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3 Benefits of an Analysis of Customer Profitability

analysis of customer profitability

Over time weeds grow in any garden. In the same way, unprofitable customers work their way into your company. To avoid the high costs of low profit customers, you should perform an annual analysis of customer profitability. Therefore, weed your garden of customers who are sapping your profits and cash flow.

Although there are many ways to look at your customer base, some of the factors to consider are sales volume, gross margin, profitability, number of transactions, and average sale per transaction. Looking at this information will not only shed light on those customers who are a drain on company resources, but highlight opportunities to sell more to higher margin customers who have low activity.

Analysis of Customer Profitability Benefits

1.  The elimination of customers that are costing you money.

Sometimes the costs may be indirect. Firing the customers with low gross margins is straightforward, but what about the customers that pay a good gross margin but require a lot of effort from operations? Not only do you need to address gross margin but you need to consider the costs to service that customer.

2.  Focus!

If you get rid of the clients that are high maintenance, then it frees your organization up to focus on the more profitable customers. While a successful strategy might be to cross sell additional products or services to those clients who value the relationship, another strategy would be to target new customers with the same characteristics as the good clients you have today.

3.  Increased Productivity Across the Organization

The benefits of weeding out high-maintenance, low profit customers will reach across the organization.  The sales department benefits by focusing their prospecting on the right clients who value and will pay for the company’s products and services. Operations and finance will realize improved productivity in servicing only those customers who are reasonable in their demands for service.  No more getting beaten up on margins, “special” payment terms, or Friday afternoon rush jobs!

The bottom line is the advantage of customer profitability analysis is improved profitability and cash flow! The two ingredients necessary to grow a company faster.

Learn how to apply concepts like this in your career with CFO Coaching.  Learn More

Your CEO needs to understand each customer’s profitability and for you to be their trusted advisor. Click here to learn how you can be the best wingman with our free How to be a Wingman guide!

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What The CEO Wants You to Know

Book: What the CEO Wants You to Know

What the CEO Wants You to Know by Ram Charan is one of the financial leadership books that we encourage all of our coaching participants to read. In this book, you will learn…

Why this book is on our list?

From notable CEOs to street vendors – they all share a common secret to success by developing business acumen and learning to apply these fundamentals to all types and sizes of business. What the CEO Wants You to Know How Your Company Really Works recognizes that every business is the same inside. More specifically, all CEOs focus on cash generation, return on assets, growth, and customers. Learning how to block and tackle with these tools and stay out of the weeds comes with experience. Good CEOs cut through the complexities and bring clarity and simplicity. They look at businesses like investors would – investigating inconsistent PE multiples by revisiting the fundamentals. And most importantly, CEOs know how to execute.

Therefore, if you want to truly understand what the CEO wants you to know, the first key to getting things done is putting the right people in the right jobs, not shying away from conflict, and knowing when to make step changes along the way. Coaching is also a key success factor to execution – both from a business and behavior perspective. Synchronization and integration of efforts along with building effective social operating systems are also keys to successful execution.


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Understand These Concepts

To learn how your company really works, you must understand the concepts of cash generation, return on asset, growth, and customers.

1. Cash Generation

Cash generation is the difference between all inflows and outflows of cash into the business in a given time period. In larger organizations this concept become more complex with the introduction of credit but in the end the complexities can be distilled back to this simple concept.

2. Return on Assets

Return on Assets (“ROA”), which is similar in concept to Return on Investments (“ROI”) and Return on Equity (“ROE”), “…tells you how much money is coming into your business from the use of your assets, from the investments the business has made, or from the investment shareholders have made in the company (equity).” The return is a function of margin and velocity – that is “the faster the velocity, the higher the return.”

3. Growth

What a CEO wants you to know is that growth is vital to prosperity. It should be profitable and sustainable. Many often measure growth by a concept called Shareholder Value Added (“SVA”). Effectively SVA measures whether the business through its management team is earning “…a return that is greater than the cost of using other people’s money.” However, to gain a true perspective of the quality of growth, you will need to drill down into the details of cash generation and return on assets. Focusing on business acumen is also how successful CEOs find opportunity for profitable growth when others cannot.

4. Customers

The last concept focuses on knowing your customers. What the CEO wants you to know is that knowing your customers means knowing their preferences and what they are dissatisfied with. Direct contact with the customer often provides greater insight then solely relying on focus groups and other market research.

Author: Ram Charan

Ram Charan also spends time focusing on the people side of the equation. This includes putting the right people in the right jobs and dealing with mismatches. With regards to coaching, “…a true leader of people expands their capacity by helping them channel their skills, develop their abilities, and release their positive energy.” The focus should be both on the business side and personal behaviors. What the CEO Wants You to Know also dives into the subject of how to make groups more decisive by designing social operating mechanisms to synchronize efforts and link them to business priorities.

For example, “in a small organization, everyone knows everything that is going on….but as an organization grows and you have dozens, if not hundreds, of people working together, synchronization becomes a greater challenge.” Structures are created to encourage social interaction increasing complexity. The challenge in larger organizations is simplifying communications and unify efforts and priorities. Order Now.

To learn more financial leadership skills, download the free 7 Habits of Highly Effective CFOs.

what the ceo wants you to know

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Supply and Demand Elasticity

See Also:
Economic Indicators
Balance of Payments
Stagflation
The Feds Beige Book
What are the Twin Deficits?

Supply and Demand Elasticity

Supply and demand elasticity is a concept in economics that describes the relationship between increases and decreases in price and increases and decreases in supply and/or demand. We have described it in greater detail below.

Price Elasticity of Demand Definition

In economics, demand refers to customers’ need or desire for a given product or type of product and their eagerness to purchase that product. The more customers want a certain product, the more demand there is for that product. Less desirable or necessary products have lower demand in the marketplace.

What is elasticity of demand? Price elasticity of demand refers to the degree to which demand is influenced by changes in price. Basically, price elasticity of demand describes consumers’ sensitivity to changes in price. For example, if the price of a product suddenly goes up, broadly speaking, fewer people will buy it because it is more expensive. Perhaps people can no longer afford the product, or perhaps they feel the product costs more than it is worth. Regardless, to some extent, at least academically speaking, when prices rise, demand falls.

If a slight price increase causes a large decline in demand, price elasticity is high. Similarly, if a slight price decrease causes large increase in demand, elasticity of price is high. On the other hand, if a large price increase is required to cause any decline in demand, price elasticity is low. And if large price decreases are needed to cause any increase in demand, elasticity of price is low.

In sum, if a small price change causes a dramatic change in demand, price elasticity is high – consumers are highly sensitive to price changes. If small price changes cause little or no effect on demand, and substantial price changes are needed in order to see any effect on demand, then price elasticity is low – customers are less price sensitive.

Elasticity of Supply

In economics, supply refers to the availability of a particular product in the marketplace. If a particular product or type of product is widely available in the marketplace, that product is amply supplied. If there is a dearth of a particular product or product type in the marketplace, that product is in short supply.

Supply is also related to price. When the price of a product rises, supply will increase. This is because the makers of the product want to maximize profits by selling as much of the product as they can while prices are high. This will flood the marketplace with that product, leading to an eventual overabundance of the product. When products are too abundant – when there is too much supply available – prices fall. If everyone in town has the same red hat, you won’t be able to charge very much for yours.

If you want to find out more about how you could utilize your unit economics to result in profits, then click here to download the Know Your Economics Worksheet.

supply and demand elasticity

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Segmenting Customers for Profit

Segmenting Customers for Profit Process

Market segmentation is the process of dividing up the total market based on identifiable characteristics, which have common needs. You can also apply the concept of market segmentation to your customers. For example, you can segment your customers based on the cost to service, the size of the average sale or the number of transactions.

Though segmenting customers for profit or customer segmentation is a simple concept, it is not simple to implement in any meaningful way. The difficult part is identifying the various segments so that you can identify profitable customers versus those that can cost you time and money.

Customer Segmentation – Vertical or Horizontal

Customers may be segmented either horizontally or vertically.

Horizontal segmentation is where you divide customers by industry, geographic location or revenue size.

Vertical segmentation is where you might sell numerous services or products to just one particular type of customer.

For example, you might sell to customers in the construction industry numerous products, such as, steel, lumber and doors to that customer. Though segmenting customers based on market characteristics is useful, you might also segment your customers based on servicing characteristics (i.e.: size of order number of transactions or total sales volume).

Profitability Analysis By Customer

Once you have identified the various segments that apply to your customers you then perform a profitability analysis by customer. Take your annual sales by customer and break it out into various segments. Identify any patterns or relationships which might indicate opportunities for improvement. For example: a large number of small customers or concentration of large ones.

Customer Profitability Analysis

Next, perform a customer profitability analysis by subtracting your estimated relative cost to service from the revenue for the various segments. Estimating the cost to service may be done in general terms on a scale of one to five or in specific terms using activity-based costing. By relating your cost to service to your revenue streams, you can often identify “profit drains” that can be restructured. This restructuring might involve raising prices on select customers, implementing price discounts, sales incentives or firing customers.

If you want to learn how to price for profit, then download our Pricing for Profit Inspection Guide.

segmenting customers for profit

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segmenting customers for profit

 

Recommended reading: The Strategy and Tactics of Pricing, Fourth Edition, by Thomas T. Nagle and John E. Hogan

See Also:
Segment Margin
Activity Based Costing vs Traditional Costing
Implementing Activity Based Costing
Profitability Index Method
Net Profit Margin Analysis
Gross Profit Margin Ratio Analysis

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Purchase Option

Purchase Option Definition

Purchase option, defined as the opportunity to purchase a piece of property which is being leased after the lease is completed, is part of the many options available in a lease agreement. A purchase option is often agreed upon by the two parties involved before the contract is made.

Purchase Option Explanation

Purchase option, explained by many business owners as an option to “try it before you buy it”, is available on almost any leased asset. The value of a lease purchase option agreement is evident. A party wants to lease a piece of equipment because they can not afford to buy it. However, to keep their options open they decide on a purchase option lease. This benefits the lessor by allowing her to choose, at the final moment, whether the item has created value and is worth keeping. Additionally, the lessor can account for changes in needs, expectations, or operations by leaving their options open and opting for a purchase option.

For the lessee, it allows them to make the income from leasing the item while also making the income from selling the item. In this way, a purchase option provides a benefit to both parties. It also allows access to and income from the asset almost instantaneously. A purchase option fee may be accrued while choosing to engage in such a contract.

Purchase Option Example

Asal is renting a piece of equipment for her graphic printing firm. Asal, because of her vast equipment needs, has to watch to make sure she has the cash flow necessary to operate her business based on the current needs it has. She currently can not afford to buy this piece of equipment. Still, she sees the value in having it available in her office. Asal balances these two needs by agreeing on a purchase option with the lessor.

Asal is creating a short-term agreement to lease the piece of equipment, a commercial quality printer. She will keep this printer in her office for one year, at which point she will buy the item. Asal and her lessor agree on a fair market value for the printer. So Asal completes the purchase option agreement and begins use of the item.

One year later, Asal is seeing a lot of growth in her business. So much growth, in fact, that she is going to outsource the printing for her customers to a better equipped company. She trusts this vendor and knows the quality of the products they produce, so she trusts the company.

This change of pace negates her need to purchase the printer she was leasing. Asal is nearing the end of her lease agreement, so she informs the lessor that she will not be accepting the purchase option at end of lease. She has more important expenditures to make at this point.

Asal is happy that she made a purchase agreement. She made the right business decision and will soon see the fruits of her labor. She opens the office the next day with the feeling of success.

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Proforma Invoice

See Also:
Proforma Earnings
Proforma Financial Statements
Credit Letter
Balance of Payments
Proforma Invoice Example
Product Cost

Proforma Invoice Definition

Proforma invoice, defined as an invoice which is sent to a customer before they receive product, has more than one use. For customers it serves two main purposes. First, a proforma invoice allows customers to see estimates on what their invoice will be: product cost, shipping cost, processing fees, and more. Second, the proforma invoice format is a record to be presented to customs agents when attempting to import or export items.

Proforma Invoice Meaning

A proforma invoice, commercial invoice compared, means an invoice which is made before the sale has actually taken place. When distinguishing a proforma or performa invoice an understanding of latin may be of use: pro generally means before, while per generally means after the fact. This is the main difference between a proforma vs commercial invoice.

Often times, when importing or exporting products, customs agents want to understand the deal taking place. They have many reasons for this, to have a document to later confirm the shipment or to create an expectation of what should and should not be shipped with a product. The proforma invoice, or performa invoice for that matter, gives customs agents an understanding of shipped contents, shipping time, value of the shipment, and more.

On the other hand, clients appreciate an estimate of total cost when receiving shipment. This is akin to receiving an estimate prior to work at the car shop. This document can convey a sense of professionalism to the customer.

Proforma Invoice Example

For example, Juan distributes products to and from Mexico. His company, a fleet of 18 wheel trucks, crosses the boarder several times each day. Juan must make sure to carefully document his shipments to meet the regulations of both governments.

But a recent shipment worries Juan. The customs agents of Mexico have informed him that his shipment may be delayed for inspection. This will cause problems in the deal that Juan has made. He must think of a solution to help speed the process.

Juan has his assistant write an exceptional quality proforma invoice, vs quotation made off company letterhead, for this project. This way his company will come across as the reliable and trustworthy business that it is.

They are put to ease when the customs agents receive this proforma invoice. They still spend some time inspecting the load but release it after just a few hours, rather than holding it over for a number of days. A simple document has solved a problem that effects Juan’s entire company. Juan rests easy that night knowing he has pleased his customers.

For more ways to add value to your company, download your free A/R Checklist to see how simple changes in your A/R process can free up a significant amount of cash.

Proforma Invoice

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Prime Lending Rate

See Also:
Interest Expense
Interest Rate Swaps
LIBOR
Federal Funds Rate
Market Rate

Prime Lending Rate Definition

Prime rate, or prime lending rate, is the interest rate commercial banks charge on loans to preferred borrowers. The prime interest rate is lower than the interest rates charged to less creditworthy borrowers. Commercial banks can charge lower rates to preferred (prime) borrowers – usually corporate customers – because these borrowers are less likely to default and the loans are considered safer. The US Prime Rate dates back to 1929.

The US Prime Rate is derived from the federal funds rate, which is set by the Federal Reserve Bank. The prime lending rate is usually set 300 basis points above the federal funds rate. For example, if the federal funds rate is 2%, the prime interest rate would be 5%. The prime rate is typically uniform across the commercial banking industry, but some banks may charge their best customers more or less than the official prime lending rate.

The prime interest rate is also used as a reference point for other interest rates. Less creditworthy customers can borrow at a rate equal to the prime rate plus a certain number of percentage points, depending on the borrower’s creditworthiness. Several types of consumer loans, such as home equity, car, mortgage, and credit card loans are often linked to the prime interest rate. This rate is also considered a lagging economic indicator.

Wall Street Journal Prime Rate

The US Prime Rate is published in the Wall Street Journal, and is therefore often referred to as the Wall Street Journal Prime Rate, WSJ Prime Rate, or the WSJ Prime Lending Rate.

According to the Wall Street Journal, the prime rate is “the base rate on corporate loans posted by at least 75% of the nation’s 30 largest banks.” The Wall Street Journal only changes their published Prime Lending Rate when 23 out of 30 of the largest banks in the US change their prime interest rates.

Prime Rate History WSJ

For the Wall Street Journal Prime Lending Rate history, go to: wsjprimerate.us

Current Prime Rate

To see this rate today, as well as other rates, go to: bloomberg.com

Historical Data

For the history of prime interest rates, go to: research.stlouisfed.org.

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Prime Lending Rate, Prime Rate

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