June 29, 2017


















Strategic Insights # 9

 

BUILDING A COST MODEL TO DETERMINE CUSTOMER (ITEM) NET-PROFITABILITY

 

An 8-step journey to faster growth with much greater profitability begins with the management team reading and discussing the book:  Islands of Profit in a Sea of Red Ink by Jonathan Byrnes. The book explains why most companies lose most of their profits through cross-subsidies between profit-making and profit-losing customers and items, and what to do about them. (See stellar reviews at Amazon.)

 

The second step of the journey is the most important and difficult one:  build a “Cost-to-Serve” (CTS) model for your distribution-type business (or division) to determine customer and item profitability. To add to Byrnes’ advice on how to do this, here are a few design guidelines:

1.     Make sure the model includes all of your operating costs, so that net profits match financial reporting results.

2.     Develop a model that is optimally complex and sufficiently accurate. Simple models limit insights and action plays. Complex ones collapse under their own weight. And, no model (including existing financial reporting) can perfectly mirror the dynamic complexity of a business.

3.     Make sure initial, profitability-ranking results pass the “gut-check” test – do they tend to support your instinctive knowledge of what’s really going on. When the results later expose the inadequacy of revered operational practices and incentive plans, the model must be credible.

4.     The net-profit gain or loss for every line item (“quantum profits”) must be able to flow into higher level reports that support the next 6 steps of the journey.

STEPS 3-8 OF THE JOURNEY: 

 

The fact that a small percent of both customers and items turn out to be phenomenally profitable and others unprofitable are symptoms of what root causes? And what’s the roadmap for the rest of the journey? Here are brief summaries for steps 3 through 8:

 

#3: Create profitability ranking reports and “whale-curve” graphs for: customers, customer niches, items, item groups, suppliers, and sales territories.

 

#4: Investigate the extreme winners and losers on the ranking reports by doing a

“5-why” root cause analysis for why the extremes are so profitable or unprofitable. The investigation will require cross-analytic, deep-dive inquiry capabilities. What, for example, are the most unprofitable items and orders that our biggest losing customer is buying? Why? How then are you both losing? What is a win-win, “precision supply chain solution” you might borrow from another channel?

 

Warning!  The investigations will trigger “allocation-cost filibusters” from people who will fear making less and/or being proven incompetent for over-servicing losing accounts or buying/promoting losing items from losing suppliers. They will want to stay with the much less-precise, status-quo world of margin dollars and assume “all of our costs are fixed”.

 

Critical-mass support for the new, net-profit paradigm will be vital. Reading Byrnes’ book together and doing case studies of pairs of similar accounts with same sales but widely different profitability will help to educate and comfort everyone. And, reassure the best people that compensation will not fall, but only go up in the future with measurable, “net-profit improvements”.

 

#5: Develop the simplest, most focused, profit-improvement “plays”, backed up by “profit-improvement teams”[1]. Put everyone you can on a team.

#6: Develop tracking reports for the specific plays to monitor “net-profit improvement” year-over-year for every: customer, customer niche, item/supplier and territory.

 

#7: Create a separate, tracking-report system for measuring and improving all of the service process metrics that add up to basic service brilliance for each target niche of customers. All front-line employees should be engaged with this.

 

#8: Develop a profit-improvement  incentive-compensation reporting system that allows every employee to track how “net-profit-improvement plays” contribute to overall net-profit improvement for the company and everyone’s incentive/gain-sharing bonus. DON’T RE-INVENT THE WHEEL; RENT IT! 

 

Waypoint Analytics has done CTS model building for dozens of different types of distributors that also range from single-location operations to large chains, with nearly every type of rebate and processing step and service. Clients then continuously fine tune these models. Why not request a demo to specifically see how they do all of this?

 

Waypoint can put your cost-modeling / profit mapping project on the fast track, with results in three to four weeks, and a report inventory that would take years to build. The economics of renting the total service – fast, inexpensively and risk-free – versus building your own system in-house will become self-evident. Why not benchmark what you have now versus what Waypoint is offering today? (And, consider my extra Step #9: Attending the Fall Profit Management in Chicago. Contact me to be included on the invitation list.)

 

Bruce Merrifield

 

mailto:bruce@merrifield.com

 

 

*All Strategic Insights are posted at:  http://www.merrifield.com/insights/

**For more go to:  www.quantumprofitmanagement.com

 



[1] For more on “plays” and “scripts” see: www.merrifield.com/quantum and merrifield.com/exhibits 56-62.