Managerial Auditing Journal

Emerald Article: Customer profitability analysis:: an activity-based

costingapproach
Malcolm Smith, Shane Dikolli
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To cite this document: Malcolm Smith, Shane Dikolli, (1995),"Customer profitability analysis:: an activity-based
costingapproach", Managerial Auditing Journal, Vol. 10 Iss: 7 pp. 3 - 7
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3 CUSTOMER PROFI TABI LI TY ANALYSI S: AN ABC APPROACH
The impact of activity-based costing (ABC) on customer
profitability analysis (CPA) has attracted relatively little
attention in the management accounting literature. Bellis-
Jones[1], Howell and Soucy[2] and Smith[3] have
examined the importance of customer profitability
without exploring the potential usefulness of ABC in
developing an accurate CPA.
CPA is justifiable if the cost-benefit of compiling the
information is favourable and the outcome of any
subsequent strategic decision leads to income increases.
Strategic decisions may range from changing the delivery
terms of a customers contract to terminating business
dealings with an unprofitable customer.
Smith[3] observes that strategic consideration of
customer-related costs can lead to a cost-effective change
in the way customers needs are satisfied. Figure 1
encapsulates the range of possible customer expense
categories and identifies four key factors which impact
on customer profitability.
Further embellishment of this figure for each of the key
factors allows the development of characteristics which
distinguish profitable from unprofitable customers.
A consideration of discounts, commissions and sales
support allows the impact of purchasing patterns to be
specified, as shown in Table I.
Discount and commission data, sorted by customer, is
likely to be readily available in most computerized
accounting systems. However, the determination of field
service and sales support costs for each customer will
necessitate some form of ABC. For example, the average
length of time spent taking a customers order might be
measured and then applied as a weighting factor to the
number of telephone calls made. Large switchboard
systems are capable of providing such statistics
automatically. Time and information management
systems can be added to smaller telephone systems to
collect statistics relating to the frequency of calls to
customers telephone numbers.
Sales representatives planning sheets or an associated
computerized system could provide statistics regarding
the number and distance of customer visits. Alternatively,
an estimated number of calls per customer, weighted
according to the distance of the visit, might be used as a
basis of allocation of sales-support costs. Ultimately,
significant purchasing pattern dollars revealed in a
customer profitability analysis should focus
managements attention towards attempting to modify a
customers purchasing behaviour.
A consideration of distribution costs and frequency and
special delivery requirements allows a further distinction
to be made, as shown in Table II.
Even with ABC, the split of the distribution cost between
customers on a common delivery run is difficult.
Assuming each delivery consumes the same amount of
time, the most logical allocation of distribution cost is an
even split between all customers to reflect capacity-
consuming packaging or, more commonly, significant
distances from the distribution point.
The number of customer deliveries should be extractable
from the sales ordering system and will be a useful input
to the process of allocating distribution and shipping
frequency costs to customers. Resource costs associated
with shipping frequency might be split between standard
and non-standard shipping activities, the latter requiring
some form of manual monitoring. However, such a
process will be worthwhile if it highlights those
customers who place abnormal resource-consuming
demands on the organization.
The impact of differential ordering and debt-handling
procedures on the cost of the accounting function further
specifies the characteristics typical of the unprofitable
customer, as shown in Table III.
Managerial Auditing Journal, Vol. 10 No. 7, 1995, pp. 3-7
MCBUniversity Press Limited, 0268-6902
Cust omer pr of i t abi l i t y anal ysi s:
an act i vi t y- based cost i ng appr oach
Malcolm Smith and Shane Dikolli
A syst emat i c appr oach i s essent i al i n at t empt i ng t o devel op an ABC anal ysi s
4 MANAGERI AL AUDI TI NG JOURNAL 10,7
While the valueof sales credits per customer is easily
determined, the consumption of resources associated
with administering the number of sales credits can only
be determined only with analysis and measurement of
occurrences of the activity driver.
The activity costs of processing customer remittances can
logically be allocated to customers on the basis of the
number of remittances received, but those customers who
pay late might be assigned a weighting factor to reflect a
greater consumption of organizational resources (for
example, through follow-up telephone calls) than by on-
time customers. A further weighting factor might also be
applied to customers who receive settlement discounts on
accounts greater than, say, seven days.
Order entry and processing would similarly be allocated
to customers based on the number of invoice line items,
with customers with standing orders or complex orders
assigned an appropriate weighting factor. Despite the
apparent arbitrariness of such weighting factors, the final
analysis resulting from their implementation may
provide a number of opportunities with which to alter the
management of customer accounting activities.
Inventory-support and holding requirements, too, are
often customer-specific with a direct impact on their
relative profitability, as shown in Table IV.
Customers requiring immediate deliveries will necessitate
the organization holding greater inventory levels. The
increased costs of storing inventory can be assigned to
such customers using weighting factors. Determination
of such weighting factors per customer requires an
accumulation of statistics relating to required delivery
promptness. These statistics may necessitate manual
collection, or could be modelled from computerized
systems to reveal the average number of days between a
customers order and the corresponding delivery date.
Decisions can be made to change the characteristics of a
customer from profitable to unprofitable, but the success
of such decisions depends on the accuracy of the
information provided in the CPA. While ABC can
improve the accuracy of such information, conventional
ABC systems have limitations that need to be addressed.
Not all ABC systems will analyse cost drivers in the area
of customer-related costs, despite the likelihood of their
not being volume-dependent. More sophisticated ABC
systems may manage customer-related costs effectively,
but this depends largely on the objectives of the ABC
system and/or the nature of the production process.
Where the primary objective of the ABC system is to
determine product profitability, then the cost drivers
selected will probably be quite different from those
selected for customer-related resource consumption
analysis. Delivery costs, for example, might be assigned
accurately to customers based on distance travelled to the
Tabl e I . Purchasing patterns and customer profitability
Characteristics of Characteristics of
Expense profitable customers unprofitable customers
Cost of Nil to low discounts Large discounts
volume
discounts
Size of agents Low commissions High commissions
commissions
Cost of field Infrequent, successful Lengthy delays in
service to order-getting obtaining daily orders
maintain telephone calls by telephone
products
Cost of sales Few visits Frequent calls,
support assistance with
administrative
operations, help with
in-store displays
Tabl e I I . Delivery policy and customer profitability
Characteristics of Characteristics of
Expense profitable customers unprofitable customers
Distribution Located close by, Located long distance,
expenses standard packaging, unique capacity-
barcode reading consuming packaging
Shipping Infrequent large-lot Daily deliveries with
frequencies deliveries additional deliveries
on demand
Freight fleet No special Require purchase or
requirements requirements conversion of custom-
made delivery trucks
Purchasing patterns
Delivery policy
Accounting procedures
Inventory holding
Customer
profitability
Fi gur e 1. Expense categories impacting on customer
profitability
5 CUSTOMER PROFI TABI LI TY ANALYSI S: AN ABC APPROACH
customer premises; but where product profitability is the
ultimate objective, it is simpler to assign delivery costs
based on the volume or weight of the product delivered to
customers, irrespective of where the product was
delivered.
For example, to allocate accurately delivery costs of
$10,000 over a total distance travelled to customers of
2,000 kilometres, it is necessary to trace the distances
travelled to each customer and assign costs at the rate of
$5 per kilometre. In many cases the individual distances
could reasonably be estimated without too much
difficulty. From a product-profitability perspective,
allocating accurately the $10,000 over different products
requires tracing of the distances travelled by each
product to each customer. The nature of such a task,
particularly in an environment with a diverse product
range, would be extremely onerous. An alternative, but
less accurate, way of allocating the cost would be to use a
capacity or volume-based measure. This may be feasible
from a cost-benefit standpoint.
By contrast, in environments where custom-made
products dictate the nature of the production process, the
activity drivers from both a product-profitability and a
customer-profitability perspective are likely to be similar
because the custom-made product is delivered to a
customer and the associated distance travelled will be the
same for either the customer or the product as the cost
object.
In mass-manufacturing environments, it would seem
more likely, then, that the activity drivers selected for a
customer profitability analysis would differ from the
activity drivers selected for a product profitability
analysis.
Johnson[4] suggests that activity-based concepts are
being oversold and that focus on total customer
satisfaction is of paramount importance. He argues that if
customers really want frequent deliveries in small-lot
sizes, and an alternative supplier can meet the customer
needs, then activity analysis might be misleading the
supplier. This assumes that the supplier is prepared to
decline the customers business and allow a competitor to
supply that customer. Using ABC in a customer
profitability analysis, the supplier may indeed accept that
the customer is unprofitable and be willing to meet the
customers needs. Kaplan[5] discusses three types of
potentially unprofitable customer who might be retained:
(1) new and growing customers, who promise
profitable business in the future and may provide a
stepping stone for penetrating lucrative new
markets;
(2) customers providing qualitative rather than
financial benefits, including customers at the edge
in the development of new markets who provide
valuable insights into likely trend movements in
consumer demand;
(3) customers providing increased capability because
of their status as recognized leaders in their
markets or fields of expertise.
Thus, where a CPA reveals that a particular customer is
unprofitable, it does not necessarily follow that this
customer should be eliminated. Nor does it follow that the
customer must be persuaded to accept terms and
conditions that will reduce the customers level of
satisfaction. Negotiations with a customer might well
reveal that less frequent deliveries would actually benefit
the customer (i.e. less workload for the receiving officer,
Tabl e I V. Inventory holding and customer profitability
Characteristics of Characteristics of
Expense profitable customers unprofitable customers
Inventory Predictable delivery Requires delivery on
support and inventory demand at irregular
requests times
Distribution Collects sales orders Requires free delivery
support to a remote or
long-distance location
Holding Compatible with Will take business
requirements your JIT scheduling elsewhere if required
inventory is not held
Tabl e I I I . Accounting procedures and customer profitability
Characteristics of Characteristics of
Expense profitable customers unprofitable customers
Sales credits Collates any sales Initiates separate sales
credits and claims credits for each item of
monthly product returned
Settlement Discounts, if any, Receives discounts on
discounts apply to cash sales accounts greater than
seven days
Debtor Pays on time Pays late
collection
support
Order Maintains regular Requires immediate
processing bulk orders crisis deliveries
resulting from
stockouts, but whose
order details are so
complex that multiple
queries result before
the transaction can be
completed
6 MANAGERI AL AUDI TI NG JOURNAL 10,7
fewer purchase orders, fewer transaction input entries,
less paperwork) without causing costly stockpiles.
Clearly, there is scope for negotiating with customers to
influence their behaviour (so that they act in ways which
are more profitable for the firm) without compromising
the customers level of satisfaction. Some aspects of
improved negotiation might include:
G non-cash incentives from sunk-cost investments
for example, sponsoring a season of a major
cultural event primarily yields advertising
benefits; however, seats in the accompanying
corporate boxes might also yield enticing
customer incentives. Similarly, a companys
accumulated frequent-flyer points may perhaps be
spent on customers, new or existing;
G restructure of delivery runs to create a more timely
but less frequent service for the customer;
G capacity maximization on delivery runs that are
required for profitable customers by offering a more
frequent service for the potentially unprofitable
customer with unpredictable demands;
G purchase of equipment on behalf of customers
which they can use rent-free, in lieu of discounts
and/or agents commissions. The cash saved on
reduced discounts/commissions potentially should
exceed the cost of the asset. Additionally,
ownership is retained and a stronger bond is
forged with the customer, thereby generating
greater negotiating power in future;
G free short-term financial advice which will create
efficiencies for the customer, leading to reduced
internal workload and consumption of resources;
G new products at no cost in return for reduced
discounts, to serve a dual purpose: improving
customer profitability while providing a useful
vehicle for the promotion of new products;
G a trade-off between quantity discounts and
settlement discounts that minimizes the costs of
cash overdraft and maximizes long-run production
scheduling.
The overriding consideration with a CPA is that
management will at least be armed with information
about unprofitable customers and can focus attention on
developing those innovations/strategies that might
reduce the lack of profits of a particular customer,
without reducing that customers satisfaction.
Alternatively, provided a shift of thinking is possible,
management can restructure the manufacturing process
that will ultimately lead to a shift in the results of a
customers profitability.
The role of the mechanics of ABC in developing a CPA
should not be underestimated. With ABC, general ledger
amounts are dissected, making the assignment of costs to
customers easier. In particular, the associated on-costs of
employing sales staff and motor vehicles would be
analysed in detail and be readily available. This would
embrace vehicle operating costs (depreciation, petrol,
licensing, insurance and vehicle signage) as well as
superannuation, fringe benefits and payroll tax, holiday
and long-service leave entitlements, workers
compensation insurance, mobile telephone and training
costs. Several of these items might conveniently be
omitted from a non-ABC customer profitability analysis
because of the complex analysis required to divide the
general ledger amounts between the activities of different
salespersons.
Resource to activity allocations (e.g. gas, water,
electricity) provide a more accurate representation of
resource consumption by customers. A non-ABC
alternative is likely to cause customer-cost distortions in
such translations. Additionally, activity drivers will
assist in the assignment of activity costs to customers,
where otherwise arbitrary allocation methods would be
employed. Thus, distribution costs might be assigned on
a zone basis depending on the delivery destination
activity, rather than being spread across all customers in
an arbitrary fashion.
A systematic approach is essential in attempting to
develop an activity-based costing CPA. Lewis[6] outlines
a simple ABC system for recognizing marketing costs by
product line. He also indicates how these ideas can be
easily transferred into a profitability analysis statement
by territory. It follows that Lewiss ideas could be
extended further to a full CPA, or at least provide a useful
starting-point for developing a CPA.
For more sophisticated models, Turney and Stratton[7]
present an activity-based model using micro and macro
activities which lead to assignment of cost to final
products. This two-tiered activity structure could apply
just as well to an assignment of cost to customers as it
does to final products. The primary advantage of this
type of model is that dual objectives may be satisfied, as
follows:
G customer costing objective depicting the
profitability of a customer using the cost of macro
activities;
G performance improvement objective isolating
detailed areas for potential improvement by
focusing on micro activities.
The two-tiered activity model reduces many of the
difficulties associated with conventional ABC systems
where the activity drivers to the final cost object are so
aggregated that the level of accuracy is potentially
compromised.
Detailed analysis of customers, and associated service-
cost differences, may be justified if the cost of obtaining
7 CUSTOMER PROFI TABI LI TY ANALYSI S: AN ABC APPROACH
and maintaining information is not excessive, or if the
information so generated is useful in the making of
strategic decisions.
Analysis of the revenue streams generated by customers,
relative to their service costs, may lead to some customers
being eliminated from the business or, at least, a change
of emphasis in the way in which resources are allocated
between customers.
In each case incremental costs and price elasticities of
demand must be examined and a customer loyalty profile
established to determine sensitivity to prices or to the
levels of service provided. How will our internal costs
change in response to variations in the level of service
provided? A fundamental analysis of customers, and the
effect of variations in service on internal cost structures,
will provide the information to support strategic
decisions relating to the customer base. A more accurate
ABC model, tracking resource consumption by
customers, is likely to cause fewer customer-cost
distortions than are non-ABC alternatives.
The need for a strategic approach is evident. We must not
be tempted to pigeon-hole TQM, ABC or CPA and
examine each in a blinkered fashion. They must be
employed simultaneously so that all aspects of customer
focus can be considered, with projected costs and
revenues appropriately quantified.
Ref er ences
1. Bellis-Jones, R., Customer profitability analysis,
Management Accounting (UK), February 1989, pp. 26-8.
2. Howell, R.A. and Soucy, S.R., Customer profitability: as
critical as product profitability, Management
Accounting (US), October 1990, pp. 43-7.
3. Smith, M., Customer profitability analysis revisited,
Management Accounting (UK), October 1993, pp. 26-8.
4. Johnson, H.T., Its time to stop overselling activity-based
concepts, Management Accounting (US), September
1992, pp. 26-35.
5. Kaplan, R.S., In defense of activity-based cost
management, Management Accounting (US), November
1992, pp. 58-63.
6. Lewis, R.J., Activity-based costing for marketing,
Management Accounting (US), November 1991, pp. 33-8.
7. Turney, P.B. and Stratton, A.J., Using ABC to support
continuous improvement, Management Accounting
(US), September 1992, pp. 46-50.
Malcolm Smith is Associate Professor of Accounting in the School of Economics and Commerce, Murdoch University,
Murdoch, Western Australia and Shane Dikolli is Lecturer in Accounting in the School of Accounting, Curtin University
of Technology, Perth, Western Australia.