Measuring Customer Profitability

Over a period of five years, Alpha Corporation’s sales to Omega, Inc. averaged $9 million and its gross margin $1.8 million. To maintain that level of sales, Alpha spent $600 thousand annually in selling and marketing to Omega. The company’s management believed it could double its sales to Omega over the next three years if it doubled its sales and marketing effort, so it increased the amount it spent on developing Omega’s business to $1.2 million per year.

After one year, sales to Omega increased to $12 million and its gross margin remained at 20%. After taking into account sales and marketing costs, however, Omega’s profit as a percentage of sales fell from 13.3% to 10.0%. Does that mean that Omega became a less profitable customer? Financial accounting, and nearly two-thirds of the respondents to our recent poll, would suggest that it did. With Omega showing a lower profit percentage, would management believe it needed to reconsider its strategy? Would it attempt to increase Omega’ prices and, perhaps, hamstring its effort to increase sales to this important customer?

Over the ensuing two years, management struck with its strategy. This proved to be a sound decision as sales to Omega rose to $15 million in Year 2 and $18 million in Year 3. As noted in the summary below, its profit as a percentage of sales rebounded to 12% in Year 2 and returned to 13.3% in Year 3.

Was Omega really a less profitable customer in Year 1 and Year 2? I would suggest that it maintained the same level of profitability during the entire three-year period.

Revenue from the sale of products and services provides the funds an organization needs to operate. Some of those funds are used to produce those products, provide those services, and sustain the business at its current level of operations. Revenue in excess of those amounts represents the organization’s profit. Expenses incurred to grow the organization are a use of that profit, not a cost attributable to business that generated the revenue. They may show up as “expenses” on the financial statements, but they are actually “investments” in growing the organization.

During the three-year period, the steady profitability of Omega’s business provided the funds required for Alpha to grow that customer’s business as shown in the summary below. Sales & Marketing Expense remained at the historical level of 6.7% of sales with the excess invested in growing Omega’s sales.

The same situation presents itself when a company cuts back on those expenditures necessary to maintain its current level of business. Consider another scenario where Alpha cut back on the amount it spent selling to Omega in Year 1 by $200 thousand and, as a result, sales to Omega decreased from $9 million to $8 million while its gross margin remained at 20%. As shown in the summary below, Omega appeared to become a more profitable customer. In Year 2, Alpha compensated for the shortfall in its Year 1 sales and marketing expenditure by spending $200 thousand in addition to the normal $600 thousand and Omega’s sales returned to the $9 million level. Its profitability, however, fell to a level lower than its earlier five-year average. Finally, in Year 3, Alpha resumed its $600 thousand annual spend on Omega and its customer profitability returned to its earlier levels.

Did Omega’s profitability really increase when Alpha cut back on the spending required to sustain its business at the $9 million level? History would suggest that the cost of maintaining its volume at Year 1’s $8 million level would be $533 thousand (6.7% of sales). The momentum from previous years’ spending kept Year 1’s sales from falling by more than $1 million, but that momentum would erode without compensating for the that spending shortfall is subsequent periods. Using the sales and marketing expense required to sustain Omega’s sales at the Year 1 level reduces its customer profitability to the historical 13.3% level. As an organization, Alpha’s profits increased by $133 thousand because it did not spend the amount required sustain Omega’s sales at the Year’s sales level. Omega as a customer did not become more profitable.

Similarly, in Year 2, Omega did not become less profitable. Alpha simply paid $200 thousand more than required to sustain Omega’s $9 million sales level to make up for the $200 thousand it underspent in the Year 1. Alpha’s profits decreased by $200 thousand because it had to compensate for business sustaining expenses it had avoided the previous year. A clearer view of Omega’s profitability is shown in the summary below:

Admittedly, this is a simple example used to make a point: When measuring product, service, and customer profitability, only and all expenses required to sustain the business at its current level should be included.

I once had a client in the marketing services industry that had grown from $5 million to $30 million in sales over a five-year period while accumulating very little debt. The owner was concerned that, despite its growth, the firm had never shown a profit. It soon became clear that the reason his firm could grow so quickly with while incurring so little debt was because its various marketing services were extremely profitable. Those profits, however, were reinvested in creating new services. Because of the nature of the business, those investments were not in tangible assets that could be capitalized and depreciated. They were, instead, invested in ideas developed his creative staff whose salaries and support costs were expensed in the financial records. The profits from his existing services funded the creation of new services, but because overhead rates included those growth costs, those existing services appeared to be unprofitable.

Expenses made to grow the business and those incurred to compensate for the failure to made business sustaining expenses in the past should be excluded when measuring product, service, and customer profitability and in periods where the required business sustaining expenses are not made, those required expenses should still be included.

That’s my take on the topic. What’s yours?