ACCA - P5 Study text - Emile Woolf INT

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Chapter 13: Measuring performance

Customer profitability

 Profitability: customers and channels of distribution

 Customer profitability analysis

 Using customer profitability analysis

 Improving customer profitability

6 Customer profitability

6.1 Profitability: customers and channels of distribution

In highly competitive markets, it is important that companies should remain

profitable.

 They should avoid the risk of selling goods or services to customers at prices

that are too low, and fail to cover the costs of selling to the customer.

 They should also avoid selling products through channels of distribution that

are unprofitable.

For example, a book publisher might sell popular books to the general public

through bookshops, and educational books to schools and universities by means of

direct selling (with sales representatives visiting schools, universities and

educational conferences). Selling to each type of customer, through different

marketing channels, will involve different marketing and selling costs.

Companies should therefore measure the profitability of each of their customers, or

each category of customers.

Traditional management accounting systems fail to do this.

 A traditional management accounting system reports gross profit for the period,

and selling and distribution costs and administration costs are then treated as

period costs (fixed costs). These are deducted from gross profit to arrive at the

net profit for the period.

 Many costs associated with selling to customers are sales and distribution costs.

For different types of customer, the costs of sales and distribution can differ.

Traditional management accounting systems do not record these ‘customer

costs’.

Example

A company has two customers X and Y. Customer X buys about 100 units per

month and requires daily deliveries of five units on each working day of the month,

to a location about 50 kilometres away. Customer Y also buys 100 units each month,

but requires only one delivery each month, at the beginning of the month, to a

location less than five kilometres away. The goods are delivered in the company’s

own transport vehicles.

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It should be obvious that the costs of delivery to customer X will be much higher

than costs of delivery to customer Y. There are more deliveries to customer X each

month, and the goods have to be delivered a longer distance.

Because selling costs vary for different customers, the profitability of customers can

also vary. Traditional management accounting systems would not record the

differences in selling costs between customer X and customer Y. A system of

customer profitability reporting, on the other hand, will recognise the different

selling costs for each customer. The profitability of a customer can be measured as

the gross profit from selling goods to the customer, minus other ‘customer costs’ –

particularly selling and distribution costs associated with the customer.

6.2 Customer profitability analysis

Another approach to decision analysis involves assessing the profitability of

particular channels of marketing or particular types of customer. A company might

have several different types of customer, and it might sell to each type of customer

in a different way.

Relevant cost analysis can be used to identify whether it is profitable to sell to

particular types of customer:

Sales revenue from category of customer A

Variable/relevant production costs B

Gross contribution from category of customer (A – B)

Relevant marketing and selling costs C

Contribution of customer category to profits (A – B – C)

To analyse customer profitability, information is needed about the relevant costs of

selling to each particular type of customer. This information might be obtained from

activity based costing, where activities associated with different categories of

customer can be identified and costed.

For example, some types of customer might buy in large volume orders, whereas

another type of customer might buy in small size orders. The annual costs of

processing and delivery per unit sold will probably be much lower for the

customers who make large orders. These customers could therefore be much more

profitable. Activity based costing might be useful by identifying the costs and cost

drivers for order processing.

A potential benefit of activity based costing is the information it can provide to help

managers with customer profitability analysis.

6.3 Using customer profitability analysis

Customer profitability analysis can be extremely useful in reaching pricing

decisions.

Chapter 13: Measuring performance

 Prices charged to customers should be sufficiently high to cover all the ‘customer

costs’ for that customer.

 In order to retain customers, or win new customers, prices should not be

reduced to a level where they fail to cover customer costs – except perhaps as a

short-term loss-making action to retain or win business.

 To improve profitability, it should be possible to consider ways of reducing the

costs of selling to customers, as well as ways of improving the gross profit.

 If some types of customer are more profitable than others, a company might

concentrate most of its marketing efforts on selling to the most profitable types

of customer.

6.4 Improving customer profitability

An examination question on customer profitability analysis may also require you to

suggest how the profitability of different categories of customer might be improved.

There are three broad approaches to improving customer profitability.

 Improvements can be made in the processes used to supply customers, such as

reducing production costs or distribution costs to the customer.

 Another important aspect of customer profitability is pricing. Large customers

may be unprofitable if they are given large price discounts.

 Managing customer relationships. Companies spend money to develop

customer relationships. For example, they may spend heavily on advertising to

win new customers, or they may employ sales representatives to develop

relationships with key clients. Customer profitability can be improved by

making sure that the benefits from additional sales are more than the costs

incurred in developing and maintaining the relationships. For example, it is not

worth spending money on advertising for new customers, if the profits they

provide are less than the cost of the advertising.

Customer profitability can be improved by making improvements in processes. In

particular, improvements might be possible in the following processes:

 Order handling and production processes. It might be possible to persuade a

customer to make fewer and larger orders, so that set-up costs and other batch

costs can be reduced. (Alternatively, if a customer wants to have a just-in-time

system of purchasing, he should be prepared to pay for the extra costs associated

with producing in small batches.)

 Delivery processes. It might be possible to introduce improvements into delivery

arrangements. For example, a customer might agree to accept delivery of goods

at one location, instead of several different locations.

 Advertising. A company might reduce its spending on advertising and other

forms of marketing (such as direct mail) to customers whose profitability is low.

It is important to look at the total relationship with a customer, and assess the

overall profitability of the customer from all the different transactions. In banking,

for example, a corporate customer of a bank will use many different services of the

bank. The bank will charge for each different service that it provides, such as

electronic payments, processing cheques, foreign exchange transactions, borrowing

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facilities and so on. The bank might be prepared to offer some of these services at a

loss, in order to make profits on other types of transaction with the customer,

provided that the customer contributes to the profitability of the bank taking the

entire relationship into consideration.

Companies should also consider the relationship with a customer in the longer

term, not just the short term. High initial costs might be incurred to establish a

relationship with a new customer – for example, sales representatives might spend a

long time in meetings or discussions with potential customers and new customers.

In the short run, because of these high initial costs, the customer may be

unprofitable. In the longer term, however, selling to the customer should become

profitable. The high initial costs and early losses will be justified by the longer-term

profits.

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Advanced performance management

CHAPTER

Strategic models and

performance measurement

Contents

1 Five Forces model

2 Boston Consulting Group (BCG) model

3 Ansoff’s growth vector analysis

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Five Forces model

 Competitive strength and the five forces

 Existing competitors and competitive rivalry

 Threat from new entrants

 Bargaining power of suppliers

 Bargaining power of customers

 Threat from substitute products

1 Five Forces model

Using strategic models to set targets and measure performance

Several strategic planning models have been developed that can be used to set

strategic planning targets, and to measure and assess actual performance in relation

to strategic targets. These include:

 The Five Forces model of Michael Porter

 The BCG matrix of the Boston Consulting Group

 Ansoff’s product/market growth strategies.

Each of these models considers strategies for achieving a competitive position for

products in their markets, or for developing products and markets to grow the

business.

1.1 Competitive strength and the five forces

Michael Porter (in Competitive Strategy) developed a model for analysing the

competitive nature of markets and the competitive position of companies. It is also a

model for assessing the problems that a company faces in establishing a strong

competitive position in a market.

The model should be used to analyse a ‘strategic business unit’, rather than a

company as a whole. A strategic business unit (or SBU) is a part of a company’s

operations for which there is a separate and distinct market.

The model is called the Five Forces model, because Porter suggests that there are

five factors or ‘forces’ that affect the competitive position of a company in a market.

These five forces are:

 existing competitors and the rivalry between existing competitors

 the threat from new entrants to the market

 the bargaining power of suppliers

 the bargaining power of customers

 the threat from substitute products.

Chapter 14: Strategic models and performance measurement

Threat from new

entrants

Bargaining power of

customers

Existing competition.

Competitive rivalry

Bargaining power of

suppliers

Threat from substitute

products

A management information system should be able to provide measures relating to

each of these five forces, to assist management in making decisions about

competitive strategy.

1.2 Existing competitors and competitive rivalry

The strength of competition varies between different markets. Some markets have

several rival companies competing for customers. Other markets are dominated by

a single company, although there may be some small and weak competitors.

When competition is strong, companies are likely to pursue active competitive

strategies to retain existing customers and win new customers from their rivals.

They might compete by offering lower prices, a wider range of products or products

with a superior design or quality. For example, in the UK the retail market for food

products is dominated by four large supermarket chains (Tesco, Sainsbury’s, Asda

and Wm Morrison), which compete with each other mainly on the basis of price,

product range and location (convenience).

In a competitive market, an initiative by one company – such as a decision to the

reduce prices of some goods – is often copied quickly by its rivals. Gains in market

share might therefore be short-lived.

Companies in a competitive market try to retain or increase their share of the

market, and important information for management is therefore information about:

 growth in the total market, and

 the market share of each competitor in the market.

If a company is losing market share, or if a competitor is gaining market share, this

might indicate a weakness with the company’s existing strategies.

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Switching costs

Switching costs might affect the strength of competition in a market. Switching costs

are the costs that a customer would incur by switching from one supplier to

another. In some industries and markets, switching costs might be high. For

example, it might be necessary to train employees in a different technology of the

new supplier.

Switching costs might be high, for example, if a customer is considering a switch to

a new supplier of software. All the existing data files would have to be converted to

a format suitable for the new software and employees would have to be trained to

use the new system.

1.3 Threat from new entrants

In some markets, it is difficult for new competitors to enter the market. (The

‘barriers to entry’ are high.) This may be because entry to the market would require

a large capital investment, and any company entering the market would therefore

be taking a big risk.

The strength of the threat from new entrants depends on the strength of the barriers

to entry. Barriers to entry may not prevent competitors entering the market

eventually, but they can delay the entry of new competitors.

The nature of barriers to entry

A variety of factors might create strong barriers to entry.

 Economies of scale. Economies of scale refer to the ability of an entity to reduce

the average cost per unit of sales by producing and selling a larger quantity of

the product. They occur for a variety of reasons:

- By making and selling more units, fixed costs are spread over a larger

quantity and fixed costs per unit fall.

- An entity might be able to use larger machines that can produce larger

quantities more efficiently than smaller machines.

- An entity might be able to buy materials at a lower cost, by purchasing in

larger quantities.

 Capital investment. Entering a new market might require a large capital

investment. This might deter a new entrant, because the investment could be

high-risk.

 Customer loyalty. Entities already operating in the market might have strong

customer loyalty and a strong brand name. This would make it difficult for a

new entrant to win market share.

 A barrier to entry might exist in the form of legal or political protection. For

example, the products made by a company already in the market might be

protected by patent. Government protection might be provided in the form of an

import ban or by law. An example in 2006 was the failure of European online

gambling firms to enter the US market, because of US legislation against online

gambling. This legislation protected companies that operated casinos in the US.

Chapter 14: Strategic models and performance measurement

Weak barriers to entry

In some markets, barriers to entry might be low, and it might be fairly easy for new

competitors to enter the market. This is often the case with markets for services,

where the service relies on the skill or expertise of the service provider. For

example, it is often fairly easy for a professional person, such as an architect or a

solicitor to set up in business.

Occasionally, technological changes might reduce barriers to entry and make it

easier for new companies to enter. For example, the Internet has made it possible for

some companies to enter a market by offering goods or services for sale on the

Internet. Selling through a web site avoids the need for large investments in retail

stores or office property.

Barriers to entry would be lowered the government offered a subsidy or grant to

companies that invested in a particular industry.

A management information system should be able to provide information about

any new entrants to the market, the type of product or service they are providing,

the prices they are charging and the success they seem to be having in attracting

customers.

1.4 Bargaining power of suppliers

The competitive position of a company in its market might be affected by the ability

of one or more key suppliers to influence the market. Suppliers can have a very

strong influence when:

 there are very few suppliers to the market, and

 there are a large number of companies in the market, buying from the same

suppliers.

An example is the influence of producers of oil and natural gas over the energy

markets.

Powerful suppliers might be able to increase prices or control the supply of their

product to the market. Companies in the market are exposed to the risk that the cost

or the supply of a key resource could be changed by their supplier’s decision.

Companies in a market should try to:

 avoid reliance on a single supplier, if possible, and try to use several different

suppliers, or

 develop close strategic relationships with key suppliers.

When suppliers have a strong influence over a market, a company’s management

information system should provide information about:

 the number and identity of suppliers in the market

 their prices

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 the proportion of total purchases of key products that are obtained from each

supplier.

1.5 Bargaining power of customers

The competitive position of a company might also be affected by reliance on one or

a small number of customers. An entire market might be dominated by a small

number of potential customers. For example, the market for sophisticated weapons

systems is influenced by the power of the rich governments that can afford to buy

them. Similarly, the market for large passenger aircraft is strongly influenced by the

bargaining power of the fairly small number of airline companies that might buy

them.

The bargaining power of customers is particularly strong in markets where there is

a large number of suppliers but only a few customers. The UK retail market for food

was referred to earlier. In this market, there are only four major supermarket chains,

which buy a large proportion of all food products sold in the UK, but there are large

numbers of small suppliers. The powerful buyers are often able to dictate terms to

the suppliers, and can threaten to switch to different suppliers if the do not get what

they want.

When customers have a strong influence over a market, a company’s management

information system should provide information about:

 the number and identity of the major customers in the market

 what these customers are asking for, in terms of product or service quality and

price

 the proportion of the company’s total sales that are made to each major

customer.

1.6 Threat from substitute products

The competitive strength of a company might also be affected by the existence of

substitute products. The company needs to be aware that its competitive strategy

could result in a switch of customer demand to or from a substitute product.

For example, an increase in the worldwide price of tea could lead to a switch in

demand from tea to coffee. Similarly, higher prices for travel by railway could lead

to a switch by customers to alternative forms of transport, such as air or road.

When there are close substitutes for a company’s products or services, management

should be provided with market information about these substitutes. For example, a

company that supplies tea should monitor the market for coffee and other drink

products.

ACCA - P5 Study text - Emile Woolf INT - 2010

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