WHICH CUSTOMERS MATTER MOST?
by Donald V. Potter
Customer profitability differs dramatically in non-hostile and hostile markets. Does the relative importance of one customer versus another change as well? The answer is less evident than many business leaders believe.
“The 90-20 Rule”
“Traditional accounting shows large customers as less desirable.”
In a non-hostile market, 80% of a supplier’s volume — and 90% of its profits — come from its largest customers. This ratio generally holds true not only for the market leaders, who serve the very largest customers, but also for second-tier suppliers, who gain most of their profitability from their relatively largest customers.
Why are large customers so disproportionately profitable? In a non-hostile market, they can seldom negotiate price discounts greater than 3-6%, yet, because of their large volume purchases, they are more than 3-6% less expensive to serve.
In a hostile market, however, the situation is reversed. Large customers cite their volume of purchases to negotiate price discounts of 20% or more. Yet the cost of serving these large customers does not drop – it may even rise, as large customers also insist on additional service or support. Conventional accounting practices show that these large customers are now far less profitable and desirable than medium-sized to smaller customers who pay higher prices.
The Customer Pyramid
To understand why conventional accounting can be misleading, envision a company’s customer mix as a pyramid. Large customers form the foundation because their volume enables a company to spread its costs across a broad base. High-volume customers are just as important in hostile markets as in non-hostile markets because, without their volume, the mid-sized or smaller customers that appear profitable would not actually be economic to serve. The calculations that make smaller customers seem more desirable presume an infrastructure that wouldn’t exist if not for the volume that only large customers can bring.
At the same time, enlarging the top of the pyramid may be less feasible than imagined. Targeting small to medium-sized customers for additional sales entails potential problems.
First, they rarely offer enough volume to replace fully the large customers. Second, they often have confused strategies themselves and make inconsistent demands on suppliers. Third, they do require more service per unit of sale than do large customers. And, finally, other keen suppliers are also likely to seek them out and reduce their relative profitability through more aggressive pricing.
Smart Companies, Foolish Choices
“A company may regret a pull back.”
Although high-volume customers continue to be the key, in hostile markets as well as non-hostile, many companies turn away from their largest customers when hostility sets in. “They are treating us like a commodity,” suppliers complain as they pull back from serving customers who seem, suddenly, not only “unprofitable” but also difficult.
It is a choice that many companies come to regret. In theory a supplier might be able to avoid large customers or to scale back on serving them for a time-perhaps even a few years- without permanent loss. They might be able to “get away with it” for a while because of their strong brand franchise or customer inertia. In reality, though, few suppliers can ever reverse their course of action later in hostility. The larger customers see this as failure.
One supplier’s failure to keep a customer satisfied is another supplier’s
opportunity for new business. As many market leaders realize too late, second tier suppliers are waiting for such opportunities. Failing to satisfy a customer is opening the door to a competitor, often a smaller supplier who can use the volume to grow stronger. This is how today’s second-tier players become tomorrow’s market leaders.
A few examples:
- Motorcycles: In the ’70s, most European motorcycle makers ceded the heart of the market to the Japanese in the hope of keeping their profitable high-end niches. Later, they lost most of the high-end market as well, as the Japanese expanded into these niches.
- Semiconductors: In the ’80s, many chip makers found the high-end application-specific integrated circuit market a poor long-term haven from the turbulent commodity memory chip market. The high profits in the smaller market attracted the largest players as well.
- Truck Manufacturing: In the ’90s, Freightliner, which was not even among the top five suppliers ten years prior, became the industry leader by serving the largest customers that the erstwhile leaders either failed or ignored.
Even in hostile times, ignoring the demands of current large customers in the hope of finding more attractive business elsewhere is a risky choice.
(Note: This Perspective was written in the context of the economy in 1994. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)