SELF TEST #26: Identify the Profit Increase from the Improvement in the Mix of Customers
What types of customers, by profitability, are there?
There are three types of customers: Core, Near-core, and Non-core customers:
Near-core customers are customers whose pricing and cost-to-serve characteristics enable the Company to earn a positive return on net capital employed, but a return below its total cost of capital, on sales made to the customer through the business cycle.
Non-core customers are customers whose pricing and cost-to-serve characteristics allow the Company to realize a positive cash flow, but a negative return on net capital employed, on the sales made to the customer through the business cycle.
How would the Company estimate the likely profitability of a customer it does not serve?
In a Stable market, where Returns on Investment for the industry are near or above the average for all industries, profitability tends to vary directly with the size of the customer. Customers pay prices that are relatively close to one another. As a result, the larger customers tend to provide more profitability because of the Economies of Scale of serving a large, rather than smaller customers.
In a Hostile market, Small and Medium customers are often more profitable than the larger customers. In these markets, the profitability of the average customer may be inversely related to the customer’s size. The larger the customer, the less profitable the customer is likely to be. The best way to estimate likely profitability of a customer is to estimate the price this customer is likely to pay compared to the average price paid for customers of similar size.
No, there are two cases in which a company might choose to serve a Very Large customer whose likely profits will not create a positive Return on Net Capital Employed. The first is occasions where the company has excess capacity. If sales to this Very Large customer will produce positive cash flow, the company is likely to be better off in selling to this customer than not. The second, and more common, situation occurs due to the Industry Leader Effect. The Industry Leader Effect is an increase in sales volume and profitability the Company receives from smaller customers because of the good reputation the company acquires by serving the industry’s leading few customers.
When the Industry Leader Effect operates in a market, a company should evaluate the industry leading customer’s profitability in connection with the profitability of all the other sales volume that the more profitable followers in the industry bring to the company as well.
The improvement in customer mix, which is a shift of the proportion of sales toward more Core customers and away from Non-core and Near-core customers, should improve the operating margins, or Return on Sales, in the Company because Core customers pay higher average prices and may cause lower average costs than Near-core and Non-core customers. This customer mix improvement may also improve the Effectiveness of the use of capital in the business by producing more sales dollars per dollar of capital employed. In either case, the improvement in customer mix improves the Company’s Return on Investment.