RF30 and LF45.Calculate the cost pool rates for Olson’s customer service activities.Calculate the gross profi t, customer net profi t, and customer profi t margin for Infrared Technologies.Is Infrared Technologies a profi table customer? Why or why not?What actions could Ford take to increase Infrared Technologies’ profi tability? Should these actions be applied to all of Olson’s customers?

F5-9 Customer profi tability (LO 2) Ray Panneton, president of Okus Designs, met with his CFO and vice president of marketing to discuss the profi tability of the company’s top 10 customers. These customers account for 80% of the company’s revenues. The follow-ing table was prepared by the accounting department to assist Ray in his decision making.

a.b.c.

d.e.

Cost of Selling Customer Customer Customer Revenues Sales Costs Net Profi t Profi t Margin

Meredith’s Boutique $ 5,000,000 $ 3,750,000 $ 750,000 500,000 10.00%Stewart Industries 4,890,000 3,618,600 978,000 293,400 6.00%T&P Incorporated 4,500,000 3,375,000 1,129,500 (4,500) (0.10%)Talley Design Studios 4,200,000 3,192,000 378,000 630,000 15.00%UPPtown Productions 4,100,000 2,870,000 902,000 328,000 8.00%O’Brien’s Tavern 3,900,000 2,730,000 1,365,000 (195,000) (5.00%)House of Claire 3,850,000 2,887,500 885,500 77,000 2.00%Copper Metalworks 3,700,000 2,664,000 888,000 148,000 4.00%J Floral Designs 3,625,000 2,501,250 1,486,250 (362,500) (10.00%)Old Main Masonry 3,500,000 2,485,000 770,000 245,000 7.00%

Total/Average $41,265,000 $30,073,350 $9,532,250 1,659,400 4.02%

RequiredRay is concerned about the customers with negative customer profi t margins. If these customers are dropped, what will be the new total customer net profi t and customer profi t margin (assume the cost of sales and selling costs can be eliminated)?Ray is also concerned about customers with customer profi t margins below the current company average. If all customers with below-average profi t margins are dropped, what will be the new total customer net profi t and customer profi t margin (assume the cost of sales and selling costs can be eliminated)?Compare your answers to parts (a) and (b). What do you notice?If Ray were to drop all customers with profi t margins below average, how much in new customer revenues would need to be added to make the company as well off as it would be if it only dropped the customers with negative profi t margins? Use an average profi t margin for the new customers equal to the one you calculated in part (a).What action do you recommend Ray take?

F5-10 Customer profi tability (LO 2) In 2005, electronics retailer Best Buy received a great deal of press about the changes managers were making to Best Buy stores. The com-pany had profi led its customer base and identifi ed four types of desirable customers: young customers who embrace technology, affl uent male professionals, affl uent suburban mothers, and family men. Because each type of customer was found to exhibit unique buying charac-teristics, the company designed a store for each one.

This practice, referred to as customer centricity, identifi es profi table customers, segments them, redesigns stores to target specifi c segments, and empowers employees to meet custom-ers’ needs. In the quarter ended May 28, 2005, sales in Best Buy’s newly designed stores were up 8.4% over the same period in 2004.

a.

b.

c.d.

e.


RequiredExplain how activity-based customer profi tability analysis can assist in implementing customer centricity.As part of this analysis, Best Buy identifi ed customers who shopped primarily during sales events. Those customers, who purchased a large volume of merchandise, had been considered desirable customers. After the analysis, however, the company ceased to mail sales notices to them. Why would Best Buy decide to ignore those customers?Because sales were up in the newly designed stores, would you conclude that the move to customer centricity was a profi table one for Best Buy? How should the company determine the profi tability of the change?

a.

b.

c.

E N D N O T E

1. Larry Selden and Geoffrey Colvin, Killer Customers: Tell the Good from the Bad—And Dominate Your Competitors (New York: The Penguin Group, 2003). This book was originally published as Angel Customers & Demon Customers.

Endnote 417


focus on customer profitability

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