Mine that Customer of Mine

transcript

Presented by: Dan Hill, CMA, CFM

Mine that Customer of MineUsing Customer Profitability to Mine Your Most

Valuable Customers

Today’s Agenda• Why customer profitability?• The customer profitability implementation

framework• A numerical example• Segment customers based on homogenous

needs• Use value propositions to improve customer

segment performance• A real world example

A Bold New Plan

What is Customer Profitability?

• Customer profitability– Measures the profitability for every customer or

customer segment– The sum of the profitability of all the products and

services the customer buys, adjusted for costsspecific to that customer

• Customer Profitability Management (CPM)– Uses customer profitability to measure and manage

corporate performance

A Crucial Principle

Profitable customers,current and future, are

the source of allcorporate value.

Customers are NOT Created Equal

Research shows:• About 20% of customers generate 150% to

300% of company profits• About 70% of customers are breakeven• About 10% of customers reduce or destroy

50% to 200% of company profits

(Kaplan and Narayanan 2001)

Profitability Whale Curve Tells the Tale

Custom er Profitability W hale Curve - $

$0$10$20$30$40$50$60$70$80$90

0 5 10 15 20

N umber C ustomers (R anked Most to Least P rofitab le)

Eight custom e rsa re profita ble

Five custom e rsa re bre a k-e ve n

The re m a ining 7custom e rs a reunprofita ble

What’s the Upside?

Custom er Profitability W hale Curve - $

0 5 10 15 20

N umber C ustomers (R anked Most to Least P rofitab le)

its ($

P ote ntia l profitim prove m e nt of $96m

Old School

• Common practice is to measure profitability ofproducts, services, or departments

• This yields average product profitability – theaverage of all customers using that product

• Averages have a tendency to hide importantdetails

• Need to de-average product profitability tothe customer level

Old School, Too

• Most companies organize around products,regions, or functions, not customers orcustomer segments

• A customer’s total relationship often spansdepartments, which is hard to see from insidea single department (or silo)

• Managers are rewarded based on departmentperformance – not customer results

Ignorance is Not Bliss

Not understanding customer profitability leadsmanagers and employees to:

– spend too much time on the wrong products andcustomers

– encourage unprofitable customer behaviors, forexample, “... bring it back if it doesn’t fit”

– incentivize the wrong things, e.g., promoting aproduct whether or not that product is right forthe customer

SMA – Customer Profitability Management

CPM Implementation Framework

Decision Phase

BusinessAlgorithms

Production andResults

Strategic Integration

FoundationBasics

CostingTransaction

SystemOptions

1. Decision Phase

• Explore the value and reasons for a CPMsystem

• Analyze financial consequences -implementation, maintenance, production

• Make “go or no-go” decision• Establish the primary purpose to guide

development and use

Decision Phase

BusinessAlgorithms

FoundationBasics

CostingTransaction

SystemOptions

2. Foundation Basics – Cost Object

• Establish the ultimate cost object –customer, account, invoice, segment, etc.

• Must be compatible with transaction data• Revenue must be measureable for it• Credit Union Example

–Customer is ultimate cost object–Account is intermediate cost object

Credit Union Customer Hierarchy

Define Customer, Product, Channel

• Customer– Define the customer

• Delivery channel– Define how customers interact with

the company• Products or services

Credit Union Product Hierarchy

Calculate Profitability Your Way

• Establish accounting principles• Resolve thorny accounting issues

– Unsuccessful sales efforts– Capitalization of large marketing programs– Controllable versus non-controllable

• Determine how customer profitabilitywill be measured

Customer Profitability Report

Decision Phase

BusinessAlgorithms

FoundationBasics

CostingTransaction

SystemOptions

3. CostingTo know customer profitability, one must knowcustomer costs:• Product costs

– Direct material and labor costs

• Costs to serve– Selling, distribution, invoice processing, receivables

funding

• Corporate sustaining costs– Landscaping, accounting, IT services, patent amortization,

executive salaries, etc.

The ABC’s of Customer CostsCustomer level costs require ActivityBased Costing (ABC):• ABC captures costs at the activity level so

each cost object is charged for the numberof times it performs each activity

• ABC captures the different resourceconsumption patterns of every customer

• Conventional costing assumes customers arehomogenous and consume resources equally

Standard ABC Model

Simple Credit Union Example

Decision Phase

BusinessAlgorithms

FoundationBasics

CostingTransaction

SystemOptions

4. Transaction Data

• Measuring a cost object depends on theavailability of transaction counts (productsand channels, too)

• CPM data is sourced from disparate computersystems– General Ledger (GL) for financial data– Core application systems for transaction data– Data warehouses for everything

Vast Sources of Data

Vast sources of data are buried deep inyour company’s IT systems• Harnessing that data for CPM can be costly

and time consuming• Accurate, repeatable, and timely sourcing of

data is difficult• Data sourcing poses the greatest risk of failure

to a CPM system

Cost What You Can Source

Maxim – Cost what you can source andsource what you can cost• Data must be available for the cost object to

build an activity cost driver• An activity cost pool must be available to

make use of an activity cost driver• Do not source driver data when no activity

cost pool exists, and vice-versa

Cost What You Can Source

Decision Phase

BusinessAlgorithms

FoundationBasics

CostingTransaction

SystemOptions

It Takes CoordinationFoundation basics, costing, and data phasesare highly interdependent:• Foundation basics are limited by costing

and data limitations• Cost object must have transaction data• Cost object activities determines what data

to source, and available data determineswhat activity cost pools to develop

Decision Phase

BusinessAlgorithms

FoundationBasics

CostingTransaction

SystemOptions

5. System Options

Select the appropriate information technology (IT)solution:• Two calculation engines for CPM

– Costing system – calculates cost driver rates– Profitability system – uses cost driver rates to calculate

cost object profitability• System expenses never end:

– Ongoing maintenance – backups, re-runs, data repair, etc.– Software upgrades – installation and testing– System refinements – changes in processes or data

sourcing

Decision Phase

BusinessAlgorithms

FoundationBasics

CostingTransaction

SystemOptions

6. Business Algorithms

Develop formulas that calculate cost driverrates and cost object profitability

• Similar to Excel where formulas areprogrammed into a spreadsheet

• Involve all employees as they know theirareas

• Thoroughly testing the entire CPM system iscrucial to its success

Decision Phase

BusinessAlgorithms

FoundationBasics

CostingTransaction

SystemOptions

7. Production and Results

Production – system runs monthly and producesCPM reports• Maintain high levels of quality control to

support confidence and usage• CPM reports – understandable, relevant,

usable, and actionable• Update cost driver rates every 12 to 18

months

Decision Phase

BusinessAlgorithms

FoundationBasics

CostingTransaction

SystemOptions

8. Strategic Integration

Customer profitability• Integrate into strategic decisions• Provides customer insights not

available before• Goal is to improve company’s

performance

The $64,000 Question

???!!!

But First – A Numerical Example

1. Decision Phase– Simple example from financial services industry– CPM purpose is to measure success of strategic

initiatives with customer profitability

2. Foundation basics– Establish the Cost Object:

• Customer account (e.g., checking account,mortgage loan account)

2. More Foundation Basics–Define the customer

• Customer profitability is sum of accountprofitability

–Define the Products• Loan• Deposit

–Define delivery channels• Branch• ATM (Automated Teller Machine)

2. More Foundation Basics

–Define the Activities• Open an account• Make a deposit• Make a withdrawal• Make a loan payment

– We’ll skip Phase 3 for now

4. Transaction Data Phase

Transaction data needed for cost object• Date account opened (new account)• Number deposits by channel for account• Number withdrawals by channel for account• Number loan payments by channel for

account• Account balance, account interest, and

account fees

4. Sample Data File

Now Back to Phase 3: CostingFour steps to costing

1. Arrange general ledger expenses intodepartments

2. Develop activity cost pools in eachdepartment

3. By department divide each activity cost poolby its number of transactions to yielddepartment cost driver rates

4. Combine department cost driver rates into atotal cost driver rate for each activity

1. Arrange GL Expenses by Dept.

2. Develop Activity Cost Pools

3. Calculate Dept. Cost Driver Rates

4. Combine Dept. Cost Driver Rates

Phase 6. Business AlgorithmsThree steps to determine customerprofitability

1. Calculate costs for each customer account(the cost object)

2. Calculate profitability for each customeraccount (the cost object)

3. Calculate profitability for each customer(sum of customer’s accounts)

1. Calculate Each Account’s Costs

2. Parameters Needed

Credit union requires parameters forprofitability• Funds Transfer Pricing• Provision for Loan Losses• Corporate Overhead Rate• Tax Rate

2. Economic Profits Require FTP• Funds Transfer Pricing (FTP)

– Capital cost of funding loan balances, or– Capital benefit of investing deposit balances

• For Example– Banks are paid interest on loans (GAAP interest

income)– Capital cost of the funds loaned are not

accounted for by GAAP– FTP assigns a capital charge to the loan’s

2. Loans Have Default Risk• Loans are charged a provision for loan

loss expense– Accounts for the risk of default– Similar to an insurance premium

• Loan loss provision rates vary by– Product risk– Customer risk– Bank exposure to customer– Other loss risk factors

2. Fully Loaded Corporate Overhead

Derivation of the Corporate OverheadRate:

(a) Exp. w/o Corp Sustaining=$1,177,000(b) Corporate Sustaining Costs=$292,500(b)/(a) Corporate Overhead Rate = 24.9%

2. Profitability Parameters

Parameters needed for credit unionprofitability calculations:

– FTP Cost of Funding Loans 6.5% annual rate– FTP Earnings Credit on Deposits 6.5% annual rate– Loan Loss Provision rate 0.6% annual rate– Corporate Overhead Rate 24.9%– Tax Rate 35.0%

2. Calculate Each Account’s Profits

3. Calculate Customer Profitability

Too Much Data – What To Do?

The $64,000 Question Remains

???!!!

Let’s Get Some Help!

FYI - availableat Amazon.com

Killer Customers - 2 Big Ideas!

1. Customer segmentation basedon homogenous needs

2. Value propositions targeted tosatisfy the needs of eachsegment

Idea One

Needs based customer segments:“Customer segments are groups of customers

whose traits, needs, and desires aresufficiently similar that the members of thesegment can be most profitably servicedwith similar value propositions.”

Killer Customers: Tell the Good from the Bad –and Crush Your Competition, Larry Seldenand Geoffrey Colvin

Idea Two

Targeted value propositions:• The complete experience a company delivers

to its customer• The winning value proposition is the one that

most profitably meets all customer needs forthe targeted segment, including price

Killer Customers: Tell the Good from theBad – and Crush Your Competition, LarrySelden and Geoffrey Colvin

1. Customer segmentation basedon needs

Reality of Customer Segments

• Some customer segments are morevaluable than others

• Customer segments must be treateddifferently

• Overcome idea that all customers shouldbe treated the same

• Profitable customers should get betterservice

A Real World ExampleMid-sized credit union (similar to a bank)• 275 employees• 60,000+ steady state customers• 7 quarters of customer profitability data• Starting point is steady state customers

– No new accounts– No closed accounts– No charged-off accounts

Customer Segmentation is a 5 StepProcess

1. Group all customers into profitability deciles2. Study behaviors within deciles to understand

why some are profitable and others are not3. With this understanding, define needs-based

customer segments4. Group each needs-based segment into

profitability deciles5. As experience and knowledge grow, re-define

and re-segmentKiller Customers, Selden and Colvin

CU Profitability Deciles – All Customers

Most profitable

Least profitable

Credit Union Whale Curve

Correlations Sometimes Help

Two Big Myths

Two rules of thumb have long existedin the banking industry:

1. Loan balances drive profitability2. Cross sale more products to make a

customer more profitable

Loan Balances are Important

Looks like a strongrelationship to loan

balances

We Need More Than Loan Balances

Closer look shows for bulk ofcustomers, the relationship to

loan balances vanishes

Cross Selling – That’s the Ticket?

Most profitable:3.4 accounts per

customerLeast profitable:2.4 accounts per

customer

Correlations of Decile 1 – the MostProfitable

Decile 1 – See Any Patterns?

Maybehere?

Decile 1 – A Closer Look

A lot of Decile 1 folks haveno loan balances at all!

Bottom Line at Top of the Organization

• Actionable information from high levelanalysis of customer data is rare and tenuous

• High level “rules of thumb” often fail whenexamined under the lens of customerprofitability

• The reasons customers fall into a particularprofitability decile are different and varied –there is no one way to reach them

Customers Have Needs

Customer needs• What problem or desire needs to be fulfilled

• What value is placed on solving that problemor satisfying that desire

• Needs include both cost and non-cost

• Needs are not demographic or psychographic(e.g., age, zip-code, income, occupation,attitudes, marital status)

Watch Those Behaviors!

Customer behaviors• How does the customer transact

business• Can behaviors be measured or tracked• Can behaviors be ascertained from the

products and services purchased• Can we impact these behaviors – for

Build a Needs Based SegmentLate Retirement Segment• Advanced age – over 80• Income from pension/401k and investments• Little need for loan balances (small mortgage?)• Investment needs not met by credit union• Large deposit balances• Not user of technologies (ATMs, online banking)• Uses drive-through and grocery store tellers• Pays little to no feesIMA’s 93rd Annual Conference – CMA: 40 Years of Excellence © 2012Institute of Management Accountants. All rights reserved. Page 87

What We Cannot See

Late Retirement segment needs• Small local bank• Good customer service• Pleasant people so feels comfortable

Define Your Proxies

Credit Union Data Reveals

Late Retirement Profitability Deciles

THIS IS APROFITABLESEGMENT!

A few are stillunprofitable

Late Retirement - See Any Patterns?

Maybehere?

What the Profitability Data Tells

Late Retirement Segment• Small but highly profitable segment• Average customer profitability = $2,085• Total segment profitability = $608,774,

which is 3.7% of the organization’s totalprofitability

• Possible relationship to deposit balances

What Can We Conclude?

Late Retirement Segment• Retain and attract these customers• Cross sell other appropriate services,

such as safe deposit boxes andCertificates of Deposits (CDs)

• Obtain some or all of their investmentbusiness

1. Customer segmentation basedon needs

Target Needs of Segment

Winning value propositions• Developed for each customer segment• Satisfy customers’ needs in a profitable

manner• Exist for customer segments with

homogeneous needs• Likely do not exist at the corporate,

product or service level

Profitability is the Yardstick

• Value proposition–Must be measurable to be actionable–Customer profitability tracks its success

or failure• Measuring profitability insures new

initiatives send us down the right path

Where to Begin?Stages of value proposition1. Creation – propose methods to profitability

meet homogenous customer needs2. Communication – communicate the proposition

to customers and employees3. Execution – implement the proposal and

measure its results using customer profitability4. Learn and repeat – customer profitability leads

the way

Late Retirement Segment – Value PropositionInitiatives

Late Retirement Segment - More ValueProposition Initiatives Segment

Where Have We Been?

• Use the customer profitability framework to builda CPM system

• A numerical example illustrates the calculation ofcustomer profitability

• Too much data - Killer Customers comes to therescue

• Real world Credit Union example– Top of the organization – no “magic bullet”– Needs based segment – needs are not

demographics– Value propositions – profitability is the yardstick

ConclusionStep 1 – Needs based segmentation groups

customers by homogenous needsStep 2 – Value propositions address the

homogenous needs of eachcustomer segment, including price

Step 3 – Customer profitability measuresthe success or failure of valuepropositions

Does Your Company Know?

“A key assumption must be that allcustomers are not created equal. If acompany does not know the current orpotential profitability of its customers,then it is likely misallocating its scarceand valuable resources.”

Gary Cokins, Performance Management, JohnWiley & Sons, Inc., 2004, pg 164

Contact Information

Dan Hill, CMA, CFMSenior Vice President, CorePROFIT Solutions, Inc.

DanHillCMA@att.netOffice: (704)509-6076

Cell: (704)618-0126www.coreprofit.com

Mine that Customer of Mine

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