Customer/Product Rationalization

In our experience, many clients can increase company profits by substantial amounts (even up by 25%) with no capital expenditures by using CPR to determine what to sell, how to make it, and to whom it is sold. (Ouellette, 2003)

If your business has multiple customers, products, or services, and multiple processes to perform your business, you may have had an occasion to ask yourself:

• "How do I know which customers are the most profitable?"
• "How do I know which products and services are the most profitable?"
• "How do I know the most profitable way to provide these products and services?"

The truth is that the vast majority of businesses use old finance models to try to answer these questions, and these old models are fundamentally flawed. Many businesses use "average costing" as a basis for determine the profitability of their output. Average costing takes some or all of the overhead costs associated with running the business and allocates them equally amongst the production units. This leads to a misleading estimate of the cost of manufacture of a product or the delivery of a service. Management decisions based on these faulty data can lead you to conclude that some products lose you money, when in fact they don't, and that other products are highly profitable, when in fact they lose you money.

Customer / Product Rationalization (CPR) is a method by which the true costs of manufacturing a product or providing a service are calculated using a cost allocation scheme (something approaching Activity-Based Costing though we more usually use a statistical sampling technique) and Total Asset Utilization (TAU). TAU identifies bottlenecks in production and the trade-offs made between different products and services, but says nothing about profitability. The cost allocation scheme identifies the true cost of manufacture or provision, but doesn't identify anything about the trade-offs made between different products, customers, and flowpaths. By combining these two things together, you can perform a Portfolio Analysis, which analyzes current profitability by customer/product/service/process/region or whatever other stratifiers or combination of stratifiers you have collected that are of interest. By generating a plan to use this information to influence selling and marketing activities, you begin to achieve CPR.

This is a central step to achieving BPE, and the activities associated with CPR are done early in the BPE process.

To illustrate the value of CPR, consider the case study below. This is an example of one of the CPR Portfolio Analysis outputs found at a client, stratified by customer. The blue line is the cumulative contribution to profit by customer, the red line is the cumulative contribution to revenue. What the graph tells you is that 25% of the customers provided 84% of the sales and 116% of the profit, and that 50% of the customers provided 91% of the sales and 123% of the profit.

So how is it that less than 100% of the customers provide more than 100% of the actual profit? By examining the portion of the curve on the right we can see profit drop precipitously, while the revenue jumps up. This is one customer who is single-handedly responsible for about 7% of the company's revenue, but the costs associated with this customer, when appropriately allocated, drop the profitability of the company by about 20%. The ironic part of this story is that the customer had been considered essential to the survival of the company.

With the above information, as well as other outputs from the Portfolio Analysis, a variety of management decisions can be made. What do you do with the customer eating up 20% of your profit? Do you

• "fire" the customer ("We can't afford to take your money anymore, please stop shipping it to us")
• raise the price on the products they buy?
• assess the product mix at the customer to determine if there is a profitable way to supply some of their business
• commission a team to investigate what is leading to these costs and try to drive them down (after all, you already have the revenue and volume)

The "right" answer could be any one or a combination of the above points - it all depends on the focus of your business. Using the same type of output stratified by product, you can generate a list of products sorted in order of contribution to profit. By giving this list to your sales and marketing forces, and by changing their reward from revenue- or volume-based to "contribution to profit" based, you can move towards an optimal customer/product mix. And by the way, any customers you determine to be incapable of contributing to your company's profit and fire will be picked up by your competitors (particularly in commodified markets). Since your competitors probably use a costing scheme that hides the true profitability, they will be saddled with the high-revenue, higher-cost customer.

This is just a brief overview of the benefits of CPR. For a more technical discussion, including a simplified case study, click here to read the TAU and then the CPR papers written by Dr. Luftig.