If you had a new client offer you $1 million revenue, should you take it? Or is there a price in saying “Yes”? Read more to find out!
In Treacy and Weirsema’s Customer Intimacy and Other Value Disciplines (Treacy & Wiersema, 1993), they posit that there are three ways to differentiate your business from your competitors.
Operational Excellence (OE) – this type of business differentiates by providing standard quality at the lowest total cost. Think McDonald’s or Wal-Mart.
Product Leadership (PL) – this business is the only place to buy what you are looking for and are constantly innovating (and obsoleting) products. Like Apple or Intel.
Customer Intimacy or Best Total Solution (BTS) – This business makes a custom product to the exact needs of their customer. As Ritz-Carlton or many consulting firms (including mine!).
Treacy and Weirsema say that to be a world-class company you have to choose just one of these to excel in, while maintaining market parity for the other two.
This has profound consequences for an organization. Let’s imagine a Product Leadership company. If they are truly going to excel in their market as the product leader, they are going to hire people who like to constantly innovate, provide processes that will support them in developing new products or services and obsoleting the old ones. Their production facilities will be designed to accommodate changing products, their production people will be working in an environment that is never stable. Their sales and marketing is all about selling the new and improved version and why the old one is old hat.
Now imagine a customer comes along to such a business and offers $1 million in revenue. If this company rewards their sales folks based on revenue (a common error), Sales will be ecstatic at this opportunity. Frequently, this is exactly what businesses do, only to find out later that their revenue is at an all time high, but their profits have not followed, or are even worse.
Let’s take a moment to figure out why.
This business has people and structures designed to create new products and sell them. What if the $1 million dollars comes from a customer who expects a Customer Intimacy model? They will make that $1 million contingent on getting personal service, customization of the product, higher return rates, or whatever else will make it a special experience for them. “Surely,” the CEO might think, “they are giving us a million dollars! We can afford a little special treatment!”
The problem is that there are no existing systems to do such things, so now that company has to build a parallel set of processes for this one customer. The type of people who innovate all the time are not the type of people who can easily be re-tasked to make a customizable product. The production department is used to changing how they do things to accommodate new product lines, but not customization within a product. Additional returns due to the additional customer intimacy requires additional personnel to process and resolve them.
In short, the consequences of taking on a high-revenue customer with different expectations can be substantial. And these changes can have a substantial cost impact.
But here is where it gets really depressing. Many companies use average cost accounting, which just means that they take the overall costs of doing what they do, and they spread them out equally across customers, products, production lines, geographical areas, and so on. Rarely, in this scenario, do companies allocate the cost of taking that $1 million to the customer providing it.
And that means that all the additional costs in taking the $1 million get spread out over all the other products, customers, and so on.
This leads to an artificially high profit calculation for the big new customer, and artificially low calculations for the other products they have been making this whole time. To the business leader, it looks like the new customer is awesomely profitable, but that overall profits on the other things are a bit lower. Think about what a manager might conclude: we need more of this new business and I need to go yell at everyone about how they are messing up the other stuff. This is exactly the wrong action to take, and will make profits spiral down a deep, dark hole while everyone feels powerless to understand why.
I have seen examples where taking that $1 million might cost the company $1.5 million or more in profit, while the whole time looking like it is a profitable decision due to average costing! This is the price of saying, “Yes!” when the trade you are accepting is something that your business is not structured to do.
The solution, of course, is adequately allocating costs where they belong. I am not advocating full Activity-Based Accounting. In my experience, this often takes so much work that whatever benefits could be accrued are lost in the bookkeeping. But something short of that where a company can reasonably sample or allocate some level of costs incurred uniquely by customer, product, production line or geographical area, is essential for making good management decisions.
If you are interested in learning more about how that might work, I can refer you to another article I wrote laying out the math of how that might look for a simple scenario I called Top 10 Stupid Six Sigma Trick #8.
Treacy, M., & Wiersema, F. (1993). Customer Intimacy and Other Value Disciplines. Harvard Business Review.