Chapter 06 - Managing Customer Profitability

CHAPTER 6
Managing Customer Profitability
Chapter Outline

A. Cost Management Challenges — Chapter six addresses five cost management challenges.

1. How can you determine in advance whether investments of time, effort, and information
systems to prepare customer profitability information are worthwhile?

2. How can customer profitability analysis be more relevant for service and governmental
organizations than for others?

3. How do you evaluate the trade-offs among the desires for relevant, accurate, and timely
information?

4. How do you evaluate the trade-offs among the desires for relevant, accurate, and timely
information?

5. How can you determine whether operational changes in customer service have been
beneficial or harmful?

B. Learning Objectives

1. Explain the value of analyzing customer profitability according to major customer types.

2. Organize and prepare customer profitability analyses and reports using activity-based
analysis.

3. Identify alternative actions and recommend improvements for overall and customer
profitability based on analyzing customer related activities.

C. Customer profitability analysis applies the concept of activity-based costing to determine how
serving particular customers causes activities to be performed and costs to be incurred. Some
activities that differ among customers include ordering in small quantities frequently or ordering
in large quantities occasionally; changing orders; requiring special packaging or handling;
requesting special (expedited) delivery or other special treatment.

It is important to know customer profitability through identifying costs and benefits of specific
customers or customer types to be able to improve an organization’s overall profitability.

Identifying and assigning costs to customers can be a challenge. Customers may cause costs from
the time marketing and salespeople have their first contact with them until they stop being
customers. Identifying costs and then determining profits generated from different customers
requires completion of customer profitability analysis.

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1. The first step in developing a customer profitability system is to develop an activity-

based costing analysis of certain customer-related costs. These costs can range from
processing orders to special packaging.
2. The next step is to estimate costs, customer by customer, to see which customers cause
how much cost. Revenue information is combined with cost of goods sold to get gross
margin by customer. The customer costs that have been identified are subtracted from
gross margin to get operating income generated by each customer. Companies whose
customers are other businesses usually have major customers who generate a lot of
revenues but who may also cause a lot of cost. Sometimes customers who generate little
revenue cause a lot of cost too. These customers may actually be unprofitable.

3. The third step is to perform trend analysis of customer profitability to see if profit
performance of customers is predictably high or low or following an upward or
downward pattern. The most useful type of graphing is customer by customer, with a
separate line for each major customer cost. Then managers can see which costs need
attention.

4. A useful fourth step is to rank customers based on the amount of operating income they
generate. A graph of this information is called a customer profitability profile.

5. It is important to identify effective and ineffective customer-related activities.

Sometimes, we may suffer from over-satisfied customer-relations activities where
customers are satisfied, but the company starts losing money because of providing
excessive services.

D. Traditional profitability analysis by product line is often done without adequate scrutiny and
proper identification of costs to the relevant product lines. The approach taken in this chapter is to
provide more accurate customer profitability analysis using the activity-based costing concepts.

1. Through establishing a customer profile, customers may be categorized according to

major activities or factors that drive revenues and costs.

2. It must be noted that if the customer values a service, he would be probably be willing to
pay for it. Free service escalates costs, and the company providing it could suffer.

3. It is also useful to keep track of customer’s sales patterns and the profitability that they
generate.

4. Customer profitability analysis involves closer scrutiny of selling costs, marketing costs,
ordering costs, distribution costs, and general and administration costs.

a. Customer selling costs include the costs of all personnel databases, equipment, and
facilities devoted to sales activities. The challenge is to segregate these costs by
customer type.

b. Marketing costs include the costs of personnel, databases, equipment, and facilities
devoted to marketing research, marketing strategy, and marketing plans. The
challenge here again is to be able to segregate these costs by customer type.

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c. Customer distribution costs include the costs of packing, shipping, and delivering the
products or services to customers, and it should be determined how much of these
resources are consumed by what type of customers.

d. Customer general and administration costs include costs of research and development
and other related administrative costs.

E. Product life-cycle costs encompass the costs of five phases in a product’s life cycle. They are (1)
product planning and concept design; (2) preliminary design; (3) detailed design and testing; (4)
production; and (5) marketing, distribution, and customer service.

1. In order to justify a product’s costs, sales revenue that it will generate over its life should
be sufficient to cover all of these costs. This is especially important for products with
short life cycles, because there is little time to adjust one’s pricing strategy or production
methods to ensure that the product will be profitable.

F. With all the information on customer profitability, the final task is to see what we can do with it.

1. A common-size profitability report can show profitability by type of customer. If

margins are satisfactory on all customer types or product lines, no action may be
necessary.

2. If some product lines are losing money, action should be taken to improve their
performance or review possible alternatives in case those product lines or customers are
phased out.

3. If decision is made to phase out some product lines or customers, the company must
make sure that the operating activity costs are proportionately reduced rather than being
shifted to another product line.

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Problem 1 – Chapter 6
LO: 3
Customer profitability analysis

Anderson Plumbing has two types of customers, commercial and residential. The company resources are
spent as follows in this quarter:

Activity Cost driver Commercial Residential Total Amount

Customers Customers in dollars
Phone operator Number of calls 240 760 $13,200
Billing Number of invoices 55 745 $19,200
Direct marketing Number of promotional packs 390 1,410 $34,200
Accounting tasks Number of accounts 135 1,165 $28,600
Plumbing work Number of hours 5,500 7,500 $315,000
Sales $275,000 $202,500 $575,000

Required: Determine segment profitability if a) customer-related costs are allocated based on sales, b)
customer-related costs are allocated based on cost of sales (plumbing work). Assume that the cost of
plumbing tasks are at $30 an hour for commercial work and $20 an hour for residential work, c)
customer-related costs are allocated based on plumbing work hours, d) customer-related costs are
allocated using ABC costing, e) discuss in what way using ABC costing for this enterprise is more useful
for management’s decision making.

Problem 1 - Solution

a) Cost allocation based on sales

Commercial Residential Total
Sales 275,000 262,500 537,500
Cost of work 165,000 150,000 315,000
Gross income 110,000 112,500 222,500
Selling costs 48,707 46,493 95,200
Operating income 61,293 66,007 127,300
b) Cost allocation based on cost of sales
Sales 275,000 262,500 537,500
Cost of work 165,000 150,000 315,000
Gross income 110,000 112,500 222,500
Selling costs 49,867 45,333 95,200
Operating income 60,133 67,167 127,300
c) Cost allocation based on number of plumbing hours:
Sales 275,000 262,500 537,500
Cost of work 165,000 150,000 315,000
Gross income 110,000 112,500 222,500
Selling costs 40,277 54,923 95,200
Operating income 69,723 57,577 127,300

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d) Cost allocation using ABC costing

R
e
s
i
d
e
n
t
i
a
Sales 275,000 262,500 537,500 Activity Rate Commercial l
7
6
Cost of work 165,000 150,000 315,000 Phone operator 13.2 240 0
7
4
Gross income 110,000 112,500 222,500 Billing 24 55 5
1
4
1
Phone operator 3,168 10,032 13,200 Direct marketing 19 390 0
1
1
6
Billing 1,320 17,880 19,200 Accounting tasks 22 135 5
Direct marketing 7,410 26,790 34,200
Accounting tasks 2,970 25,630 28,600
Total selling costs 14,868 80,332 95,200
Operating income 95,132 32,168 127,300
e) ABC costing and management shows where the overhead is going and where the saving potentials are.
It also shows a more accurate picture of profitability considering costs associated with customers.

Problem 2.
LO: 1
Assessing customer’s profitability
Estimated time: 15 minutes
Shahnaz Design has two groups of customers: small and large. There are 90 small customers and 10 large
ones. Shahnaz has determined that many of these small customers are quite a headache – although the
accounting records do not show the loss, if any, associated with it. Shahnaz has determined that small
customer’s billing takes an average of four hours whereas large customer’s billing takes an average of
eight hours. However, the average small customer bill is $1,850 whereas, the average large customer bill
is $9,950. Furthermore, the small customer post-sale service needs is an average of three hours per order
and the large customer post-sale service needs is an average of six hours. Billing costs amount to $30,720
and customer service costs amount to $48,000. Assume an average of two bills for small customers and
four bills for each of the large customers. Twice as much time is needed for customer service on each bill.
Determine the billing and customer service costs associated with each order.
Solution:
Billing costs: 30,720 / ((90 * 2*4) + (10 *3*8)) = $32
Customer service: 48,000 / ((90 * 2* 8) + (10 *3*16)) = $25
Small order billing and customer service per order: (4*32) + (8*25) = $328

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Large order billing and customer service per order: (8*32) + (16*25) = $656
The Company may want to take this cost breakdown in the pricing of future orders.

Problem 3:
LO: 1 and 2
Determine customer profitability
Estimated time: 20 minutes
Shahnaz Design has two groups of customers: small and large. There are 90 small customers and 10 large
ones. Shahnaz has determined that many of these small customers are quite a headache – although the
accounting records do not show the loss, if any, associated with it. Shahnaz has determined that small
customer’s billing takes an average of four hours whereas large customer’s billing takes an average of
eight hours. However, the average small customer bill is $1,850 whereas, the average large customer bill
is $9,950. Small customers had an average of two bills and large ones three bills for the period.
Associated billing and customer service costs amount to $328 per invoice for small customers and $656
for large customers (see problem 2 above). Assuming that direct cost per job of small customers amounts
to $1,150 and $7,140 for large customers, prepare an income statement by customer category and assess
the profitability of each group.

Problem 4
LO: 2 and 3
Analyzing customer profitability
Estimated time: 15 minutes
Use the data in problem 3 above to provide a detailed analysis in terms of small and large customers.
Also determine the company’s ROI and margin, assuming that company investment amounts to $657,900.
Solution:
The above data indicates that the direct margin (sales less direct cost) on small jobs is an average of 38%
and on large jobs only 28%. This makes sense because large jobs are a lot less time consuming, and the
larger customers have potentially more leeway in choosing their suppliers and negotiating their prices.
Billing costs for small jobs amount to 6.9% of sales whereas, billing costs for large jobs amounts to about
2.6% of the sales amount. Customer service costs amount to 10.8% of sales for small jobs and only 4%
of sales for large jobs.

Even though small jobs have a larger direct margin, their net profit is slightly lower (20.1% versus 21.6%)
as compared to large jobs because of the incurrence of more billing and customer service costs. Finally,
Return on investment: 131,580 / 675,900 = 19.47%; Margin: 131,580 / 631,500 = 20.84%

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Sample Quiz
Use this data to respond to questions 1 through 9.

CNS Company has three major customers. Customer related costs and applicable cost drivers are as
follows:
Activity Cost driver Amount Activity Level
Processing orders Purchase orders $120,000 2,000
Sales visits Visits 48,000 80
Billing Invoices 36,000 1,200
Engineering/design changes Design changes 90,000 300

Customer use of the above activities, sales, and gross margin on sales are as follows:
Activity Customer 101 Customer 102 Customer 103
Processing orders 1,200 600 200
Sales visits 50 20 10
Billing 700 350 150
Engineering/design changes 180 85 35

Sales $256,000 $329,000 $396,000

Gross margin on sales $129,500 $137,500 $112,600
Under traditional costing, selling expenses were allocated based on sales value.

1. The cost rate per purchase order amounts to

a. $30
b. $60
c. $300
d. $600
e. None of the above.

Answer: b Learning Objective: 2

120,000 / 2,000 = $60

2. The cost per sales visit amounts to

a. $30
b. $60
c. $300
d. $600
e. None of the above.

Answer: d Learning Objective: 2

48,000 / 80 = $600

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3. Billing cost chargeable to customer 101 amounts to

a. $4,500
b. $10,500
c. $14,500
d. $21,000
e. None of the above.

Answer: d Learning Objective: 2

36,000 / 1,200 = $30; 30 * 700 = $21,000

4. Engineering change costs chargeable to customer 102 amounts to

a. $10,500
b. $25,500
c. $30,500
d. $54,000
e. None of the above.

Answer: b Learning Objective: 2

90,000 / 300 = 300; 85 * 300 = 25,500

5. Sales visits chargeable to customer 103 amounts to

a. $6,000
b. $12,000
c. $18,000
d. $30,000
e. None of the above.

Answer: a Learning Objective: 2

48,000 / 80 = 600; 600 * 10 = $6,000

6. Order processing cost chargeable to customer 102 amounts to

a. $12,000
b. $36,000
c. $48,000
d. $72,000
e. None of the above.

Answer: b Learning Objective: 2

120,000 / 2000 = 60; 60 * 600 = $36,000

7. Net income under activity-based costing for customer 101 amounts to

a. $47,500
b. - $47,500
c. $53,500
d. - $53,500
e. None of the above.

Answer: b Learning Objective: 2

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8. Net income under traditional costing for customer 102 amounts to

a. $38,900
b. - $38,900
c. $52,788
d. - $52,788
e. None of the above.

Answer: a Learning Objective: 2

9. Net income under activity-based costing for customer 103 amounts to

a. $6,079
b. $- 6,079
c. $79,600
d. $- 79,600
e. None of the above.

Answer: c
Learning Objective: 2

10. Customer profitability analysis identifies

a. the benefits of serving specific customers
b. the costs of serving specific customers
c. both the costs and benefits of serving specific customers
d. product cost associated with each customer but not the non-productive costs.
e. none of the above
Answer: c
LO: 1

11. Some studies suggest that only

a. 20% of customers generate profit
b. 30% of customers generate profit
c. 40% of customers generate profit
d. 50% of customers generate profit
e. none of the above.

Answer: a
LO: 1

12. Customer profile categorizes

a. individual or types of customers according to the major activities that drive revenues
b. individual or types of customers according to the major activities that drive costs
c. customers according to the number of years they have been in business
d. customers according to their level of income
e. a and b only.

Answer: e
LO: 2

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13. Saba Company anticipates to sell 500 units of the software it has developed that has a cost per unit of
$300. If the company wants a return of 15% of its investment of $200,000, what should be the target
cost?
a. $220
b. $240
c. $260
d. $280
e. none of the above.

Answer: b
LO: 2

14. Arman Company has a product that cost $200, if he wants a return of 20% on sales, the selling price
should be
a. $240
b. $245
c. $250
d. $260
e. none of the above

Answer: c
LO: 2

15. The following cost category(s) should be included in determining customer profitability:
a. selling cost
b. marketing cost
c. ordering cost
d. distribution costs
e. all of the above.

Answer: e
LO: 2

16. Distribution costs include the cost(s) of

a. packing
b. shipping
c. delivering products to customers
d. all of the above
e. b and c.

Answer: d
LO: 2

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