Part 1: Quantifying Cost Reduction Objectives
Increasing Margins by Improving Customer Mix
The Company may close part of its shortfall in financial results by improving margins through selling a greater proportion of sales to Core customers.
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Symptoms and Implications:
The end point for all of the Company's costs in this diagnostic is a customer order. As with products, customer orders have revenues and competition. They have costs and a resultant profitability. The Company uses an analysis of customer profitability to determine the customers to keep and to drop over the long-term. In turn, the improvement in the mix of customers helps the Company reach its financial objectives.
The Company’s diagnostic task is to identify its most important customers, and to determine the mix that these Core customers represent in the current and the future sales volume of the Company, and then identify the Return on Investment improvement that the improved mix of customers will produce for the Company.
We discuss each of these topics below in the following sections:
There is a more extensive discussion of customer types and the identification of Core customers in Basic Strategy Guide Step 11 and in the Advanced Site at Diagnose/Segments/Final Targets
Types of Customers
A Company has three categories of customers: Core customers, Near-Core customers, and Non-Core customers. The customer's likelihood of producing a good Return on Investment determines its membership in one of these categories.
A Core Customer is one whose pricing and cost-to-serve requirements allow the Company to earn its cost of capital on the relationship through the business cycle of the industry. Core Customers are the backbone of the Company's profit structure. Core Customer Examples »
Other customers would be either Near-Core or Non-Core customers, both of whom are expendable.
A Near-core customer is one whose pricing and cost-to-serve characteristics enable the Company to earn a positive return on capital, but a return below its total cost of capital, through the business cycle. The Company maintains Near-core customers in the expectation that these customers will eventually become Core customers or to use some of the Company’s excess capacity in the medium term while its Core customers grow. Near-Core Customer Examples »
A Non-core customer is one whose pricing and cost-to-serve characteristics allow the Company to realize a positive cash flow, but a negative return on capital through the business cycle. The Company maintains relationships with these customers only to use excess capacity over a relatively short term. Non-Core Customer Examples »
Identification of Core Customers
The identification of Core customers assumes more importance in very difficult markets. In Hostile markets, customer profitability is far more variable than in Stable markets, where Returns on Investment for the industry are at, or above, the average for all industries. In the average industry, the profitability of the customer relationship depends first and foremost on the size of the customer. The Company may often predict the expected profitability of a customer the Company does not presently serve by noting the size of the customer compared to the average customer in the market. The larger customers tend to be more profitable than are the smaller customers. On the other hand, the size of the customer is a much less reliable predictor of the expected profitability of a customer relationship in a Hostile market. In a Hostile market place, profitability of a customer relationship often may be greater with smaller customer relationships than with the larger customers. This shift in expected profitability from larger customers in the average industry to Small and Medium customers in a Hostile industry is the result of differences in prices.
The price paid by a customer is a substantial factor in that customer's profitability. In a Hostile marketplace, the largest customers pay substantially lower prices than do smaller customers. But this assertion holds only for the average customer in a size segment. Within any customer size segment, prices paid by individual customers vary widely. In a Stable market, where returns on investment for the industry are at or above the all-industry average, the price differences between large and small customers are less significant than they are in Hostile marketplaces. At the same time, the range of variability from the average in prices paid by individual customers in a customer size segment is also much smaller in a Stable market.
The individual customer price variations create a wider divergence in customer profitability in a Hostile market than in a Stable market. In a Stable market, the average profitability of a segment is a good representation of the profit expectation for a potential new customer. In contrast, the profitability of each customer in a Hostile marketplace can vary so significantly from the average that the Company must evaluate, individually, the profitability of each current customer and the likely profitability of each prospective customer relationship.
There are cases where the Company would choose to carry an unprofitable customer. Some, though few, unprofitable customers bring other business to the Company. One common example might be an industry leader. Industries where one or two companies dominate by reputation, quality and market share see smaller firms play "follow the leader." If the industry leader adopts a product or process, many others in the industry follow. This is the Industry Leader Effect.
In an industry with this Industry Leader Effect in place, the Company may find that the leading company in the industry is unprofitable as a stand-alone customer. However, if the industry leader chooses the Company as its supplier, many of the follower customers in the industry will also choose the Company as a supplier. These follower customers may be profitable, attractive customers but the Company would not have gained them were it not for the Industry Leader Effect. In such a situation, the Company should evaluate the industry leading customer's profitability in connection with the profitability of all the other sales volume that the more profitable follower customers in the industry would bring to the Company as well.
The identification of Core, Near-core, and Non-core customers may change the Company's plan for capital investment in tough markets. Before the Company would undertake capital investments to support growth in the marketplace, it would assure itself that its worst customers would enable the Company to earn an acceptable return on any new investment the Company must make. If not, the Company would choose not to make the new investment but would, rather, use the Non-core or Near-core customer volume to support the needs of the more profitable customers.
Near-core and Non-core customer returns would support only the highest return capital investment options, those that cost little and add little capacity. In a Hostile market, the Company would not undertake major capacity additions, such as a new production line or a greenfield plant expansion until such an expansion were necessary to support Core Customers.