Cost Management Profitability Analysis

By: Decimal  09-12-2011
Keywords: profitability, Cost Management

Budget cutbacks, increased customer (taxpayer) demands, increased operational complexity— many of today’s managers have to deal with these challenges. Every organization, be it public or private, operates in an environment that is going through fundamental and ongoing changes. It is vital, therefore, that these organizations equip themselves with the management tools that will allow them to progress at the same rapid pace.

Knowing how your costs break down and especially how they behave depending on a variety of different situations and decisions are two elements vital to sound organizational management. Knowing how fast things change today is yet one more reason to deploy a strategic cost management enabling you to react quickly.

In the public sector, taxpayers demand more services while requiring the use of technology and new distribution means such as the internet. The rapid transformation of the government sector has had a major impact on its cost structure. For the federal government, “knowing your costs is part of knowing your business”. Departments with external user fees are required to know their costs and report on them. Cost management is part of a sound governance process and leads to an accountable environment.

In the private sector, managers have to deal with exchange rate fluctuations, aggressive and increasingly numerous competitors in an ever-expanding global market. As company equipment ages, managers wonder how they can modernize it without negatively affecting customer service and productivity. The ability to determine the consequences of such decisions in advance is thus not only a vital component of managerial decision-making but also confers a strategic competitive advantage.

Indirect costs continue to climb as a result of the company’s increasing focus on improving the way it manages both itself and its relationships with external partners. All these elements combine to modify your company’s cost structure and behavior. All too often, the limitations of conventional cost models prevent the company from seeing the complete cost mix picture. 

The Pareto Principle states that 20% of a company’s customers generate 80% of its sales. This law has been part of our lives for quite some time already, and our guess is that it will be around for a long time.

For example, for most manufacturers, Walmart usually represents a huge customer (in top dollars) and is most definitely part of the top quadrant of the 80-20 rule. But where does profitability fit into that law? Is Walmart a profitable customer? Is your best customer always in the top most profitable quadrant?

In these times of budget cutbacks and rigorous cost management, managers have a tendency to look solely at costs and possible ways of reducing them. However, it is now more than ever necessary to know the mix of elements that makes up your profitability. How would you answer the following questions?

  • Exactly how much profit does each of your customers generate?
  • Which are the most, which are the least profitable, and why?

Some studies show that a mere 20% of your clientele generate anywhere from 150 to 300% of your profits, while as few as 10% reduce your profits by 50 to 200%. The following figure shows the results of one study in table form.

Thus, if you had made $1 million in profit by year-end, 10% of your customers would have generated losses of between $500,000 and $2 million. It would seem logical to try and identify those particular customers. This brings us to another question:

Are your most loyal customers also your most profitable ones, or are they merely profitable?

Here is what the authors of a study on this subject had to say about customer loyalty and profitability:

"Specifically, we discovered little or no evidence to suggest that customers who purchase steadily from a company over time are necessarily cheaper to serve, less price sensitive, or particularly effective at bringing in new business.” (1)

The use of our solutions provides a close-up view of all the elements of your profitability. You will realize exactly how profitable your products, services and customers are and thereby find answers the following questions:

  • Which are my most profitable clients and, by the same token, my least profitable ones?
  • Which are my most profitable products and services?
  • Which sources of information do I rely on to review my marketing strategy?
  • How should I respond to my clients’ increasingly complex demands?
  • Would reviewing my production mix generate more profits?
  • How is it possible for my production costs to remain steady while my profit margin steadily decreases?

 (1) "The Mismanagement of Customer Loyalty", by Werner Reinartz and V. Kumar, Harvard Business Review, #1407, p. 6

The information in this article was current at 06 Dec 2011

Keywords: Cost Management, profitability

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