Managerial Auditing Journal

Customer profitability analysis:: an activity-based costing approach

Malcolm Smith Shane Dikolli
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Malcolm Smith Shane Dikolli, (1995),"Customer profitability analysis:", Managerial Auditing Journal, Vol. 10 Iss 7 pp. 3 - 7
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 CUSTOMER PROFITABILITY ANALYSIS: AN ABC APPROACH
Customer profitability analysis:
an activity-based costing approach
Malcolm Smith and Shane Dikolli
A systematic approach is essential in attempting to develop an ABC analysis
The impact of activity-based costing (ABC) on customer
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profitability analysis (CPA) has attracted relatively little
attention in the management accounting literature. Bellis-
Jones[1], Howell and Soucy[2] and Smith[3] have
examined the importance of customer profitability
without exploring the potential usefulness of ABC in
developing an accurate CPA.
CPA is justifiable if the cost-benefit of compiling the
information is favourable and the outcome of any
subsequent strategic decision leads to income increases.
Strategic decisions may range from changing the delivery
terms of a customer’s contract to terminating business
dealings with an unprofitable customer.
Smith[3] observes that strategic consideration of
customer-related costs can lead to a cost-effective change
in the way customers’ needs are satisfied. Figure 1
encapsulates the range of possible customer expense
categories and identifies four key factors which impact
on customer profitability.
Further embellishment of this figure for each of the key
factors allows the development of characteristics which
distinguish profitable from unprofitable customers.
A consideration of discounts, commissions and sales
support allows the impact of purchasing patterns to be
specified, as shown in Table I.
Discount and commission data, sorted by customer, is
likely to be readily available in most computerized
accounting systems. However, the determination of field
service and sales support costs for each customer will
necessitate some form of ABC. For example, the average
length of time spent taking a customer’s order might be
measured and then applied as a weighting factor to the
number of telephone calls made. Large switchboard
systems are capable of providing such statistics
Managerial Auditing Journal, Vol. 10 No. 7, 1995, pp. 3-7
© MCB University Press Limited, 0268-6902
3
automatically. Time and information management
systems can be added to smaller telephone systems to
collect statistics relating to the frequency of calls to
customers’ telephone numbers.
Sales representatives’ planning sheets or an associated
computerized system could provide statistics regarding
the number and distance of customer visits. Alternatively,
an estimated number of calls per customer, weighted
according to the distance of the visit, might be used as a
basis of allocation of sales-support costs. Ultimately,
significant purchasing pattern dollars revealed in a
customer profitability analysis should focus
management’s attention towards attempting to modify a
customer’s purchasing behaviour.
A consideration of distribution costs and frequency and
special delivery requirements allows a further distinction
to be made, as shown in Table II.
Even with ABC, the split of the distribution cost between
customers on a common delivery run is difficult.
Assuming each delivery consumes the same amount of
time, the most logical allocation of distribution cost is an
even split between all customers to reflect capacity-
consuming packaging or, more commonly, significant
distances from the distribution point.
The number of customer deliveries should be extractable
from the sales ordering system and will be a useful input
to the process of allocating distribution and shipping
frequency costs to customers. Resource costs associated
with shipping frequency might be split between standard
and non-standard shipping activities, the latter requiring
some form of manual monitoring. However, such a
process will be worthwhile if it highlights those
customers who place abnormal resource-consuming
demands on the organization.
The impact of differential ordering and debt-handling
procedures on the cost of the accounting function further
specifies the characteristics typical of the unprofitable
customer, as shown in Table III.
 4 MANAGERIAL AUDITING JOURNAL 10,7

Figure 1. Expense categories impacting on customer Table II. Delivery policy and customer profitability
profitability
Characteristics of Characteristics of
Purchasing patterns Expense profitable customers unprofitable customers

Delivery policy
Distribution Located close by, Located long distance,
expenses standard packaging, unique capacity-
Customer
profitability barcode reading consuming packaging
Shipping Infrequent large-lot Daily deliveries with
Accounting procedures frequencies deliveries additional deliveries
on demand
Inventory holding Freight fleet No special Require purchase or
requirements requirements conversion of custom-
made delivery trucks

While the value of sales credits per customer is easily

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determined, the consumption of resources associated

with administering the number of sales credits can only apparent arbitrariness of such weighting factors, the final
be determined only with analysis and measurement of analysis resulting from their implementation may
occurrences of the activity driver. provide a number of opportunities with which to alter the
management of customer accounting activities.
The activity costs of processing customer remittances can
logically be allocated to customers on the basis of the Inventory-support and holding requirements, too, are
number of remittances received, but those customers who often customer-specific with a direct impact on their
pay late might be assigned a weighting factor to reflect a relative profitability, as shown in Table IV.
greater consumption of organizational resources (for
example, through follow-up telephone calls) than by on- Customers requiring immediate deliveries will necessitate
time customers. A further weighting factor might also be the organization holding greater inventory levels. The
applied to customers who receive settlement discounts on increased costs of storing inventory can be assigned to
accounts greater than, say, seven days. such customers using weighting factors. Determination
of such weighting factors per customer requires an
Order entry and processing would similarly be allocated accumulation of statistics relating to required delivery
to customers based on the number of invoice line items, promptness. These statistics may necessitate manual
with customers with standing orders or complex orders collection, or could be modelled from computerized
assigned an appropriate weighting factor. Despite the systems to reveal the average number of days between a
customer’s order and the corresponding delivery date.
Table I. Purchasing patterns and customer profitability Decisions can be made to change the characteristics of a
customer from profitable to unprofitable, but the success
Characteristics of Characteristics of of such decisions depends on the accuracy of the
Expense profitable customers unprofitable customers information provided in the CPA. While ABC can
improve the accuracy of such information, conventional
Cost of Nil to low discounts Large discounts ABC systems have limitations that need to be addressed.
volume
discounts Not all ABC systems will analyse cost drivers in the area
Size of agent’s Low commissions High commissions of customer-related costs, despite the likelihood of their
commissions not being volume-dependent. More sophisticated ABC
systems may manage customer-related costs effectively,
Cost of field Infrequent, successful Lengthy delays in
service to order-getting obtaining daily orders but this depends largely on the objectives of the ABC
maintain telephone calls by telephone system and/or the nature of the production process.
products
Where the primary objective of the ABC system is to
Cost of sales Few visits Frequent calls,
support assistance with
determine product profitability, then the cost drivers
administrative selected will probably be quite different from those
operations, help with selected for customer-related resource consumption
in-store displays analysis. Delivery costs, for example, might be assigned
accurately to customers based on distance travelled to the
 CUSTOMER PROFITABILITY ANALYSIS: AN ABC APPROACH 5

Table III. Accounting procedures and customer profitability requires tracing of the distances travelled by each
product to each customer. The nature of such a task,
particularly in an environment with a diverse product
Characteristics of Characteristics of
Expense profitable customers unprofitable customers range, would be extremely onerous. An alternative, but
less accurate, way of allocating the cost would be to use a
capacity or volume-based measure. This may be feasible
Sales credits Collates any sales Initiates separate sales
from a cost-benefit standpoint.
credits and claims credits for each item of
monthly product returned
By contrast, in environments where custom-made
Settlement Discounts, if any, Receives discounts on products dictate the nature of the production process, the
discounts apply to cash sales accounts greater than
activity drivers from both a product-profitability and a
seven days
customer-profitability perspective are likely to be similar
Debtor Pays on time Pays late because the custom-made product is delivered to a
collection customer and the associated distance travelled will be the
support same for either the customer or the product as the cost
Order Maintains regular Requires immediate object.
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processing bulk orders crisis deliveries

resulting from In mass-manufacturing environments, it would seem
stockouts, but whose more likely, then, that the activity drivers selected for a
order details are so
complex that multiple
customer profitability analysis would differ from the
queries result before activity drivers selected for a product profitability
the transaction can be analysis.
completed
Johnson[4] suggests that activity-based concepts are
being oversold and that focus on total customer
satisfaction is of paramount importance. He argues that if
customer premises; but where product profitability is the customers really want frequent deliveries in small-lot
ultimate objective, it is simpler to assign delivery costs sizes, and an alternative supplier can meet the customer
based on the volume or weight of the product delivered to needs, then activity analysis might be misleading the
customers, irrespective of where the product was supplier. This assumes that the supplier is prepared to
delivered. decline the customer’s business and allow a competitor to
supply that customer. Using ABC in a customer
For example, to allocate accurately delivery costs of profitability analysis, the supplier may indeed accept that
$10,000 over a total distance travelled to customers of the customer is unprofitable and be willing to meet the
2,000 kilometres, it is necessary to trace the distances customer’s needs. Kaplan[5] discusses three types of
travelled to each customer and assign costs at the rate of potentially unprofitable customer who might be retained:
$5 per kilometre. In many cases the individual distances (1) new and growing customers, who promise
could reasonably be estimated without too much profitable business in the future and may provide a
difficulty. From a product-profitability perspective, stepping stone for penetrating lucrative new
allocating accurately the $10,000 over different products markets;
(2) customers providing qualitative rather than
financial benefits, including customers at the edge
Table IV. Inventory holding and customer profitability
in the development of new markets who provide
valuable insights into likely trend movements in
Characteristics of Characteristics of consumer demand;
Expense profitable customers unprofitable customers
(3) customers providing increased capability because
of their status as recognized leaders in their
Inventory Predictable delivery Requires delivery on
markets or fields of expertise.
support and inventory demand at irregular
requests times Thus, where a CPA reveals that a particular customer is
Distribution Collects sales orders Requires free delivery unprofitable, it does not necessarily follow that this
support to a remote or customer should be eliminated. Nor does it follow that the
long-distance location customer must be persuaded to accept terms and
Holding Compatible with Will take business conditions that will reduce the customer’s level of
requirements your JIT scheduling elsewhere if required satisfaction. Negotiations with a customer might well
inventory is not held reveal that less frequent deliveries would actually benefit
the customer (i.e. less workload for the receiving officer,
 6 MANAGERIAL AUDITING JOURNAL 10,7
fewer purchase orders, fewer transaction input entries,
less paperwork) without causing costly stockpiles.
Clearly, there is scope for negotiating with customers to
influence their behaviour (so that they act in ways which
are more profitable for the firm) without compromising
the customer’s level of satisfaction. Some aspects of
improved negotiation might include:
● non-cash incentives from sunk-cost investments –
for example, sponsoring a season of a major
cultural event primarily yields advertising
benefits; however, seats in the accompanying
corporate boxes might also yield enticing
customer incentives. Similarly, a company’s
accumulated frequent-flyer points may perhaps be
spent on customers, new or existing;
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● restructure of delivery runs to create a more timely
but less frequent service for the customer;
● capacity maximization on delivery runs that are
required for profitable customers by offering a more
frequent service for the potentially unprofitable
customer with unpredictable demands;
● purchase of equipment on behalf of customers
which they can use rent-free, in lieu of discounts
and/or agent’s commissions. The cash saved on
reduced discounts/commissions potentially should
exceed the cost of the asset. Additionally,
ownership is retained and a stronger bond is
forged with the customer, thereby generating
greater negotiating power in future;
● free short-term financial advice which will create
efficiencies for the customer, leading to reduced
internal workload and consumption of resources;
● new products at no cost in return for reduced
discounts, to serve a dual purpose: improving
customer profitability while providing a useful
vehicle for the promotion of new products;
● a trade-off between quantity discounts and
settlement discounts that minimizes the costs of
cash overdraft and maximizes long-run production
scheduling.
The overriding consideration with a CPA is that
management will at least be armed with information
about unprofitable customers and can focus attention on
developing those innovations/strategies that might
reduce the lack of profits of a particular customer,
without reducing that customer’s satisfaction.
Alternatively, provided a shift of thinking is possible,
management can restructure the manufacturing process
that will ultimately lead to a shift in the results of a
customer’s profitability.
The role of the mechanics of ABC in developing a CPA
should not be underestimated. With ABC, general ledger
amounts are dissected, making the assignment of costs to
customers easier. In particular, the associated on-costs of
employing sales staff and motor vehicles would be
analysed in detail and be readily available. This would
embrace vehicle operating costs (depreciation, petrol,
licensing, insurance and vehicle signage) as well as
superannuation, fringe benefits and payroll tax, holiday
and long-service leave entitlements, worker’s
compensation insurance, mobile telephone and training
costs. Several of these items might conveniently be
omitted from a non-ABC customer profitability analysis
because of the complex analysis required to divide the
general ledger amounts between the activities of different
salespersons.
Resource to activity allocations (e.g. gas, water,
electricity) provide a more accurate representation of
resource consumption by customers. A non-ABC
alternative is likely to cause customer-cost distortions in
such translations. Additionally, activity drivers will
assist in the assignment of activity costs to customers,
where otherwise arbitrary allocation methods would be
employed. Thus, distribution costs might be assigned on
a zone basis depending on the delivery destination
activity, rather than being spread across all customers in
an arbitrary fashion.
A systematic approach is essential in attempting to
develop an activity-based costing CPA. Lewis[6] outlines
a simple ABC system for recognizing marketing costs by
product line. He also indicates how these ideas can be
easily transferred into a profitability analysis statement
by territory. It follows that Lewis’s ideas could be
extended further to a full CPA, or at least provide a useful
starting-point for developing a CPA.
For more sophisticated models, Turney and Stratton[7]
present an activity-based model using micro and macro
activities which lead to assignment of cost to final
products. This two-tiered activity structure could apply
just as well to an assignment of cost to customers as it
does to final products. The primary advantage of this
type of model is that dual objectives may be satisfied, as
follows:
● customer costing objective – depicting the
profitability of a customer using the cost of macro
activities;
● performance improvement objective – isolating
detailed areas for potential improvement by
focusing on micro activities.
The two-tiered activity model reduces many of the
difficulties associated with conventional ABC systems
where the activity drivers to the final cost object are so
aggregated that the level of accuracy is potentially
compromised.
Detailed analysis of customers, and associated service-
cost differences, may be justified if the cost of obtaining
 CUSTOMER PROFITABILITY ANALYSIS: AN ABC APPROACH
and maintaining information is not excessive, or if the
information so generated is useful in the making of
strategic decisions.
Analysis of the revenue streams generated by customers,
relative to their service costs, may lead to some customers
being eliminated from the business or, at least, a change
of emphasis in the way in which resources are allocated
between customers.
In each case incremental costs and price elasticities of
demand must be examined and a customer loyalty profile
established to determine sensitivity to prices or to the
levels of service provided. How will our internal costs
change in response to variations in the level of service
provided? A fundamental analysis of customers, and the
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effect of variations in service on internal cost structures,
will provide the information to support strategic
decisions relating to the customer base. A more accurate
ABC model, tracking resource consumption by
customers, is likely to cause fewer customer-cost
distortions than are non-ABC alternatives.
The need for a strategic approach is evident. We must not
be tempted to pigeon-hole TQM, ABC or CPA and
Malcolm Smith is Associate Professor of Accounting in the School of Economics and Commerce, Murdoch University,
Murdoch, Western Australia and Shane Dikolli is Lecturer in Accounting in the School of Accounting, Curtin University
of Technology, Perth, Western Australia.
7
examine each in a blinkered fashion. They must be
employed simultaneously so that all aspects of customer
focus can be considered, with projected costs and
revenues appropriately quantified.
References
1. Bellis-Jones, R., “Customer profitability analysis”,
Management Accounting (UK), February 1989, pp. 26-8.
2. Howell, R.A. and Soucy, S.R., “Customer profitability: as
critical as product profitability”, Management
Accounting (US), October 1990, pp. 43-7.
3. Smith, M., “Customer profitability analysis revisited”,
Management Accounting (UK), October 1993, pp. 26-8.
4. Johnson, H.T., “It’s time to stop overselling activity-based
concepts”, Management Accounting (US), September
1992, pp. 26-35.
5. Kaplan, R.S., “In defense of activity-based cost
management”, Management Accounting (US), November
1992, pp. 58-63.
6. Lewis, R.J., “Activity-based costing for marketing”,
Management Accounting (US), November 1991, pp. 33-8.
7. Turney, P.B. and Stratton, A.J., “Using ABC to support
continuous improvement”, Management Accounting
(US), September 1992, pp. 46-50.
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