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Statements on Management Accounting

B U S I N E S S P E R F O R M A N C E M A N A G E M E N T

C R E D I T S

T I T L E

IMA® would like to acknowledge the work of the authorsof this SMA: Nabil Elias, Ph.D., FCMA (Canada),University of North Carolina at Charlotte; and Dan Hill,CMA, CFM, CorePROFIT Solutions, Inc. Thanks also go

to Gary Cokins of SAS and DeWayne L. Searcy, Ph.D.,CMA, CPA, CIA, of Auburn University, who served asreviewers, and Raef Lawson, Ph.D., CMA, CPA, CFA, ofIMA, who serves as series editor.

Customer ProfitabilityManagement

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Statements on Management Accounting

T A B L E O F C O N T E N T S

CUSTOMER PROFITABILITY MANAGEMENT


Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2II. CPM Implementation Framework . . . . . . . .6III. Decision Phase . . . . . . . . . . . . . . . . . . . . . . . . . . .8IV. Foundation Basics . . . . . . . . . . . . . . . . . . . . . .10V. Customer Costs . . . . . . . . . . . . . . . . . . . . . . . . . .18VI. Transaction Data . . . . . . . . . . . . . . . . . . . . . . . .26VII. System Options . . . . . . . . . . . . . . . . . . . . . . . . .28VIII. Business Algorithms . . . . . . . . . . . . . . . . . . . .29IX. Profitability Information . . . . . . . . . . . . . . .31X. Strategic Integration . . . . . . . . . . . . . . . . . . . .32XI. Behavioral Considerations . . . . . . . . . . . . . .37XII. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41Appendix 1: Example of Applying the CPMImplementation Framework . . . . . . . . . . . . . . . . . . .43Appendix 2: Technical Considerations for the Management Accountant . . . . . . . . . . . . . . . . . .51

ExhibitsExhibit 1: Customer Profitability

Whale Curves . . . . . . . . . . . . . . . . . . . . . .3Exhibit 2: More Whale Curves . . . . . . . . . . . . . . . .4Exhibit 3: CPM Implementation

Framework . . . . . . . . . . . . . . . . . . . . . . . .7Exhibit 4: The Multidimensional

Views of Profitability . . . . . . . . . . . . . .11Exhibit 5: Customer Account Hierarchy :

Bank and Credit Union Example . .12Exhibit 6: Product Hierarchy – Bank and

Credit Union Example . . . . . . . . . . . .13Exhibit 7: Customer Profitability Report . . . .14Exhibit 8: Customer Lifetime Value . . . . . . . . . . .15Exhibit 9: Cost What You Can Source . . . . . . .25Exhibit 10: Profit-Lift from Existing

Customers . . . . . . . . . . . . . . . . . . . . . . .33Exhibit 11: Profit-Lift from New Customers .34Exhibit 12: Business Rule Documentation . . . .54

E X E C U T I V E S U M M A R YManaging profitability requires not only a customer-centric focus but also a thoroughunderstanding and effective management of customer profitability. Customer profitabilitymanagement (CPM) is a strategy-linked approachto identifying the relative profitability of differentcustomers or customer segments in order todevise strategies that add value to most-profitablecustomers, make less-profitable customers moreprofitable, stop or reduce the erosion of profit byunprofitable customers, or otherwise focus onlong-term customer profitability.

Managers are often surprised to find out that asmall percentage of customers generate substan-tially more than 100% of profits, and the remaining customers are either breakeven orunprofitable. Using a customer profitability management system replaces intuitive impressions of customer profitability with fact-based information and supporting analysis.

The backbone of a CPM system is a costing system that is focused on tracing and causallyassigning costs to each customer or customersegment without arbitrary broadly averaged costallocations. Assigning revenues to customers orcustomer segments can present a few issues, butthe major challenge in implementing a CPM system is the selection and implementation of anaccurate and informative costing system. A costing system should not only accurately assignproduct costs and gross margin to customers orcustomer segments, but it should also assign thecosts to serve.

Cost accuracy and visibility are important inCPM. Using time-driven activity-based costing(TDABC) provides costs that identify resourceconsumption by customers or customer seg-ments. The signals provided by the CPM system,

based on full costing of traceable costs to cus-tomers and making visible business-sustainingcosts, will lead management to consider strategiesto increase profits. The signals do not provideanswers in themselves, but they could lead to gen-erating alternative courses of action. Decisionsrelated to customer profitability strategiesrequire tailor-made analysis.

There are system issues that must be consideredin the design and implementation of a CPM system. Awareness of the commitment of time,financial, and personnel resources required by aCPM system is critical to its success.

Investments in customers should be consideredin view of an estimate of customer life value. Thatis, in addition to current customer profits, thepotential of generating future profits from a customer should also be considered. Managing customer life value is a means to enhancing long-term profitability.

Essential to the success of CPM is the buy-in byemployees and managers who will be affected byits implementation. Resistance to change is a phe-nomenon that applies equally to CPM as it doesany other organizational change. To develop theCPM system and then seek the support ofemployees and managers is not likely to result indeveloping a sense of ownership, nor will it guar-antee an effective CPM system. To get employeesand managers to buy in at the outset, they shouldbe involved in its development and their ideasmust be sought. Only with a sense of ownershipwill the organization be able to navigate the trou-bled waters of change.

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I . I N T R O D U C T I O NMany companies and managers are unaware thatthe secret to improving profitability is to measureand manage customer or customer segment profitability. Companies that implement cus-tomer profitability management (CPM) systems are able to see which customers contribute to profits, which customers do notcontribute to profits, and which customers erodeprofits. CPM is a strategy-linked approach toidentify the relative profitability of different customers or segments of customers, to devisestrategies that add value to most-profitable customers, make less-profitable customers moreprofitable, stop or reduce the erosion of profit bycustomers, and otherwise focus on long-term customer profitability.

A CPM system is a profitability measurement andmanagement system, and its backbone is a costingsystem that is focused on assigning costs to eachcustomer or customer segment. A CPM systemalso assigns net revenue to each customer or customer segment. The resulting profit is identified with each customer or customer segment. As can be expected, customer-relatedcosts are more problematic to trace or assign thancustomer-related revenues. It is important toemphasize that the quality of the CPM cost information is critical for the quality of CPM. Ourapproach is to focus on a cause-and-effect costingsystem, such as activity-based costing (ABC), thatis relatively accurate in assigning costs to products, customers, customer segments, or otherrelevant cost objects. We briefly discuss a simplification of ABC—time-driven activity-basedcosting (TDABC).

The CPM Whale CurveOnce profitability is measured for each customeror customer segment, they are ranked from mostprofitable to least profitable and are plotted on aprofit graph, popularly referred to as a whalecurve (WC) or profit cliff chart, where 100% ofprofits are the sea level (see Exhibit 1). The Y-axisof the graph shows profits in dollars or as a percentage of profit from all customers, and theX-axis shows cumulative customers or customersegments ranked from high to low in terms ofprofitability. Typically, about 20% of customersgenerate anywhere from 150% to 300% of compa-ny profits (50% to 200% above sea level), about70% of customers are at breakeven, and 10% ofcustomers reduce or destroy anywhere from 50%to 200% of company profits, bringing cumulativeprofit to sea level (Kaplan and Narayanan 2001).

Exhibit 1, Customer Profitability WhaleCurves, shows customer profitability in dollarsor percentages plotted on a whale curve. As canbe seen, the potential improvement in profit inthis case is $47 million, or a 112% increase in current profit level.

Exhibit 2, More Whale Curves, shows anothertypical customer profitability whale curve, wherethe highest tip of the curve is higher than inExhibit 1. The potential improvement in cus-tomer profitability increases with the distancebetween the highest tip of the whale curve andsea level. In this case, the potential improvementin profitability is $96 million, or a 200% increasein current profit level.

The improvement in profit depicted in these fig-ures is predicated on the assumption that thepotential profitability is the highest level of profiton the graph, which is contributed by a small per-centage of customers before being eroded byunprofitable customers. In fact, with CPM, the

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3


$100

$90

$80

$70

$60

$50

$40

$30

$20

$10

$0

Customer Profitability Whale Curve–$

Number of Customers (Ranked Most to Least Profitable)

Cum

ulat

ePr

ofits

($M

illio

n)

0 5 10 15 20

250%

200%

150%

100%

50%

0%

Customer Profitability Whale Curve–%


Perc

ento

fCum

ulat

ive

Profi

ts

0 5 10 15 20

Top eight customersprovide 212% ofbottom line

All other customerseither don’t add tothe bottom line orsubtract from it.

Eight customersare profitable

Five customersbreak even

The remainingseven are unprofitable

Sea Level

Customer ProfitRanking1234567891011121314151617181920

Cumulative %

52%100%143%179%198%205%210%212%212%212%212%212%212%210%202%190%171%150%126%100%

Cumulative Profitin million $2242607583868889898989898988858072635342

22201815

832100000-1-3-5-8-9

-10-1142

Data for Above ChartsCustomer Profitin million $

EXHIBIT 1: CUSTOMER PROFITABILITY WHALE CURVES

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$160

$140

$120

$100

$80

$60

$40

$20

$0

Customer Profitability Whale Curve–$


Cum

ulat

ive

Profi

ts($

Mill

ion)

0 5 10 15 20

CustomerProfit Ranking

123456789

1011121314151617181920

Cumulative %

67%125%175%217%250%275%292%298%300%300%300%300%300%298%296%277%256%215%163%100%

Cumulative Profitin million $

326084

104120132140143144144144144144143142133123103

7848

Customer Profitin million $

322824201612

8310000-1-1-9

-10-20-25-3048

Data for Above Charts

$160

$140

$120

$100

$80

$60

$40

$20

$0

Customer Profitability Whale Curve — %


Perc

ento

fCum

ulat

ive

Profi

ts($

Mill

ion)

0 5 10 15 20

Potential profitimprovement of$96m

Sea Level

{

What's the potential if the break-even and unprofitable customers are turned into profitable customers?

EXHIBIT 2: MORE WHALE CURVES

potential improvement in profit is even greaterthan indicated on the whale curves by turningmarginally profitable customers into more profitable customers and turning profit-erodingcustomers into profitable customers or otherwiseeliminating the profit erosion.

Organizational Types That Benefit from CPMCPM is suited for all types of profit and not-for-profit organizations where products (or servicelines) and customers are not homogeneous. Incompanies where products and customers arehomogeneous, using the same distribution chan-nels and pricing policies, there would be littleneed to use CPM other than to increase visibilityto types of activities and their costs. But there arefew if any companies that meet this description.CPM is thus suited to organizations where products or service lines are different, customersor customer segments are heterogeneous, and pre-sale or post-sale customer service requirements vary.

These latter nonproduct or nonstandard service-line costs are commonly referred to as“costs to serve.” As products and service linesincreasingly become more commodity-like, withcomparable cost levels among competitors, thereis a shift toward activities to serve customers asthe basis for gaining a competitive advantage.Hence, identifying activity cost drivers, tracingthem to customers, and measuring the costs to serve forms a key benefit of CPM.

Service organizations such as banks, insurancecompanies, and other financial service companiesnaturally fit the circumstances that benefit fromthe application of CPM. Manufacturing compa-nies can apply the same concepts in business-to-business settings and in repeated, more frequentproduct purchase environments. Not-for-profitorganizations that are customer-based can also

benefit from applying CPM. For example, creditunions can successfully apply CPM to make mem-bers (what credit unions call their customers/owners) more profitable, and in turn, reduce thefees or rates to their members.

Organizations that may not benefit from CPMinclude those whose costs to serve are small andpre-sale and post-sale services are not importantin gaining a competitive advantage. This would bethe case in organizations whose customers arerelatively homogeneous or indistinguishable. Insuch rare cases, customer gross margin may besufficient to obtain CPM benefits. Because of therelatively low costs to serve, CPM in these organizations could be referred to as CustomerGross Margin Management. The strategic impli-cations are the same as in CPM nonetheless. Onthe other hand, organizations whose customersare not homogeneous, and who compete or cancompete on pre-sale or post-sale activities, areprime candidates for reaping the benefits of CPM.

Impediments to CPM ImplementationIf CPM offers such competitive and sustainableadvantages, why is it not more widely imple-mented and used? We do not have any surveydata to offer as an answer to this question, but wecan speculate on the most likely reasons for thelack of CPM implementation.

First, it is clear that many companies are traditionally managed as functionally structuredorganizations without the customer focus. Thistypically would exist in organizations that rely on“supply push” rather than “demand pull” strategies. In such situations it is difficult formanagement to appreciate the effects of applyingCPM. Even in organizations that utilize “demandpull” strategies, it is not clear that managers fullyappreciate the potential benefits of CPM. It is also

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possible that some managers may not have a clearidea of what to do if they identified profitable andunprofitable customers.

Second, driver-based costing applications can betime consuming and costly, thus making theapplication of CPM difficult. In other cases thelack of available data (e.g., outsourced IT systemsor not collecting cost driver data) may hinder theinterest in gathering and implementing new systems.

Third, some of the available material on CPMmakes it hard to understand and implement (seeCokins 2008). One of the purposes of this SMA isto provide guidance as to how to effectively imple-ment CPM. Applying CPM requires not only adesire and commitment by management to CPM,but it will also require an investment of resources.It is not easy to quantify the personnel effort andcosts, on the one hand, and the benefits of CPM,on the other. But, the incremental investment,efforts, and costs of organizations that have suc-cessfully implemented CPM are justified byincreased profitability and enhanced customervalue. The well publicized success of CPM at BestBuy is just one example.

The value that CPM brings to an organization willdepend on the quality of the information devel-oped for managing customer profitability and onits ability to become customer-centric. Becomingcustomer-centric requires the buy-in by decisionmakers and their ability to forge effective imple-mentation teams.

CPM implementation and profitability reportingshould not be seen as a one-off system.Information should flow on a regular basis, trig-gering a process of customer profitability assess-ment, feedback, analysis, decisions, and imple-mentation. This process enables management to

tap the potential for increasing profitability bydevising different customer targeting strategies,implementing differentiated services or servicelevels to customers, and making operating, mar-keting, or pricing adjustments in its attempt tomake all customers profitable and manage overallcustomer profitability.

The potential benefits result from identifyingcustomer or customer-segment profitability andthen developing appropriate differential strate-gies for different customers. Held perceptionsand biases in an organization may be shattered inlight of facts and analysis. Armed with new infor-mation about customer profits, managers canfocus on appropriate actions related to profitablecustomer retention and acquisition, makingunprofitable customers profitable and reducingor eliminating profit erosion resulting from customers who destroy shareholder value.

I I . T H E C P MI M P L E M E N TAT I O NF R A M E W O R KImplementing a CPM system requires a frame-work as displayed in Exhibit 3, The CPMImplementation Framework. This frameworklays out the phases for implementation, withsome phases being highly interrelated and run-ning in parallel while other phases proceedsequentially.

The major phases to implement a CPM system: 1. Decision Phase2. Foundation Basics3. Customer Costs4. Transaction Data5. System Options6. Business Algorithms7. Profitability Information8. Strategic Integration

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The decision phase, required for any strategicinitiative, is where the value and reasons for pursuing a CPM system are explored, the finan-cial consequences analyzed, and a “go or no-go”decision is made. Another important componentof this phase is establishing the purpose of theCPM system to guide its development and implementation.

The next three phases—foundation basics,customer costs, and transaction data—are highlyinterrelated. A decision in one of these areasdirectly impacts decisions in the other two.

The foundation basics phase establishes the costobject and ultimately what will be measured.This phase also includes establishing the system’scosting principles, how profitability will be calculated, and how contentious accounting

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Decision Phase

Foundation Basics

CustomerCosts

TransactionData

System Options

Business Algorithms

ProfitabilityInformation

Strategic Integration

EXHIBIT 3. CPM IMPLEMENTATION FRAMEWORK

issues (e.g., capitalizing marketing costs) will behandled. Lastly, this phase is where customers,products, and channels are defined.

The customer costs phase is where considerationis given to the extent to which cost assignmentscan accurately be made to products or servicelines, and the costs to serve can accurately beassigned to customers based on causality. Thisphase is where traditional general ledger unit-based cost allocations are replaced with cus-tomer, or cost object, costs. CPM’s need for rela-tively accurate customer-level costs points to theuse of some form of activity-based costing (ABC).

The transaction data phase poses many chal-lenges. Although most companies have vastsources of disparate data buried in their variousIT systems, harnessing it to serve a CPM systemis costly and time consuming.

The reason these three phases are so interde-pendent is that decisions about which activities toinclude in costing are dependent on what transac-tion data is available (or obtainable). On the otherhand, the transaction data to seek for availabilityis dependent on what activities are to be costed.And the cost object and costing principles estab-lished in the foundation basics must be compati-ble with both the available transaction data andthe proposed costing activities.

The system options phase involves selecting thecosting and profitability IT systems. This phaseruns parallel to and is interrelated with the foundation basics, customer costs, and transac-tion data phases. IT resources, data sourcingrequirements, and costing considerations must befactored into the selection of the appropriate ITsystems.

Once the first five phases are complete, then thedesign and build of the business algorithms, orrules, will begin. The business algorithms mustintegrate with the IT systems and be consistentwith the principles established in the foundationbasics. Testing of the business algorithms runsconcurrently with their design and build, followedby a total and thorough testing of the completedsystem.

The profitability information phase follows testing, where monthly or quarterly results areproduced and distributed. This phase is where theCPM system enters production, system maintenance and upgrades occur, and the qualityof results is guaranteed.

Finally, and most importantly, is the strategicintegration phase, where CPM information isintegrated into the company’s strategic and tactical decisions. For example, CPM resultscould be incorporated into the organization’sperformance measurement systems. The ultimategoal is to use customer-based information toimprove company performance and profitability.

Each phase of the CPM implementation frame-work is discussed in this SMA. A separate discussion of the behavioral considerations whenimplementing a CPM system is also provided.Appendix 1 is an example of the implementationframework applied in the financial servicesindustry, and Appendix 2 covers technical considerations for the management accountantnot discussed in the main body of the SMA.

I I I . D E C I S I O N P H A S EThe decision phase is when senior managementbecomes aware of CPM and attempts to under-stand its potential benefits, costs, and strategic

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implications. It is important that managementunderstands CPM, how it will benefit the organi-zation, and how to develop and use the informa-tion to run a more profitable customer-centricorganization. The benefits and costs are discussedin the next subsection. In order for managementto be more effective, managers should obtainsome training in CPM. Once a decision is made toimplement CPM, as with any project, manage-ment should apply appropriate project manage-ment techniques with the full support andendorsement of senior management.

Benefits and Costs of CPMIt is important to estimate the costs and benefitsof implementing CPM. If management is aware ofhow CPM can improve customer profitability, arough estimate of the recurring benefit is the dif-ference between actual profitability and the peakof the whale curve, although the benefits canoften exceed this amount. The problem is that inthe absence of a customer profitability system, itis difficult to arrive at a precise estimate of thebenefits of implementing CPM. Judgment mustbe made in the absence of precise information.

The cost of implementation will depend on theexisting costing system and its appropriatenessfor CPM. If a company has a variant of an ABCsystem, the cost of implementation may relate torefinements necessary to capture data related tocustomers as the cost object to track their consumption of resources. The extent to whicharbitrary cost allocations characterize the costingsystem might indicate the need to redesign thecosting system, which of course can become acostly proposition. On the other hand, there aresimplifications that may prove less costly, such astime-driven ABC.

An accurate CPM system requires an accuratecosting system that assigns costs to cost objectsbased on the cost objects’ consumption ofresources. Implementing activity-based costing insome form or another may be required to obtainaccurate customer profitability estimates. Itshould be kept in mind that in a competitive environment, an accurate costing system isrequired whether or not a CPM system will beinstalled. Given that cost accuracy supports survival in a competitive business environment,the incremental cost of adapting a costing systemto suit the needs of CPM could be relatively marginal. Without customer profitability infor-mation, customer profitability management is ashot in the dark.

Management must appreciate that effective CPMimplementation integrates customer profitabilityinformation into a company’s strategic decisionsrelated to exploring profit opportunities witheach customer or customer segment. Such strategic decisions affect financial outcomes, butthey could require operational or marketingadjustments to meet customer needs as shaped byCPM strategic decisions. In this fashion, CPMprovides long-term competitive advantages thatcan be sustained as long as it is periodically calcu-lated, reviewed, evaluated, and used.

Obtaining CPM Buy-InIt is important for management to pave the wayinternally for CPM implementation by dispellingthe myths and existing perceptions of customerprofitability. Senior management’s unquestion-able support is required, and they should obtainthe support of all those who are likely to beaffected by the CPM system. Once the decision ismade to embark on implementing CPM, it isimportant to pay attention to the behavioralissues that can make a difference in its success orfailure. These issues are discussed more fully

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below. Briefly, any change creates resistance dueto the uncertainty it creates, particularly by thosewho might be adversely affected by it. Buy-in canbe obtained by getting affected employeesinvolved from the beginning. Successful CPMimplementation requires a team approach. Aswith any major organizational change, tact, com-munication, education, training, and excellentleadership skills can make the differencebetween the success or failure of CPM.

The Role of Data in CPMTo make the decision to implement CPM requiresan appreciation of the role and importance oftransaction data. The reason that many compa-nies currently find improving profitability elusiveis that the customer-detailed information theyneed is buried in transactional databases. If all acompany does with its customers is manage theaccounts receivables, and all it focuses on is over-all customer profitability as reinforced by high-level, general ledger (GL)-based performancemeasures, it is missing important strategic opportunities to manage customer profitabilityand to increase the lifetime economic value of itscustomers. CPM measurements will replace theoften erroneous impressions, guesses, or hunchesabout the relative profitability of customers withmore objective information. For example, Searcy(2004) reports cases where entrenched perceptions about sales volume and profits wereshattered when a company properly calculated itsprofitability measures by customer and channelsegments.

I V. F O U N D AT I O N B A S I C SThe foundational design of the CPM system isdriven by the purpose established in the decisionphase and starts with the definition of the costobject: customer, customer segment, product,channel, customer account, etc. The cost objectdetermines what will be measured and managed.Clarity of purpose and thoughtful and clear definition of the cost object will lead the way to aneffective CPM system.

Establish the Cost ObjectThe cost object chosen must be compatible withboth the transaction data available from the com-pany’s core application systems and the costingprinciples. Compromises may be required asdesired features may not be available in thetransaction data. The cost object chosen mustalso support the CPM system’s purpose asdefined in the decision phase.

For example, in the financial services industry,the customer account often becomes the costobject and the platform on which to attach allcosts consumed. This approach works for thatindustry because information is already main-tained for every customer account. Individualcustomer accounts belonging to the same customer are combined for customer-levelreporting and management. Thus, customer A’sprofitability is the sum of the profitability of herindividual accounts, such as her checkingaccount, CD accounts, auto loan account, andhome equity line of credit account.

An important consideration in establishing thecost object is whether its revenues are measura-ble. The ease or difficulty of collecting revenuedata for the cost object depends on the industryand the company’s core application systems. Incases where revenue is not measurable for thecost object (e.g., fast food), then the cost object

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will need to be aggregated to the level at whichrevenues are measurable (e.g., customer segment).

The cost object as the basic building block of theCPM system has a major advantage: multidimen-sional profitability. In the financial servicesindustry every customer account (the cost object)is not only identified with a customer, but alsowith a product (or service line), the sales channel,the organizational unit assigned, the geographiclocation, the age of the account holder, and anynumber of other data tied to a customer’s account.Although the CPM system’s main purpose is tomanage customer profitability, a customeraccount cost object allows profitability to bemeasured by any of the dimensions attached to acustomer’s account, such as product profitability,branch profitability, profitability by region, andprofitability by age. These are different ways ofmeasuring the same thing from different perspec-

tives, and from which arise the profitability identity. Exhibit 4, The Multidimensional Viewsof Profitability, shows the profitability identityas follows:

Total Customer Account Profitability = Total Product Account Profitability = Total Organizational Account Profitability

Although not all industries have customeraccount cost objects that can be used in this manner, those that do can take advantage of themultidimensional approach. For example, product profitability that includes customer costsis far more reliable than product profitabilityderived from average GL-based allocationassumptions. As another example, data summedby channel will yield channel profitability, possi-bly available for the first time to the company.

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CUSTOMER PROFITABILITY

Account #Account 1Account 2Account 3Account 4

:

CustomerSmith FamilySmith FamilyABC AutoJack Cove

:

ProductChecking AcctMrtg LoanChecking AcctAuto Loan

:

Org CenterBranch 1Branch 1Branch 1Branch 2

:

Revenue$ 10$ 125$ 1,500$ 36

:

Total Exp$ 8$ 35$ 1,530$ 23

:

NIBT$ 2$ 90$ (30)$ 13

:

If profitability iscalculated atthe account orlowest level,then di!erentviews ofprofitabilityflow fromexisting data

S Customer Profitability =

S Product Profitability =

PRODUCT PROFITABILITY

ORGANIZATION PROFITABILITYS Product Profitability =

EXHIBIT 4. THE MULTIDIMENSIONAL VIEWS OF PROFITABILITY

A word of caution when selecting the cost object:The cost object determines the detail availablewithin the CPM system, which further deter-mines the ability of the system to drill down anduncover underlying problems or answer specificquestions. There is always a tendency to add asmuch related data as possible to provide deeperdrill-down and the ability to answer questions notyet considered. Detail does not come withoutcosts, however. The one-size-fits-all informationsystem that can answer all questions posedrequires more complex costs and transactiondata, which adds significantly to the cost of developing and maintaining the CPM informationsystem.

Define Customer, Product, and ChannelDuring the foundation basics phase it is impor-tant to precisely define what constitutes a cus-tomer and whether customers will be combinedinto households or relationships. If so, a customerhierarchy table can assist in these combinations.

A hierarchy table is simply a document or data-base table showing how subgroups roll up, or arecombined, into groups, which can further be com-bined into higher-level groupings. See Exhibit 5,Customer Account Hierarchy, for an example ofa customer hierarchy for a bank or credit union.

Another foundational basic is the definition ofproducts or service lines. A product hierarchydefines the products and how they are combinedinto groupings. It is often practical to roll upproducts with similar processes into a higher-level product for costing purposes. If the like-kind products appear to be homogeneous in theirconsumption of activity costs, then combiningthem into one costing product will reduce systemand report complexity. Exhibit 6, ProductHierarchy, shows a product hierarchy for a

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Mr. Smith Checking AccountMr. Smith Savings AccountMr. Smith Auto Loan

Mrs. Smith Checking AccountMrs. Smith Auto Loan

Mr. & Mrs. Smith MortgageMr. & Mrs. Smith Certificate of Deposit

ABC Auto Checking Account Store 1ABC Auto Checking Account Store 2ABC Auto Checking Account Store 3ABC Auto Checking Account Store 4

ABC Auto Parts On-Line

ABC Auto Checking Account Store 1ABC Auto Checking Account Store 2ABC Auto Checking Account Store 3ABC Auto Checking Account Store 4

Mr. Smith

Mrs. Smith

Mr. & Mrs. Smith

ABC Auto Parts

ABC Auto Parts On-Line

Account Level Customer Level Relationship Level

Smith Family

ABC Auto PartsCorporation

EXHIBIT 5. CUSTOMER ACCOUNT HIERARCHYBank and Credit Union Example

typical bank. The column titled Costing Productindicates the product level at which cost driverrates are developed.

Other foundation basics include the organization-al hierarchy and the definition of delivery chan-nels, if applicable. The organizational hierarchydefines general ledger cost or profit centers, displaying the relationship of the centers ordepartments where work or activities take placeand resources are consumed.

A customer delivery channel may be includeddepending on the industry and other considera-tions. The customer delivery channel is where

customers interact with the company, or the cus-tomers’ “touch-point.” Large retail stores offersales venues through their stores or on their website. In this case, there are two customerdelivery channels: physical stores and a website.

Costs can vary significantly between customerdelivery channels. It is likely that physical storesales require relatively more resources and aretherefore more costly than website sales. A retailcompany may therefore consider strategies toencourage their customers to buy through itswebsite rather than visiting its physical stores, a

13


Core Product

Commercial Loan - PrimeCommercial Loan - LIBOR

Auto Loan - NewAuto Loan - Used

Regular CheckingInterest CheckingPremier Checking

Regular SavingsMoney Market Savings

ABC Costing Product

Commercial Loan

Auto Loan

Noninterest Checking

Savings

Core products using the sameprocesses with similar costs aregrouped together. Revenuecomponents are assigned at theaccount level since they may di!er(e.g., Prime versus LIBOR rates).

The activities for these products arecosted in the ABC system. Combininglike-costed core products reducescomplexity and improves usefulness.

Develop ABCcosts forthese products

Revenuesdi!erent,costs the same

EXHIBIT 6. PRODUCT HIERARCHYBank and Credit Union Example

process called channel migration. A channeldimension included in the CPM system wouldhelp with these strategic initiatives.

In addition to defining who the customer is, it isalso important to consider identifying relevantcustomer segments. Customer segments definepatterns of customer characteristics and behaviorthat drive customer profitability (Epstein et al.2008). In some cases it may be necessary to segment customers to obtain measurable costobjects; otherwise, it may be more appropriate tocombine customers by segments once customer

profitability information has been obtained. Thiswill be discussed further in the section on strategyintegration.

Calculating Customer ProfitabilityThe final area to be covered during the founda-tion basics phase is the method of calculating customer profitability and how various account-ing issues are handled. Customer profitability istypically measured as net revenue less customercosts, overhead, and taxes.

Net revenue is the cost object’s total revenue lessreturns, allowances, or other adjustments.Customer costs are the summation of activity

14


Customer ID / CustomerSegment

Net RevenueProduct CostsCustomer Gross Margin

Costs to ServeCustomer (or Segment) Margin

Corporate Sustaining Costs AmountPre-tax Customer Profit

Income Taxes (40% )

Customer Profit

Amount

$10,000$ 4,500$ 5,500

$1,200$3,300

$2,000$1,300

$ 520

$ 780

Percent ofNet Revenue

100%45%55%

12%33%

20%13%

5.2%

7.8%

Costs to Serve include sales, order filling,customer support & service, and othercustomer identifiable costs.

EXHIBIT 7. CUSTOMER PROFITABILITY REPORT

15


Year 0 1 2 3 4 5 6 7 8 9 10

($5,

000)

$900

$1,0

00$1

,200

$1,3

00$1

,400

$1,4

00$1

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$1,5

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00

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100)

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900)

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0)$8

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$3,7

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$6,7

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($5,

000)

$833

$857

$953

$956

$953

$882

$875

$810

$750

$695

($5,

000)

($4,

167)

($3,

309)

($2,

357)

($1,4

01)

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8)$4

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$2,1

20$2

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65

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01

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EXHIBIT 8. CUSTOMER LIFETIME VALUE

costs that are assigned to the customer as the costobject. If ABC is used, then each cost object’s costis the activity driver rate times the quantity orother measure of the activity driver consumed bythe cost object.

Costs are discussed below in Section V: CustomerCosts. In general, costs assigned to cost objectsinclude product costs and any costs to service thecustomers. The difference between net revenueand product or service line costs is the costobject’s gross margin. The costs to serve appearbelow the product gross margin line, and includecosts of such activities as order getting, order fill-ing, and customer support and service. The coststo serve are assigned to the customer as the costobject and then subtracted from the cost object’sgross margin to obtain customer margin.

Customer margin contributes to corporate-sustaining costs (or corporate overhead). Incomebefore taxes is thus equal to customer marginless corporate-sustaining overhead. Incomebefore taxes less taxes provides customer netincome or profit. Exhibit 7, CustomerProfitability Report, provides an example ofsuch a report.

Return on Capital ConsiderationsWhile customer profitability provides valuableand oftentimes never-before-available informa-tion, only goes so far. Ultimately, what is mostimportant is the return on the capital invested toachieve those profits. Linking customer profitswith capital can be done in several ways, such asreturn on investment (ROI), return on equity(ROE), residual income (RI), or some variant ofthese approaches.

Linking customer profits and capital requires anassignment of capital to the cost object. This canfundamentally be done in two ways. One way is to

assign capital based on capital usage or capacityutilization. Adjustments are then made to thecapital charge to reflect higher customer risk byusing a rate higher than the average cost of capital and conversely to reflect lower customerrisk by using a rate lower than the average cost of capital. The types of customer risks to considerwill vary by industry.

A second approach, commonly used by financialinstitutions, is to assign—beyond capital usage—more capital for riskier investments or customersand less capital for less-risky investments or cus-tomers. In this case the cost of capital rate is heldconstant and not adjusted for risk; risk is account-ed for in the amount of capital assigned to eachcost object or customer.

A partial application of RI in manufacturing is tocalculate only the cost of direct investments inassets related to the customer—e.g., imputed capital cost on inventories and accounts receiv-able. A complete application of RI would requireassigning direct and indirect investments inassets financed through long-term capital.

Cost object return on capital, however measured,can be plotted on a whale curve similar toExhibits 1 and 2 in order to gain insights intomanaging customer profitability. Using ROI or RIadds to the tools of managing customer prof-itability by accounting for the cost of capitalneeded to serve the customer or customer seg-ment. A full discussion of attributing capital andmeasuring ROI and RI lies beyond the scope ofthis SMA.

Customer Lifetime Value (CLV)Customer profitability results and return on capital measures will, by definition, cover a specific time period, such as a month, a quarter, ora year. Snapshot views of any dynamic system can

16


be misleading. As such, trends of customer profitability results over several time periods provide more meaningful information and shouldbe designed into the report library requirements.

Measuring customer profitability over an expected tenure is known as Customer LifetimeValue (CLV). Pfeifer, Haskin, and Conroy (2005)refer to CLV as the discounted future cash flowsrelated to a customer. When a decision is made toacquire a customer, such as through a proposedmarketing campaign, a company should projectthe discounted future cash flows resulting frommaking the acquiring investment. It should continuously monitor the changes in customervalue that result from the ongoing interactions orlack thereof between the customer and the company. A discount factor such as the cost ofcapital can be used to discount the projectedfuture cash flows over the customer’s expectedtenure with the company. Depending on the riskof the investment made in a specific customer orcustomer segment, the discount rate can beadjusted higher or lower to reflect that risk. If therelationship between specific customers and thecompany is uncertain, probabilistic models can beused to estimate the discounted CLV of thesecustomers.

Exhibit 8, Customer Lifetime Value, shows anexample of an investment in a customer. Thecumulative cash flows are negative at the time ofmaking the investment. As the customer con-tributes revenues and incurs product costs andcosts to serve, however, the difference results incustomer margin as the measure of customerprofit. The investment will be recovered whenthe customer margin or profit equals the cus-tomer investment. Beyond that point, the cus-tomer value is positive.

Other Accounting IssuesIn addition to the costing issues that will arise,thorny accounting issues should be addressedduring the foundation basics phase to avoid laterdiscord and manipulation. Two thorny accounting issues that create heated debate inthe financial services industry are:

• Unsuccessful sales efforts. A loan officer mayapprove six loans out of the 10 loan applica-tions he takes in a day. The time spent onreviewing and declining the four unapprovedapplications represents unsuccessful salesefforts—time and effort expended where noproduct is sold nor customer created. In anoth-er example, credit card direct mail campaignscan cost tens of thousands of dollars, yet aresponse rate of 5% is considered stellar. The95% of direct mail pieces that resulted in nocredit card applications are unsuccessful salesefforts. Unsuccessful sales costs can be spreadamong the sales that were successful—in thiscase unsuccessful sales being part of the cost of successful sales. Another approach spreads theunsuccessful sales costs across all accounts ofthat product type—in this case unsuccessfulsales being a cost of offering that product to themarketplace. (This approach is often preferredby marketing executives since it reduces thecost driver rate for the sales activity.) The bestapproach for the company should be selectedearly to avoid misunderstanding, maneuvering,or gaming the system.

• Controllable versus uncontrollable costs. Notall costs are controllable by a department’smanager. How much control does a branchmanager have on the storefront rental expensefrom a contract negotiated by the bank’s facilities group five years ago? The branch manager will argue that customer profitabilityshould exclude facilities costs because they are

17


uncontrollable. This is refuted on the groundsthat the purpose of the CPM system is to meas-ure customer profitability and all costs shouldbe included—controllable and uncontrollable (corporate-sustaining costsbeing the possible exception). This choice elevates the purpose of managing customerprofitability over that of employee performancemeasurement, although the two are not necessarily incompatible.

V. C U S T O M E R C O S T STo know customer profitability, one must knowcustomer costs. How customer costs are meas-ured is critical for the effective application anduse of CPM.

The Trouble with Conventional CostingConventional cost accounting systems, with theirfocus on product or service line, cost centers, andfunctional cost classifications are neither ade-quate nor helpful for CPM purposes. These costsystems generally derive directly from the generalledger (GL) where some form of unit-based allo-cation of GL costs to the cost object is made (e.g.,by number of employees, by number of PCs maintained). The GL data tracks only cost occurrence—“what was spent” rather than why itwas spent (activity specification) or how activityresources are consumed by cost objects. Thesesystems do not provide costs based on customeror customer segment behavior.

Conventional cost allocation methods imply thatall customers or customer segments are homoge-neous. When support costs (indirect or shared,commonly called overhead) are assigned on thebasis of a unit-based common denominator, suchas units, revenues, or number of customers, support costs are averaged and do not reflect theresource consumption patterns by individual

customers or customer segments. This typicallyresults in a misallocation of costs. Unless all customers or customer segments are homoge-neous in their pattern of consumption of manu-facturing and nonmanufacturing support costs,some cause-effect cost assignment system such asactivity-based costing (ABC) should be employed.Before exploring this topic, it is first important toidentify the different types of costs involved inCPM.

The Types of CostsCustomer costs consist of all costs necessary toprovide the product or service line to the customer, not only to the point of sale and delivery but over the entire life cycle of the product or service line. These costs include coststhat add value for the customer, such as productor service-line costs and the costs to serve. Theyalso include costs that do not add value for thecustomer but are necessary for the business.

1) Product costs

a. Direct material and direct labor, if applicable.These include the typical product or service-line costs, often referred to as direct costs.

b. Manufacturing or service-line support costs.These support costs include indirect costs,which are typically assigned as product costsusing unit-based allocation schemes (e.g.,labor hours), but preferably assigned usingcause-and-effect relationships (e.g., activity-based costing).

2) Costs to serve

a. Marketing, selling, and distribution costs,typically assigned using unit-based allocationschemes (e.g., sales or product costs), butpreferably assigned using cause-and-effect

18


relationships (e.g., activity-based costing).These costs also include order-getting andorder-filling activities.

b. Post-sale service, such as warranty or coveredrepair costs, and in some cases disposal costs,typically assigned using unit-based allocationschemes (e.g., sales or product costs), butpreferably using cause-and-effect relationships (e.g., activity-based costing).

3) Business (or corporate) sustaining costs

Not all costs are related to customer productcosts or costs to serve (Cokins 2006). Forexample, the cost of landscaping, accounting,IT services, patents amortization, and executive salaries are not incurred for a customer or customer segment but areincurred to sustain the business. These costsmay or may not be assigned to customers.Caution should be used in interpreting theresults if they are assigned to customers,however, there is likely no cause and effectrelationship. On the other hand, not includ-ing these costs means that decisions basedon customer profits may in fact translateinto business or corporate losses.

Customer costs are the sum of the customer’sproduct costs and the customer’s costs to serve.Ideally these customer costs are assigned on thebasis of cause and effect—e.g., using activity-based costing or some variation. Each activitycost is based on its activity cost driver rate andthe customer-related consumption of that activi-ty. As mentioned above, whether or not toinclude business-sustaining costs is situational.Regardless, the resulting information should beinterpreted in light of whether business-sustaining costs are included in customer costsor not. Refer to Exhibit 7, Customer

Profitability Report, for an example of a multi-stage customer profitability statement.

Costing SystemThere are at least three cost system options. Thefirst is unit-based traditional costing, whichassumes that products, customers, and other costobjects are homogeneous in their consumption ofactivity resources. Since homogeneity is not avalid assumption, the second option is to useactivity-based costing (ABC). Because ABC imple-mentation requires time and resources, Kaplan(2004) suggested the use of a simplified approach:time-driven activity-based costing (TDABC). Weadvocate a form of causal cost assignment, whichlargely means ABC or TDABC. A brief comparisonof these methods is provided below. A full discus-sion of the application of ABC lies outside thescope of this SMA. (See the IMA’s Statement onManagement Accounting titled “ImplementingActivity-Based Costing,” 2006.)

Conventional CostingDirect product and customer costs do not raisequestions about the utility of their assignment tocustomers or customer segments as the costobject. The same cannot be said for assigningindirect product or shared customer costs.

Unit-based conventional costing systems assignfunctional costs (e.g., salaries or insurance) on thebasis of unit-based cost drivers (e.g., direct laborhours, dollars of customer revenue) that assumehomogeneous consumption of indirect or sharedcosts by cost objects (e.g., products, customers).The most profound criticism of conventionalcosting relates to not assigning support costs tocost objects on the basis of their consumption ofactivity resources, resulting in simplified butoften misleading results.

19


A CPM system attempts to capture the differentresource consumption patterns of different cus-tomers or customer segments so that manage-ment is better able to manage the profitability ofeach customer or customer group. In the absenceof such measurement, management is unlikely tomanage customer profitability appropriately, asconventional costing systems ignore the con-sumption patterns of activities by cost objects.

Activity-Based Costing (ABC)Activity-based costing (ABC) provides an answerto such criticism. In ABC, activities must be iden-tified, activity cost pools established, cost driversselected, and cost driver rates developed. Thecost driver rates are then applied to differentcustomers or customer segments in order toassess their profitability.

ABC requires first that activities be identified,and the costs of resources consumed by thoseactivities are assigned using resource drivers. Thisfirst step requires converting the general ledgerfunctional accounts into activity costs. The costsof support activities may be assigned to higher-level activities based on their consumption ofsuch support activities. (See multistage ABC inCokins 2008). Costs of activities that are con-sumed homogeneously by all products or servicelines are also combined into activity cost pools.

At this stage, organizations can see the cost ofeach activity, which often raises issues related tomanaging activities to minimize their costs.Activity-based management (ABM) requires re-evaluating, re-examining, and re-designingprocesses and activities for better cost manage-ment. While ABM enhances corporate profitabili-ty and supports the objectives of CPM, it is notdirectly an integral part of CPM.

After identifying the activities and their costs, thenext step is to select appropriate cost drivers fromavailable transaction data for each activity oractivity pool. An estimate is then made of thequantity or capacity of each cost driver for a peri-od of time (usually a year).

Cost driver rates are developed by dividing activity costs or activity cost pools by the estimated cost driver quantity. The cost driverrates are then applied to cost objects, such asproducts, channels, customers, or other costobjects (usually decision points), by multiplyingthe quantity of the cost driver consumed of eachactivity by the cost object times that activity’s costdriver rate. The sum of activity costs thusassigned to a cost object represents the costobject’s total product and customer costs.

Customer costs in this way include the sum of allassigned product or service-line activity costs forthe product or service line purchased by the customer or customer segment (product costs), aswell as the costs to serve the customer or customer segment using cost driver rates.Corporate-sustaining costs may also be assignedto customers or customer segments, but linkingsuch costs to customers is necessarily arbitrary.

It should be noted that ABC is not necessarilybound by the GL. For example, inventory-carrying activities generate costs that are not recognized as expenses in GAAP, such as imputedinterest, cost of capital charge, or replacementcost depreciation. Such costs may be included inABC for management purposes.

ABC often requires survey information to assignresource costs to activities and to assign activitycosts to cost objects. Such survey informationmay not be accurate and may often need to beupdated as operations or activities change. There

20


are different levels of precision that are attainablein applying ABC. The most accurate informationmay require too many cost drivers with compli-cated data to be developed and captured in thecosting system. A high level of precision, there-fore, may be too costly to attain. A balance shouldbe struck for the optimum level of precision, tak-ing both accuracy and costs into consideration.

Time-Driven Activity-Based Costing (TDABC)Because several applications of ABC in the questfor cost accuracy became cumbersome and costlyto develop, Kaplan and Anderson (2003) developed a simplified application of ABC theycall Time-Driven ABC (TDABC). Two majoradvantages of this simplified approach are (1)avoiding extensive surveys, re-surveys, and survey subjectivity, and (2) highlighting capacityutilization or lack thereof. Two parameters arenecessary to apply TDABC. The first is the practi-cal capacity of a resource determined in units oftime, and the second is the time required to perform a unit of each identifiable activity. Thecost of the resource is divided by the capacity ofthat resource to determine the cost per unit oftime. This is then assigned to cost driver rates bymultiplying the cost per unit of time of theresource by the amount of time a unit of activitytakes to perform. The cost driver rate is thenapplied to the cost object based on the quantity ofcost driver units consumed by the cost object.

As a special case of ABC, TDABC is relatively newand the evidence seems to support its advantages.But evidence about its disadvantages is alsobeginning to emerge. For example, direct observa-tion of the time to perform a unit of activity maybe affected by the observation process itself, bysampling error, or by defining when the unit ofactivity begins and ends. It is also unclear thattime is the driving force of many resources

(Adkins 2008). For further discussion on ABC, seeIMA’s Statement on Management Accounting,“Implementing Activity-Based Costing” (2006).

The choice of a costing system is critical to CPM,and the tradeoffs in the choice between conven-tional unit-based costing, ABC, and TDABC willdepend on the circumstances of the organization.It is important to recognize that there exist different forms, adaptations, and simplificationsof ABC to provide satisfactory cost information ata reasonable cost. Pursuing precise cost informa-tion dramatically increases the cost of developingand maintaining an ABC system. We tend to favorABC due to its focus on cost assignments based oncausality. Arbitrary cost allocations that do notattribute causality may be marginally beneficial,but they can also lead to misguided decisions.

Cost Driver Types, Quality, and Data AvailabilityThere are three general types of cost drivers. Costdrivers may be based on transactions (counts),duration (time), or intensity (direct tracing). Forexample, the setup activity costs may be assignedusing the number of setups if setups are similarbetween products (transactions or counts), usingthe number of setup hours if setups vary by prod-uct in the time they consume (duration), or bytracking the size of the setup crew required, thelength of time it takes to complete a setup, and theactual shop supplies required (intensity).

The quality of selected cost drivers is critical inCPM. For example, customers that place large butinfrequent orders might be assigned more thantheir proportionate share of the costs to serve ifcosts are assigned on the basis of sales volume orsales dollars, making them appear less profitableand hiding the lack of profitability of customersthat place small and frequent orders and drive upthe costs to serve.

21


The application of ABC requires that activity costdriver data be available or can be developed andmaintained. For many organizations the activitycost driver data at the customer level, particular-ly for the costs to serve, is not directly available,although it may have been captured in transac-tion data and can be sourced by the CPM system.

Issues with Using ABC Costs in CPMThere are a number of issues related to usingABC or a variant in CPM applications. These areaddressed below.

a. Cooperation between finance and otherdepartments One issue in developing CPM is that thefinance function and customer-level management must communicate clearly sothat cost information aimed at measuringresource consumption is captured correctlyin the system. This requires more coopera-tion between finance and other functionsthan is typically observed in many organiza-tions. If the company is currently using ABC,the application may have to be modified toinclude all customer-related costs and toapply ABC costs to customers as the costobjects. If the company is not using ABC, thenits subsequent design must be driven by therequirements of the CPM system.

b. Accuracy of costs Cost accuracy results from accurate costclassification, activity definition, activitycost pool determination, cost driver selection, data collection, and cost objectassignment. A successful installation of CPMrequires an accurate and functional costingsystem, preferably based on ABC or somevariant.

In developing customer cost information, it isimportant to keep in mind that complexity iscostly, not only in the development of the costinformation, but also in maintaining the cost driv-er information. A balance must be struck betweeninformation accuracy and complexity. As manyimplementers have discovered, attaining a highlevel of accuracy in costing may not only chal-lenge the comprehension of those who use thesystem, but it also increases the cost of developingand maintaining the system.

c. Capitalization and amortizationGAAP accounting currently requires theexpensing of costs considered period costs,such as marketing and R&D costs. A questionarises in costing for CPM purposes ofwhether such costs are capitalized as assetsand amortized over a reasonable period oftime. Other candidates for capitalization andamortization include unsuccessful salesefforts and large marketing campaigns.Whether a company decides to expense orcapitalize these expenses in the CPM systemwill depend on its particular circumstances;regardless, these decisions should be madeduring the foundation basics phase when thefocus is on the best CPM system for the company.

d. Arbitrary cost allocationsIt is important to recognize that some costassignment is arbitrary in nature. Even whenABC is used, some cost assignment may stillbe arbitrary—namely facility and business-sustaining costs. Examples include: 1) facilitysustaining costs in manufacturing, which aretypically assigned as product costs; 2) facilitysustaining costs of marketing, sales, distribu-tion, and post-sale services, which are typically assigned as costs to serve; and 3)business-sustaining costs of research and

22


development, landscaping, corporate head-quarters, and senior executives’ salaries.While the cost assignment for some of thesecosts using ABC can be arbitrary, it is impor-tant to realize that conventional costingresults in arbitrary cost assignments, not onlyof facility and business-sustaining costs, butalso of most other indirect and shared costs.In ABC, the allocation of facility and business-sustaining costs is necessarily morearbitrary than activity costs based on causality.

e. Cost controllabilityOne question that typically arises in theimplementation of a CPM system is this:What is the system’s primary purpose (aquestion addressed in the decision phase)?Some stakeholders may prefer that the system focus on measuring employee perfor-mance rather than customer profitability.This SMA is concerned with customer profitability management, and employee performance is certainly related to CPM. Butthe primary focus of a CPM system should beon having the best available information tomanage customer profitability.

The issue of cost controllability arises in connection with employee performancemeasurement. This would require some modification or adaptation of CPM informa-tion that is focused on controllability andemployee performance measurement.Separating costs as controllable or uncontrollable is tricky and difficult to capture in the costing system, as controllabil-ity is dependent on managerial hierarchy andtime horizon. It is less difficult to deal withthe controllability issue in the reporting system than it is in the costing system. Forexample, it is possible to deal with this issue

in a multiple performance indicator systemsuch as the balanced scorecard rather thanembedding controllability as a primary criterion for the CPM costing system.

f. ABC provides full absorption costsABC is often implemented as a full-absorption costing system that ignoresthe difference between fixed and variablecosts in assigning costs to the cost object. InCPM, this full cost is only partial, as customercosts may or may not include business-sustaining costs.

The reasons for the full-costing focus of ABCare twofold. First, cost trends in recentdecades are toward cost structures that areheavily loaded with fixed costs. To assigncosts to cost objects, fixed costs cannot beignored, and the case is no less compelling forcustomer activity-based costing. Second, thetraditional approach toward managing fixedcosts is through long-term decisions thatchange the levels of fixed costs.

Supporters of ABC claim that fixed costsmust be managed through the managementof capacity. Any unutilized capacity costshould be highlighted so that managementcan either improve profitable capacity utiliza-tion or decrease the level of capacity. Ineffect, capacity costs are considered to besomewhat flexible, and that view contributesto corporate agility that is necessary for survival in a dynamic economic environment.If not, management is likely to accept the current level of fixed costs as uncontrollablein the short term, thus deterring managersfrom searching for alternative options to utilize or to decrease capacity.

23


On the other hand, it is important to realize thatlong-term performance measures, such as cus-tomer profitability using ABC, can only providesignals for management about long-term prof-itability. Any decision that might be considered asa result of these signals requires an entirely dif-ferent analysis related to the differential effect ofthe decision on cash flows and company prof-itability. Customer profitability indicators tell management where to look but not what to do.For example, to delete an unprofitable customerbased on ABC may result in decreasing ratherthan improving profits, since some of the fixedcosts may not be avoidable, at least in the shortterm.

g. The cost behavior dilemmaFixed costs are typically included in ABCassigned customer costs, and the resultingcustomer profit does not represent the effecton company profits if a similar customer isadded or this customer is lost to the company.This raises the question of whether customer profitability should be measured intwo ways: full-absorption ABC and variable-costing ABC. In other words, the idea is to usevariable costing in addition to full-absorptioncosting.

The behavior of resource costs is challengingas it relates to the ability to adjust capacity ofany resource. This adjustability criteriondepends on the planning horizon and the easeor difficulty in adjusting capacity (resourcecost stickiness). In addition, decision makingis future-oriented while cost accumulationand assignment using any costing system arenecessarily historical. Any decision related toadding or dropping a customer or customer

segment, or modifying a customer relation-ship, necessarily requires special decisionanalysis related to the differential effects ofthat decision.

The application of ABC is sufficiently com-plex and challenging. To develop two sets ofABC costs, variable and full, is cumbersome.Even if both systems were developed, theresults of each system will only provide signals but will not directly help in decisionsrelated to customers without further analysisthat focuses on those specific decisions.Accordingly, developing a dual ABC system isa possibility that should only be considered inlight of the resulting complexity and cost.Regardless of the choice of a full ABC only, avariable ABC only, or a dual ABC system, theresults should be viewed as providing signalsthat require further decision-specific analysisto evaluate any proposed action.

h. Reconciliation of cost information with the general ledgerCustomer cost information is derived fromcost driver quantities and cost driver con-sumption. Such information is derived fromactivity cost pool information, which in turnis derived from the general ledger (GL) ordirectly from GL subsystems that feed the GL(e.g., accounts payable, payroll). The customer costs assigned to all customers orcustomer segments should reconcile withactivity cost pools, which in turn should rec-oncile with the GL accounts or their expensetransaction sources of functionally classifiedexpenses. Customer costs for a time period, intotal, should be the same as the GL functionalcosts unless the ABC system includes imput-ed costs not recognized in the financialaccounting system.

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EXHIBIT 9. COST WHAT YOU CAN SOURCE

i. Unutilized capacityIn applying activity-based costing, there aretwo main approaches related to the selectionof capacity to use in the development of costdrivers: ABC and TDABC. Early applicationsof ABC tended to ignore unutilized capacity.These applications estimated usage orexpected capacity utilization as the denomi-nator in developing activity driver rates. Thecost of unutilized capacity was thus not isolated, and activity driver rates were usuallyhigher than if the cost of unutilized capacitywas isolated. While it is possible to use practical capacity of each cost driver in deter-mining each activity cost driver rate, whichwould isolate the cost of unutilized capacity,supporters of time-driven ABC tout theirapproach not only because of its alleged simplicity but also because it isolates thecost of unutilized capacity and assigns onlythe costs associated with utilized capacity inthe activity driver rates.

Supporters of time-driven ABC claim that itis simpler to use than traditional ABC andthat it avoids the subjectivity of extensivesurveys. Both traditional ABC and TDABCcan use practical capacity in determining costdriver rates. Incorporating practical capacitydoes add a layer of complexity, as well as anelement of subjectivity—and possiblyattempts to game the system. Nonetheless,incorporating practical capacity has the dualbenefit of keeping cost driver rates constant;as the denominator, the practical capacitylevel of each cost driver does not frequentlychange. It also isolates the cost of unutilizedor unused capacity, which can be helpful inmanaging capacity costs by evaluating alter-natives for the utilization of unused capacityor for the reduction of capacity.

It should be noted that practical capacityusage is not unique to TDABC and can beused in connection with any application ofABC. All that would be required in ABC is touse practical capacity, instead of expectedusage, of each cost driver in the denominatorin determining the activity cost driver rate.This would have the effect of showing theunused capacity of each cost driver and thecost of unused capacity of each activity. Thusthe argument for TDABC reduces fundamen-tally to its simplicity.

Regardless of whether practical capacity isincorporated in ABC or not, it is clear thatcosting issues dominate in the measurementof customer profitability. The careful devel-opment of the costing system and its mainte-nance are critical in customer profitabilitymeasurement and management. It is no exag-geration to describe costing as the Achilles’heel of CPM.

VI. TRANSACTION DATAThe two preceding sections discuss the founda-tion basics and costing for a CPM system, both ofwhich are highly dependent on the availability oftransaction data. In the foundation basics, thecost object is established, but measuring the prof-itability of the cost object requires transactiondata be available for it. Likewise, other foundationbasics, such as the product and the channel, aredependent on the availability of transactioncounts (cost driver quantity) for those items.Regardless of the desirability of a particular costobject, that cost object cannot be used withouttransaction data to support it.

For example, in the banking industry an impor-tant component of customer account profitabilityis the number of times an account holder cashes acheck. Developing activity driver rates for cashing

26


checks requires data at two levels: (1) how manytotal checks were cashed to use as the denomina-tor in the ABC cost calculations—practical capacity could be used instead; and (2) how manychecks were cashed by each customer account(the cost object) to apply in calculating customeraccount profitability. Knowing how many totalchecks were cashed enables the calculation of costdriver rates, but this is of little value if the numberof checks cashed is not available for each andevery customer account (the cost object).

Data SourcesThe sources of the transaction data used in theCPM system will vary by industry and come fromdisparate computer systems within each compa-ny. Some data will come from the financial systems, such as general ledger data. Other data,such as transaction driver data, will come fromcore application systems such as sales and ERPsystems. Some companies are fortunate enough tohave built a data warehouse depository, whichmay contain much of the needed data and provides one-stop data shopping.

The elemental concept that transaction data mustbe available for an activity driver can be expressedin the maxim, “Cost what you can source, andsource what you can cost.” This says to include anactivity cost only when its driver data can besourced for the cost object, and not to source driver data for the cost object when there are norelated activity cost pools from which to developcost driver rates.

It is not uncommon to find situations whereactivity cost pools can be built, but activity driverusage data (the number of times an activity is performed) is not available for the cost object. Forexample, it may be observed that an employeespends 5% of her time answering customer questions, but the core application systems

cannot tell which customers asked questions andwhich did not; the activity driver data is not available for the cost object. In this case, the activity cost pool will require another approach,such as combining it with a more general customer-sustaining activity cost pool. The resultis the activity cost pool, although disproportion-ately consumed by a subset of customers, ischarged to all customers using the more generalactivity driver.

Exhibit 9, Cost What You Can Source, provides agraphical representation for a bank or creditunion of tracing the cost of resources from functionally classified general ledger costs toactivities, forming activity cost pools, that arethen traced to the individual cost objects usingcost driver rates. The cost driver rates are multiplied by the activity usage counts to yieldcosts for individual customer accounts (the costobject).

Add Demographic DataThe analytical robustness of the CPM system isenhanced with the addition of cost object datathat is not cost- or revenue-related. Customerdemographic data, for example, can provide information such as age, address, Zip Code,income group, and purchasing preferences. Otherdata may be internally generated, such as thelength of the customer’s relationship with thecompany, the customer’s sales representative, andthe customer’s payment history.

Once profitability is determined for the costobject, then profitability can be viewed not onlyfor the cost object (e.g., customer account), butalso by the demographic data added. For example,one can analyze customer profitability by agegroup or generation, or by the length of a customer’s relationship, if this data is sourced forthe cost object. Demographic data is another take

27


on the concept of multidimensional profitabilitydiscussed earlier (refer to Exhibit 4, TheMultidimensional Views of Profitability).

Accurate, repeatable, and timely sourcing oftransaction and other data to the CPM database isdifficult and requires great diligence to design,implement, and maintain. Sourcing data posesone of the greatest risks of failure to a CPM sys-tem. See Appendix 2, Technical Considerationsfor the Management Accountant, for additionalinformation on sourcing and maintaining data ina CPM system.

VII. SYSTEM OPTIONSThe selection of the information system infrastructure needed to support the CPM systemwill be dependent on the decisions made in thehighly interrelated foundation basics, costing, anddata phases. Once the groundwork has been laidfor these three phases, then selection of the information system infrastructure can begin.

Selection of the Database EnginesIn general, there are two separate calculationengines needed for CPM: one for costing, whichcalculates the cost driver rates; the other for costobject profitability, which applies those cost driv-er rates to the cost object. Some commercialproducts combine the cost system and the profitability system into one CPM database infrastructure, but most often the costing andprofitability systems are two separate modules orapplication systems.

There are three basic choices when selecting aCPM application system, whether for costing,profitability, or both:

1. Develop in-house2. Purchase3. Outsource

Developing an in-house application providesmaximum opportunities to custom design theCPM system. Customization comes at a cost, however, including significant managementaccounting and information technology resourcesand long implementation timelines. Further,internally developed applications often becomeoutdated as they have difficulty keeping up withthe technology of commercially developed off-the-shelf products. A large bank a few yearsago developed its own costing system in-house atgreat expense, only to abandon it three years laterfor lack of features available in commercial products.

Although purchasing a commercial off-the-shelfsoftware application will reduce the ability to customize, it will also reduce the cost and time toimplement a CPM system. Even with a purchasedapplication, though, it will not start generatingcost driver rates and customer profitability theday it is installed. These applications are morelike Excel when first opened: a blank worksheet.It is left to the purchasing company to input allthe necessary data, establish their relationships,write the formulas that perform the calculations,and generate the company’s cost driver rates andcustomer profitability. Advanced commercialCPM systems do some of this internally; nonethe-less, products, channels, relationships, transac-tion usage data, and model specifics must beestablished by the purchaser.

The third system option is an outsourced or hosted solution. Often referred to as anApplication Service Provider (ASP) or Software asa Service (SaaS), the approach entails providingcompany data to a third-party vendor, which runsthe costing and/or profitability system on itscomputers and returns output tables and reportsto the company. A hosted solution provides thefewest opportunities for customization, but it also

28


provides the lowest initial costs and fastest timeto implement. Ongoing periodic payments aregenerally required as the monthly or quarterlyprofitability reports are produced and delivered.Data security and customer privacy require special attention with a hosted profitability solution.

Other Application System ConsiderationsInformation systems and databases external tothe CPM system will be called upon regardless ofthe system option chosen. These external systemsmay already exist or may need to be developed.Two basic types of external systems are thosethat: (1) provide information to the costing orCPM systems and (2) receive information fromthe costing or CPM systems.

First, external systems will provide informationthat is used by the CPM system in calculatingactivity driver rates and customer profitability.The accounts receivable system would likely pro-vide data to the CPM system, as would an order-ing or sales tracking system. Transaction datafrom core application systems is an example ofdata sourced from external systems.

The second type of external system is the end-result reporting system used to deliver the calculated costing and customer profitabilityinformation to employees. Examples wouldinclude summaries on departmental balancedscorecards, the profitability of specific customersreported to sales staff, or data warehouses withquery tools for costing or customer profitabilityanalysis. How the costing and customer profitability results are disseminated throughoutthe organization will have a big impact on thesuccess of the CPM system.

One final system consideration is the ongoingmaintenance and occasional upgrades and

refinements that the costing and profitabilitysystems will require. Customer profitability systems, whether purchased or internally devel-oped, will have software upgrades requiringinstallation and testing. Refinements to the system will also be required when processeschange that affect the cost driver rates or whendata not available before can be sourced. Anyrefinements or upgrades need to be designed,documented, installed, and tested.

V I I I . B U S I N E S S A L G O R I T H M SThe formulas and calculations used to generatecost driver rates and cost object profitability arereferred to as business algorithms or rules. Thebusiness algorithms must be designed, docu-mented, input to the costing and profitabilitysystems, and tested. The model builder tells theapplication system how to manipulate data tocalculate cost driver rates and cost object profitability, much like an Excel user programsformulas into a spreadsheet.

The degree to which the company is involved inthe design and implementation of the businessalgorithms depends on decisions made in the system options phase. The in-house developedsystem and, to a lesser extent, the purchasedapplication system provide almost unlimited customization of the business algorithms. Theoutsourced solution, while providing the purchaser little control over the business algorithms, normally uses industry best practicesbusiness algorithms.

To the extent possible, line and back-officeemployees should be involved in the design of theCPM system; they are sure to know more abouthow their areas work than do the model builders.Including employees in the design of the CPMsystem, or at least providing them an understand-ing, will go a long way in obtaining their buy-in.

29


Employee acceptance will encourage using thecustomer profitability information in construc-tive and creative ways that add value to the organization. Section XI, BehavioralConsiderations, discusses this subject further.

Customization and CostsWhile the in-house developed or purchased CPMapplication systems provide plenty of opportunityto customize the business algorithms, this customization comes at a cost and produces several unavoidable pitfalls. Situations arisewhere there is more than one approach to calculating activity driver rates and cost objectprofitability with the different approaches yield-ing different results. As a consequence, control ofthe business algorithms will spawn politicalinfighting over which methodology to use, witheach department manager encouraging whichev-er methodology benefits his department the most.For example, the cost of marketing campaignsmay be assigned to current sales or capitalizedand amortized; the marketing department willgenerally favor capitalization since it lowers thecost driver rate of making a sale.

The way to avoid political infighting over businessalgorithms and accounting methodologies is tomake the difficult accounting choices during thefoundation basics phase, when the focus is ondesigning an accurate and strategic CPM system.

CPM System DocumentationWith customization comes the responsibility todocument the design, but the human tendency toskimp on documentation is a pitfall that is hard toavoid. The in-house developed and purchasedapplications will come with reams of documentation on how these applications work.There will be no documentation, however, on thebusiness algorithms yet to be designed and cus-tomized for the company. Consider again the sim-

ilarity with Excel, where the documentation onhow Excel works is voluminous, but any spread-sheet designed by an Excel user needs to be documented.

The documentation of the CPM system’s design—that is, the business algorithms and the data ituses—is generally left to the managementaccountants. The calculations built into the costing and profitability systems are complicated,and documentation is the only way to retain sys-tem integrity in testing, production, maintenance,upgrades, and understanding. See Appendix 2,Technical Considerations for the ManagementAccountant, for additional information on documenting the CPM system logic.

The outsourced or hosted CPM system provideslimited opportunity to customize the businessalgorithms, but this limitation has some advan-tages. Vendors providing outsourced solutionsdraw their methodologies from best practices thatare baked into their offerings, thus minimizing—ifnot eliminating—political manipulations of theCPM design. This, in turn, reduces implementa-tion time and cost. The result is that outsourcedsystems can often begin producing customer profitability information in several months versusyears for most in-house and purchased systems.

TestingThe business algorithms must be tested after theyhave been programmed into the costing and CPMsystems. Testing is an implementation cost that iseasy to downplay and minimize. This is a mistake,since thoroughly testing all aspects of the CPMsystem is crucial to its success.

A testing regimen should be built into the CPMsystem’s design and implementation plan, includ-ing any change, no matter how trivial. Althoughevery attempt should be made to build quality

30


into the system (e.g., good documentation anddata quality checks), testing the results ensurestheir accuracy and integrity. If a high quality CPMsystem has been built, testing will be quick andrelatively pain-free. Testing on a hastily built andshortcut-ridden CPM system, on the other hand,will be long and painful.

IX. PROFITABILITY INFORMATIONOnce the transaction data sourcing is complete,the business algorithms developed, and the entireCPM system thoroughly tested, then the new sys-tem will enter its production phase. In productionthe CPM system will run periodically, usuallymonthly or quarterly, and generate customerprofitability information and reports.

The periodic production of accurate CPM resultsdepends on the system’s sustainability andrepeatability. The sustainability of the system isthe ability to run the system as scheduled for eachperiod, an important design consideration. Forexample, manual data collection or manualprocesses built into an information system cancause delays—and errors—and lead to missed production schedules. Thus the adage, “Automate,automate, automate!”

Repeatability refers to the ability to produce thesame results using the same inputs no matter howmany times the system is processed. If differentresults occur when processed with the sameinputs, the system is unpredictable and unusable.

Careful thought should be put into how the customer profitability information is distributed.To be useful, CPM reports must communicate tomanagers the profitability status, the changes,and the profitability potential of a company’s customer base. Further, the CPM reports shouldbe understandable, relevant, usable, and action-able. The reports should also provide the ability to

drill down and link results with source documentsand transaction data.

Well-designed CPM reports can signal the neces-sity for action, as will be discussed in Section X,Strategic Integration. But CPM reports can goonly so far, and each decision will require its ownanalysis regarding the short- and long-term incre-mental effects on the corporation.

Since customer profitability information isfounded on the activity driver rates developedduring the costing phase, these rates should beupdated periodically, ideally every 12 to 18months. Periodic updates ensure that activitydriver rates are reliable and less susceptible toerror and criticism. Rates should be updatedsooner for any significant changes in businessprocesses that could have material impacts on theactivity driver rates.

Some sophisticated costing systems availabletoday have the capability to recalculate cost driverrates every month—almost in real time. Althoughmonthly cost driver rates have the benefits ofkeeping the rates current and absorbing 100% ofthe month’s GL expenses, they have the unfortu-nate effect of distorting perceptions of customeractivities or behaviors. It is better to hold costdriver rates constant over a period of time, say 12months, so changes in a customer’s profitabilitycan easily be translated into the actions taken bythe customer. Management accounting tools certainly exist to separate the impact of changesto the cost driver rates versus the customer’sactivities, but why add the complexity and takethe focus off of the customer’s actions?

Risks of a CPM System in ProductionThe technical risks to managing a CPM systemonce it moves into production include:

31


Data. The quality and timeliness of cost objectdata that is sourced from the company’s coreapplication and GL systems poses great risks tothe CPM system. Procedures should be estab-lished that ensure the timely delivery of high-quality data files. Nonetheless, it is unavoidablethat data from core application systems will con-tain missing values, errors, and other noise. Astrong data quality control regimen will catchmany of these errors, and error traps built intothe business algorithms will catch much of therest.

Accuracy of Results. The customer profitabilityresults must be accurate and believable to be use-ful. The only way to ensure result accuracy is tothoroughly test the CPM system and all datasourcing when the system is built and wheneverany change is made. Monthly results should alsobe tested for accuracy, such as comparing month-ly CPM totals to independent company-wideresults and other quality checks.

Timeliness. The customer profitability reportsand information must be provided in a timelymanner to be meaningful and useful. Unexpecteddelays are inherent in any information system,but steps can be taken during the design phases toreduce opportunities for setbacks. Manual collec-tion of data or manual running of processes, forexample, can cause such setbacks and should beavoided.

X. STRATEGIC INTEGRATION

Finding OpportunitiesCustomer profitability information provides customer-level insights not available before. Whoare the most profitable customers on which tofocus retention efforts? Who are the unprofitablecustomers, and what can be done to make them

profitable? What are the similarities between themost profitable and least profitable customers?What are the differences?

Many companies perform customer surveys, butmost of them do not use the information gatheredfor profitability. Few companies recognize thatsome loyal customers may be a drain on theirprofits. According to Norton and Hegate (2005), itis important to put customer understanding atthe heart of a company’s strategy. Measuring customer satisfaction and customer loyalty, however, is not sufficient as an effective strategywithout also measuring and managing customerprofitability.

The purpose of customer profitability measure-ment is to identify customers who are profitable(P), customers who approximately breakeven (B),and loss customers who destroy or erode profits(L). The three-way (PBL) classification is onlysuggestive, as customers or customer segmentscan be classified in many ways. For example, acompany might classify customers based on amatrix of volume and profitability rather thanprofitability alone (Alger 2003). For illustrativepurposes, however, this three-way PBL customerclassification is adequate.

Implementing StrategiesOnce customer profitability is measured and cus-tomers are ranked according to their dollar orpercentage profitability, those who fall in the Pcategory provide far more than 100% of currentprofitability. It is these customers that an organi-zation should strive to retain and attract. Actionsthat might be considered include:

• Find common characteristics or behaviors thatmake P customers profitable, and leveragethose findings into tangible actions to retainthem.

32


• Provide personal attention from salespeople,relationship managers, or their superiors.

• Make price or service concessions to ensurethe company remains competitive for thesecustomers.

• Find out what P customers like about the company and promote those features to attractnew customers with similar profiles.

• Develop a partnership with P customers byassigning them a high priority in service orpricing.

The B customers require a different strategy. Thereason these customers break even must first beidentified and may be due to one or more of thefollowing:• Low sales volume• Low selling prices

• High product costs• High costs to serve

Since research shows that it is much less expen-sive to hold onto an existing customer than it is toacquire a new one, it is critical to bring B customers to a profitable level for the company.The following actions would be candidates forconsideration:• Add a surcharge for small orders or for product

or service features B customers demand.• Work with B customers to make them more

successful.• Discount large orders.• Increase prices.• Improve cost management and efficiencies.• Encourage customer behavior changes that

increase long-term profitability.

When it comes to L customers, the choices aremore critical. The first step here is to examine

33


CumulativeProfit

What Actionswill lift theprofit curve?

__ __ __ __ __ __ __ __ __ __ __ __ __ __ __

{{ -----------------------------

____

____

____

____

____

____

____

__

____

____

____

____

____

____

____

__

____

____

__ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __

Get more valuefrom these

Protect these;grow them

Existing Customers*

Retain Develop,Streamline

Actions for each Customer Produces Profit–lift

Copyright © 2008 SAS Institute Inc. ([email protected]) All rights reserved. Used with permission.

EXHIBIT 10. PROFIT-LIFT FROM EXISTING CUSTOMERS

why L customers erode profits. The reasons aremany and may be internal or external. Internalreasons why a customer is unprofitable may pointto product or service quality issues. When a product or service does not live up to customerexpectations, it is likely to consume additionalcompany resources. This internal failure can alsosignal the potential gradual loss of B and P customers. On the other hand, the reasons why Lcustomers destroy profits may be external to thecompany and are customer-specific. Options thatmay be considered include the same actions thatare necessary for B customers. If these actions arenot feasible or are not expected to be effective forcertain customers or customer categories, howev-er, two other actions are possible.

The first is to outsource or sell unprofitable customers, such as a bank selling some of itsbranches to a competitor. Consideration for thisaction should focus on the selling price and the

reputation of the buyer, although the transactiontypically results in a one-time cash flow while thecompany has lost a future stream of customercontributions. This decision should be treated asa customer divestment decision, and the relevantanalysis should utilize cash flow analysis and netpresent value or internal rate of return.

Another action is to eliminate or fire unprofitablecustomers. This should be the solution of lastresort. Special analysis must be conducted todetermine if, in fact, firing these customers islegal, ethical, and will increase profits. It is impor-tant to recognize that not all costs assigned to acustomer are avoidable and would be eliminatedif the L customers were to be fired, such as fixedcosts. Similar to selling or outsourcing a customer, the analysis should be done using discounted cash flow analysis to determine if theL customer contributes positively or negatively tocustomer lifetime value.

34


CumulativeProfit

__ __ __ __ __ __ __ __ __ __ __ __ __ __ __

{{ -----------------------------

____

____

____

____

____

____

____

__

____

____

____

____

____

____

____

__Get more value

from these

Protect these;grow them

Existing Customers*

retain develop,streamline

Which Types of New Customers to Acquire?

Copyright © 2008 SAS Institute Inc. ([email protected]) All rights reserved. Used with permission

{ __ __ ____ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __Be selectivepursuing these __ __ ____ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __ __

Possible New Customers*

acquire do notacquire

Attract newcustomers with high profit profiles.

EXHIBIT 11. PROFIT-LIFT FROM NEW CUSTOMERS

Companies should avoid the temptation to fireunprofitable customers for several reasons.Research has shown that it is generally lessexpensive to turn an L customer into a P or B customer than it is to obtain a new customer (whomay herself turn out to be a B or L customer). It isalso important not to lay blame on L customers,as losses may result from company actions that donot match revenues with costs for the variousproduct or service features they buy. Indeed, Lcustomers may be doing business with a companybecause they cannot get the same deal from itscompetitors.

It is important not to take the ABC costs too liter-ally, since ABC is a full-absorption costing system.Fixed costs assigned to customers sold or firedmay not be eliminated. If, for example, none ofthe fixed costs were expected to be eliminated as aresult of deleting a customer, customer deletionmay in fact worsen the company’s overall profitsas the customer’s contribution margin is eliminated but assigned fixed costs and vacatedcapacity are not. The company may take immediate action to replace the unused capacityvacated by L customers with P customers.Alternatively, the company may decide to elimi-nate the unused capacity and its costs.

Managing capacity becomes critical as fixed costscontinue to increase with new technologies. Butthe embedded assumption in ABC costs thatmanagement can decrease capacity costs shouldbe highlighted. Capacity costs should be evaluat-ed for their responsiveness to managementactions involving customer deletions.

Instead of customer deletion, it is preferable andlikely more profitable to turn L customers into Bor P customers following the considerations listed above.

Sustainable StrategiesCPM measurements result in a classification ofcustomers based on profitability. These resultsrequire that management devise strategies toretain P customers, recruit new P customers,work more closely with B customers to turn theminto P customers, and do likewise for L customers. To turn B customers and L customersinto P customers requires a thorough examina-tion of pricing, operational processes, and customer behaviors.

The effects of managing customer profitability byimproving current customers’ profitability canresult in the lifting of the whale curve upwards aswell as sea-level, as shown in Exhibit 10, Profit-Lift from Existing Customers.

Recruiting profitable new customers based on theeconomic and market characteristics of P customers is another complementary approach toCPM. Exhibit 11, Profit-Lift from NewCustomers, shows the potential effect on thewhale curve of recruiting new profitable customers.

Strategy ImplicationsCPM signals do not directly indicate what actionsto take. Actions are based on specific differentialanalyses tailored to the decisions being consid-ered. Most strategic decisions that result directlyor indirectly from CPM analysis have pricing,operating, or relationship-management implications (Kaplan and Narayanan 2001). Inturn, pricing and operating implications affectcustomers, company finances, cash flows, andplanning and budgeting.

Customer segments based on customer charac-teristics or behavioral patterns can be examined

35


and contrasted for profitability, which can pro-vide insights into how to manage customer profitability more effectively .

Pricing DecisionsTo retain P customers, a company may offer product or service features to entrench P-customer loyalty. It may also increase prices forproduct or service features to B and L customersas a means of reducing costs or increasing revenues. Issues of product or service pricing andbundling are outside the scope of this SMA.

Operating DecisionsOnce decisions are made regarding qualityimprovements, process improvements, cost management, or pricing, the operating implica-tions in terms of quantity of product or serviceline, scheduling, delivery, etc. must be incorporat-ed into the operational plans. The benefits of aCPM system can be lost from the lack of integration of operating decisions with strategies.For example, if customer-service activities are toexpand to offer extended services to current andpotential P customers, the necessary training orhiring must be integrated with the decision toexpand such services.

Customer RelationshipBefore management invests in growing a company’s customer base, it has to identify thetypes of customers it should target based on estimated profitability profiles (Kaplan andNarayanan 2001). This avoids finding out afterthe fact that many of the new customers are notprofitable.

For existing customers, nurturing and growing P-customer relationships is critical for companyprofitability. Managing B-customer relationshipsto make them more profitable by re-pricing,process improvement, changing order size, or

expanding sales of other more profitable prod-ucts are promising approaches to increase profitability. Actions to manage the profitabilityof L customers may be taken similar to those forB customers unless the company decides to gradually divest itself of L customers or firethem. Even in such cases, it is prudent for thecompany to maintain the goodwill and reputation in the marketplace.

Financial DecisionsThe effects of strategies on operating and pricingdecisions eventually translate into revenues,expenses, and cash flows. The effects of thesedecisions should therefore be considered notonly in terms of their operational implicationsbut also their financial implications. New invest-ments or divestment decisions, including invest-ments in new customers or divestments in L cus-tomers, must be integrated with the company’scapital budgets and the cash flow effects integrat-ed with the cash budget. All decisions resultingfrom the implementation of CPM should be integrated in the planning, budgeting, and fore-casting processes within the company.

Integration of CPM with PerformanceMeasurementAs a system, CPM must be integrated with thecompany’s strategic performance measurementsystem (SPMS), e.g., the balanced scorecard(BSC). If not, responsibility is not pinned downfor the implementation of CPM strategy or forthe integration of CPM goals within the SPMS.

CPM is profit-oriented and thus fits well with thefinancial perspective of the balanced scorecard.Profits, RI, or ROI will reflect the strategic deci-sions made as part of the CPM strategy. Thesemeasures lag the metrics in the customer per-spective. Kaplan (2005), for example, suggeststhe use of metrics such as the percentage of

36


unprofitable customers or the amount of lossfrom unprofitable customer relationships. Suchcustomer perspective metrics lag the metricsimbedded in the internal or operational perspec-tive of the balanced scorecard.

A more complete breakdown of the customermetrics would include those specifically relatedto P customers, B customers, and L customers.These metrics should reflect the goals related toeach customer grouping, specific objectives, targets, and initiatives. As these metrics leadfinancial outcomes, they, in turn, lag the operat-ing metrics in the internal or operational perspective of the balanced scorecard. The operating metrics themselves lag those related tothe infrastructure, systems, and learning andgrowth perspective. This pattern emphasizeshow CPM strategy is implemented and its goalsachieved.

The BSC and strategy maps should reflect theobjectives that management sets as a result ofCPM and the focus on the leading indicators ofinfrastructure and learning and growth. Suchmetrics would include the development of theCPM system infrastructure, training, and datacollection. These will lead to the necessary operational decisions that will reflect theirresults in service cycle time, customer service,delivery, and operational changes and adjust-ments. In turn, these will result in improved customer loyalty for P customers and improvedunderstanding of how to make B and L customersmore profitable. The customer perspective willlead the profit, EVA, or ROI metrics.

Fostering an Enterprise Focus on CustomersImplementing a CPM system will enable theorganization to manage its business using customer-based metrics that highlight actualcustomer activities and behaviors. The objective

is to build marketing and retention programs forcustomers that display profitable characteristicsand to look at re-pricing, re-packaging, or otheroperational or pricing strategies to turn unprofitable customers into profitable customers. Understanding customer profitabilityprovides the foundation on which to build a successful, customer-centric organization.

Most importantly, perhaps, a CPM system fostersunderstanding throughout the organization ofthe relationship between customer behavior andcustomer profitability as well as how customerprofitability is impacted by the way the organiza-tion responds to customer behavior. Linking theCPM system with the strategic performancemanagement system (SPMS), such as the bal-anced scorecard, promises to integrate CPM intothe mainstream of corporate strategy.

X I . B E H AV I O R A LC O N S I D E R AT I O N SResistance to change is a phenomenon that existsin most organizations, and the introduction ofCPM is no exception. Introducing CPM in anorganization, like any managerial initiative,requires tact, manager and employee involve-ment, and strong and effective leadership.Management and employee buy-in and accept-ance are prerequisites for a successful CPMimplementation. In addition, it is prudent thatemployees who are likely to be affected by theCPM implementation be included in pre-implementation discussions and analysis. Ifbehavioral issues are not handled properly, a newCPM system may not reap the benefits intended.

Gaining Support for CPMCPM is intended to change the patterns and waysof thinking about customers within an organiza-tion, which means the potential for resistance tochange will likely be strong. The uncertainty that

37


people cope with during times of change can bedramatic and may result in opposing, or evensabotaging, the implementation of the CPM sys-tem. Long-held perceptions of which customers or customer segments are profitablemay be shattered by a CPM system. People insales or customer-contact positions are likely toreact to the new information with disbelief.Vested interests, if not considered and dealt within a constructive and positive manner, can lead toemployees thwarting the implementation ofCPM-based strategies. It is critical that a newCPM system be accompanied by a learning andinquisitive attitude and by minimizing the levelof unease related to coping with the inevitableuncertainty that accompanies such change.

Managers at all levels and functions must betrained to interact with the CPM system and tounderstand its reports and their implications.They must also understand the strategies under-lying the company’s approach to CPM. Withoutthis understanding and focus, the system willbecome a white elephant.

New ways to measure and manage customerprofitability not only require attention to manag-er and employee buy-in of the change, they alsorequire that incentives are realigned with what isbest for the company in light of the new measure-ment and management system. A transitionalperiod may be necessary to allow managers andemployees to adapt and realign their actions tothe new system.

Team ApproachTo ensure CPM strategies are effective, it isimportant for the company to maintain a cross-functional, team-based perspective that focuseson customers, cutting across traditional functional lines within the organization. Thisperspective is essential not only in designing

CPM but also in responding to the informationthat the CPM system provides.

The team approach required for CPM implemen-tation includes team members from marketing,finance, information technology, and operations.In functional organizations, a matrix approach isoften applied with a CPM project leader andteam. If the team selected is not sound, theresulting CPM system will reflect more compro-mises than is beneficial for the company. TheCPM project team should not be dominated byany one functional group; all must work togetherto ensure an effective and successful implementa-tion. Although the cross-functional team will beinvolved with the technical aspects of the CPMsystem, management needs to be inextricablyinvolved with overseeing the entire CPM project(Rigby, Reichheld, and Schefter 2002).

The absence of a team approach increases thepotential for self-interested interpretations ofCPM results, a serious hindrance to effectiveanalysis. Some managers will attempt to use theCPM results to their department’sadvantage at the expense of the organization’sbest interests. For example, an operations manag-er whose activity driver rate for a particular activity is lower than that of a front-line area—due to reduced customer service levels—mayargue that all processing of that transaction gothrough her less-costly department. Again, anunderstanding of how the CPM system isdesigned, combined with careful consideration ofall proposed decisions, will go a long way in over-coming self-interested gaming behavior.

Implementing CPM requires a thorough analysisof its potential impact on employees and a plan toobtain their genuine support and buy-in. If theimplementation is handled internally, managersand employees should be involved from the start

38


to develop this support. Even if a consultant isinvolved, it is a good idea to ensure the consultanthas a plan for how to win the support of managersand employees. Maintaining constant contactbetween the implementation team and the peoplewho are most likely to be impacted by this changewill enhance support and buy-in of the CPM system.

X I I . C O N C LU S I O NCustomer profitability management requiresmeasuring customer profitability. The potentialfor organizations to improve their profits bydevising operational and marketing strategies toretain profitable customers, acquire new profitable customers, make breakeven customersmore profitable, and eliminate the erosion ofprofits by loss customers can be realized throughCPM.

CPM consumes time and resources. More thanhalf of failed implementations are due, in part, tothe lack of understanding by management of thesystem and its cost and time requirements (Rigby,Reichheld, and Schefter 2002). Once implement-ed, however, CPM will start the organization on anew path of discovering how the customer andthe organization interact. The organization willbegin to learn what works and what does not workin profitably delivering value to the customer.

To climb this learning curve, ample training isneeded throughout the organization on the con-cepts of costing and customer profitability man-agement. For the CPM system to have the impactdesired, all employees, both front-office and sup-port areas, must understand how their everydayactions contribute to the profitability of cus-tomers.

Only when all employees understand the CPMsystem and its results will the organization reach

that point where employees know how to delivervalue to the customer while balancing the interests of the organization through the measureof customer profitability. The company will haveevolved into a customer-centric and more profitable organization.

G L O S S A R YACTIVITY COST DRIVER – A common denom-

inator that is used to assign an activity costor activity cost pool to cost objects. Activitycost drivers are found in internal or externaltransaction data and include such items asnumber of orders placed, number of returns,setup time, or number of checks cashed. It isthe expected capacity or practical capacity ofan activity over a specified time period.

ACTIVITY COST POOL – The cost of resourcesof an activity or group of activities that are consumed in approximately similar propor-tions by cost objects.

APPLICATION SERVICE PROVIDER (ASP),also called Software as a Service (SaaS) – Anoutsourced or hosted customer profitabilitysystem or other type of application. Theapproach entails providing company data toa third-party vendor, which runs the costingand/or profitability system on its computersand provides output tables and reports.

BUSINESS ALGORITHMS OR RULES – Thecalculations that the profitability engine per-forms to produce customer profitability.Documentation of the business rules or algo-rithms should include any upstream depend-encies, all input fields, filters, lookup tablesand joins, the operations performed on theinput data, and where the results are stored.

CORE APPLICATION SYSTEM – A term formany types of computer information sys-tems, usually but not necessarily mainframe-based, that are used by companies to recordall types of original capture information,

39


including transactional data and financialdata. The term usually excludes the generalledger financial system, the repository of thecompany’s financial records.

COST DRIVER RATE – The activity cost pooldivided by the estimated quantity (or capaci-ty) of the cost driver for that activity. It is therate that is applied to cost objects based ontheir consumption of the activity.

COST OBJECT – The object for costing purpos-es such as products, product lines, services,customers, customer accounts, customersegments, departments, plants, or geographicregions.

CUSTOMER – The definition of a customervaries by industry. A customer can be a cashor card transaction, such as with a conven-ience store; or a customer can be an accountthat holds each customer’s transactions, suchas a department store’s discount card or abank’s checking account.

CUSTOMER COSTS – Costs assigned to a customer (or customer segment), includingdirect product and service-line costs as wellas indirect and shared costs; often calledcosts to serve.

CUSTOMER GROSS MARGIN – Net revenueless product or service-line costs assignableto a customer (or customer segment).

CUSTOMER MARGIN – Equals the customergross margin less the costs to serve, whichincludes such items as the costs of order getting, order filling, and customer supportand service. It is the profit attributable to acustomer (or customer segment) beforededucting corporate-sustaining costs andincome taxes.

CUSTOMER PROFIT – Equals the customermargin less allocated corporate-sustainingcosts and income taxes; that is, the NIAT forthe customer (or customer segment).

CUSTOMER SEGMENT – Combining customers with particular similarities intogroups is known as customer segmentation.Each customer segment or group is based onsome dimension or quality of interest. Forexample, a convenience store may segmentits customers by time of day, by types of pur-chases, or by size and frequency of purchases.

DATA DICTIONARY – Core application’s sys-tem documentation that defines its tablesand fields and the relationships between thetables and fields. The data dictionary is thego-to resource when matching ABC cost andprofitability data requirements to the dataavailable in a core application system.

DATA WAREHOUSE – Centralized location ofselected data collected across a company’sdisparate computer systems. The data withinthe warehouse is often accessible througheasy-to-use query and report tools. If avail-able, it is a convenient source for ABC andprofitability data.

DELIVERY CHANNEL – How customers interact with the company, i.e., the cus-tomers’ “touch-point.” Retail stores andwebsites are two types of delivery channels.Note that the cost to sell and serve can varysignificantly between channels.

DELIVERY CHANNEL MIGRATION –Encouraging a company’s customers to useor migrate to a less-expensive or preferreddelivery channel. A retail company, for exam-ple, may consider strategies to encourage itscustomers to buy through its website ratherthan its retail stores.

HIERARCHY TABLES – A hierarchy table is adocument showing how subgroups roll up, orare combined, into higher-level groups,which can further be combined into higher-level groupings. Hierarchy tables common toCPM are product, customer, organizational,and activity.

40


HOUSEHOLD – A combination of related cus-tomer accounts into one grouping, called ahousehold or relationship. For example, theprofitability from a husband’s accounts andthe profitability from the wife’s accountswould be combined for total household profitability.

MULTIDIMENSIONAL PROFITABILITY –Ability to display profitability for differentdimensions from the same profitability data-base, such as customer profitability, productprofitability, LOB profitability, regional profitability, etc. These are different ways ofmeasuring the same thing and from whicharises the profitability identity: Total Customer Profitability = Total ProductProfitability = Total OrganizationalProfitability.

PRODUCT – Lowest-level product used in thecosting and CPM systems. Although theproduct may seem obvious, it must nonethe-less be defined and fixed prior to developingABC costs. Oftentimes it is practical to rollseveral like products subject to the same costdriver rates into higher-level costing prod-ucts to reduce complexity and maintenancecosts. If so, a product hierarchy should bedeveloped.

PROFITABILITY CALCULATION ENGINE –A relational database with custom or user-defined calculations designed to render customer profitability.

RELATIONSHIP – see Household.REPEATABILITY – Ability to produce the same

results using the same data inputs no matterhow many times the CPM system isprocessed. If different results occur whenprocessed with the same inputs, the CPMsystem is unusable.

SOFTWARE AS A SERVICE (SaaS) – SeeApplication Service Provider (ASP).

CPM SYSTEM SUSTAINABILITY – The abilityto run the CPM system as scheduled everyperiod; system design should consider timelydelivery of CPM results (e.g., no manualprocesses).

TIME-DRIVEN ACTIVITY-BASED COSTING(TDABC) – The cost of resources consumedis assigned by determining capacity in termsof time and by assigning the cost per unit oftime to each unit of activity performed onthe basis of the time a unit of activity con-sumes, which is determined through directobservation and sampling. This approachavoids the extensive use of surveys, commonin ABC systems, to allocate the cost ofresources to activities. Further, it highlightsthe cost of unused capacity.

TRANSACTION DATA – Nonfinancial data col-lected at the point of the transaction, oftencontaining identifying characteristics includ-ing transaction location, product, and cus-tomer account.

WHALE CURVE – A graph showing cumulativecustomer profitability; customers are rankedfrom most profitable to least profitable andprofitability is expressed either in amount orpercentage of a company’s total profit.

R E F E R E N C E SAlger, Mike. June, 2003. Managing a Business as

a Portfolio of Customers. Strategic Finance.Cokins, Gary. 2003. Are All Your Customers

Profitable to You? SAS White Paper.Cokins, Gary. 2006. Implementing Activity-Based

Costing, IMA Statement on ManagementAccounting, Institute of ManagementAccountants.

41


Cokins, Gary. 2008. Why Don’t CompaniesMeasure Customer Profitability? SAS Weblog,http://blogs.sas.com/cokins/index.php?/archives/73-Why-Dont-Companies-Measure-Customer-Profitability.html

Epstein, Marc J., Michael Friedl, and KristiYuthas. December, 2008. ManagingCustomer Profitability. Journal ofAccountancy.

Johnson, Lauren Keller. 2006. Best Buy: PuttingCustomers First – with the BSC. BalancedScorecard Report, Harvard Business SchoolPublishing Corporation.

Kaplan, Robert S. and V.G. Narayanan. May, 2001.Customer Profitability Measurement andManagement. Harvard Business SchoolPublishing Corporation.

Kaplan, Robert S. July-August, 2005. Add aCustomer Metric to Your BalancedScorecard. Balanced Scorecard Report.Harvard Business School PublishingCorporation.

Kaplan, Robert S. and Steven R. Anderson.November, 2004. Time-Driven Activity-Based Costing. Harvard Business Review.

Kaplan, Robert S. and Steven R. Anderson. July,2003. Drive Growth with CustomerProfitability Management. White Paper,Acorn Systems.

Norton, David P. and Sir Richard Heygate. July,2005. Putting Customer Understanding atthe Heart of Your Strategy. BalancedScorecard Collaborative, Article ReprintB0507C, Harvard Business SchoolPublishing Corporation.

Pfeifer, P.E., M.E. Haskin, and R.M. Conroy.Spring, 2005. Customer Lifetime Value,Customer Profitability, and the Treatment ofAcquisition Spending. Journal of ManagerialIssues.

Rigby, Darrell K., Frederick F. Reichheld, and PhilSchefter. February, 2002. Avoid the four per-ils of CRM. Harvard Business Review.Harvard Business School PublishingCorporation.

Searcy, DeWayne L. Winter, 2004. UsingActivity-Based Costing to AssessChannel/Customer Profitability.Management Accounting Quarterly.

Selden, Larry and Geoffrey Colvin. 2003. KillerCustomers: Tell the Good from the Bad – andCrush Your Competitors, Penguin Group(USA) Inc. (Previously published in the U.S.as Angel Customers and Demon Customers:Discover Which Is Which and Turbo-ChargeYour Stock.)

42


A P P E N D I X 1 : E X A M P L E O F A P P LY I N G T H E C P M F R A M E W O R K

The following simple example displays the major elements of the CPM Implementation Framework.This example is taken from the banking and credit union industries.

I. Decision PhaseIn the decision phase, the value and reasons for pursuing a CPM system are explored, the financialconsequences analyzed, and a “go or no-go” decision is made. An important component of this phase isestablishing the purpose of the CPM system.

Purpose:Customer profitability in this example will be used as follows:1. Use customer profitability to understand customer segment and customer segment behavior2. Design marketing and pricing programs, customer retention programs, and process changes based

on this understanding3. Measure success of these programs and changes with customer profitability4. Repeat

Other Considerations:• Financial and personnel resources required to implement and maintain a CPM system• Benefits expected and targets to measure success• System options that meet primary purposes, IT resources, and other constraints

II. Foundation BasicsIn the foundation basics, the cost object is established and the customer, product, and delivery channel are defined. Also determined are the profitability principles and methodologies and how diffi-cult accounting issues will be handled.

In this example a bank offers two products (service lines) and uses four activities with two channels todeliver those products (service lines) to its customers.

Cost Object:The customer account (e.g., a checking account, a car loan account, a savings account, a mortgage loanaccount)

Two Products:• Loan product (such as auto loan)• Deposit product (such as checking account)

Four Activities:• Open a deposit or loan account• Make a deposit to a deposit account

43


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Two Delivery Channels:• Branch• ATM (Automated Teller Machine)

III. Transaction DataIn the transaction data phase, the cost object dataneeded is designed and sourced primarily—if notentirely—from existing IT systems. The products,activities, and delivery channels defined above aredependent on whether the data to support themis, or can be made, available. On the other hand,the products, activities, and channels definedabove determine the transaction data to seek outand source. The foundation basics and the trans-action data are completely interdependent.

Required Transaction and Financial Data forthe Cost Object (customer account):• Date account is opened (new account)• Number of deposits by delivery channel for the

account• Number of withdrawals by delivery channel for

the account• Number of loan payments by delivery channel

for the account• Account balance, account interest, and account

fees

IV. Customer CostsIn the costing phase, the general ledger financialdata is transformed into cost pools and then costdriver rates using the transaction data providedabove for the cost object, products, activities, anddelivery channels defined in the foundationbasics.

This example uses four steps to develop customer costs:a. Arrange general ledger expenses into depart-

ments where activities occur and resourcesare consumed.

b. Derive the activity cost pools in each depart-ment that will be used to calculate cost driv-er rates.

c. Divide each department's activity cost poolby its total number of transactions (activitydriver) to yield the cost driver rate.

d. Combine the departments' cost driver ratesinto the total cost driver rate to apply to the cost object.

45


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V. The Business Algorithms and Profitability InformationWith the completion of the foundation basics, the collection and sourcing of the transaction data, andthe derivation of the cost driver rates, the profitability of the customer account (cost object) can nowbe determined. Before any profitability calculations take place, however, the business algorithms mustbe developed. Once thoroughly tested, the CPM system will run periodically, usually monthly or quar-terly, to generate current customer profitability information and reports.

This example uses a three-step process to determine customer account (cost object) and customerprofitability:a. Calculate the activity costs for each customer account.b. Calculate the profitability for each customer account.c. Sum the profitability for each of a customer's accounts into the customer's total

profitability.

b. Calculate the profitability for each customer accountAdditional Data Needed for the Profitability Calculations:Cost of Funding Loans (Note 1) 6.5% (annual rate)Earnings Credit on Deposits (Note 1) 6.5% (annual rate)Loan Loss Provision rate (Note 2) 0.6% (annual rate)Corporate Overhead Rate (Note 3) 24.9%Tax Rate 35.0%

Note 1: Banks and credit unions use a management accounting technique called funds transferpricing (FTP) to account internally for the capital benefit or capital cost of deposit andloan balances. Banks pay interest on deposit products (interest expense), but the funds soraised have a benefit to the bank and, therefore, earn an internal credit for funds provid-ed. Banks are paid interest on loans extended to their customers (interest income), butthe funds so used have a cost to the bank and, therefore, are assigned an internal cost offunds charge. In this simple example, only one funding credit rate and one funding chargerate are used, but in reality these rates will vary by the expected maturity of the account.

Note 2: Loan products are charged a provision for loan loss expense to account for the risk ofdefault, similar to an insurance premium (calculation is loan balance x provision for loanloss rate). In this simple example, only one Loan Loss Provision rate is used, but generallythis rate will vary by product risk, the individual customer risk (e.g., credit score), totalbank exposure to this customer, and other factors.

Note 3: Derivation of the Corporate Sustaining Rate:Total Expenses without Corporate Sustaining Expenses: $1,177,000Corporate Sustaining Costs: $292,500Corporate Overhead Rate: 24.9%

49


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VI. Strategic IntegrationDue to the simplified and limited data in thisexample, arriving at any strategic initiative—suchas a customer retention program—would bebased on a one-period snapshot of only a few customers. Refer to the discussion of strategicintegration in the SMA text for further details.

A P P E N D I X 2 : T E C H N I C A LC O N S I D E R AT I O N S F O R T H EM A N A G E M E N T A C C O U N TA N TBuilding a CPM information system will requireconsiderable technical support. It is natural toleave the technical aspects of the system to theexperts—the information technology team. Thatwould be a mistake. The technical experts knowinformation systems and database structures, butthey need to know exactly what to build into theCPM system. For that, they depend on the man-agement accountant.

This appendix discusses some technical consid-erations for the management accountant build-ing a CPM system. The involvement of the man-agement accountant in these technical concernswill vary by company and whether an internal oroutsourced system option is chosen.

Selection of the Costing and ProfitabilitySystemsWhile the IT team will decide the most appropri-ate technical approach given the company’s com-puting resources and technical abilities, the man-agement accountant will provide the CPM sys-tem specifications and requirements—what it isthat the system must do. The system specifica-tions and requirements are established in thefoundation basics, customer costs, and transac-tion data phases. The management accountantshould ensure that the databases, calculationengines, and hardware chosen by the IT teammeet these requirements.

Sourcing DataThe management accountant should activelyassist the IT team in designing the sourcing ofdata from the core application systems. Thisincludes what data to source, any manipulationor pre-processing of the data prior to loading,where to load the data in the CPM database, andany production requirements (e.g., monthly bythe fifth business day).

A critical step is the selection of the databasefields in the core application systems (or datawarehouse) that will be sourced to the CPM database. The descriptions of core applicationdatabase fields are stored in data dictionaries,which define the structure of the core applicationdatabases and all of their tables and fields.Unfortunately, data dictionaries are cryptic andoften out of date, and CPM system specificationsare seldom perfect. IT technicians will likely fillin any blanks between the two with their ownideas. Although the IT technicians mean well,active management accountant involvement inthis process will avoid erroneous IT assumptionscreeping into the CPM design.

A word of caution on the manual collection ofsourced data and manual system processes,which should be strongly discouraged. Manualdata collection and manipulation is prone todelays and errors—the biggest problem beingerrors. Automation of all data sourcing and allsystem processes will go a long way to ensure theCPM system’s sustainability and repeatability.

Data TablesAt its core, CPM system is a relational databasethat uses various database tables (or files) andfields (or columns). The structure of every tablemust be documented, defining the table’s fields,field names, type and length of data in each field,and order of the fields. The relationships of the

51


tables within the database must also be defined.This documentation is generally provided by theIT team as part of the system design. The management accountant should become familiarwith the system design documentation andensure it meets the needs defined in the founda-tion basics, costing, and data phases.

The management accountant will likely provideand maintain the constants in parameter and ref-erence tables. Parameter and reference tables arelookup tables that provide variables and con-stants to the profitability calculation engine. Thefunding cost interest rate on accounts receivablebalances, for example, would be stored in aparameter table.

Pre-Processing of DataManipulating cost object data before it is loadedreduces complexity within the CPM calculationengine and speeds processing time. Simple calcu-lations on cost object data in the core applicationsystems as data is extracted should be encour-aged whenever possible. Those on the IT teambuilding the data-extract programs may discour-age this on the premise that their extract designwill be simpler if these calculations occur withinthe CPM database. Long-term, it’s better to per-form simple pre-processing calculations in thedata-extract programs before data is loaded intothe CPM database.

For example, an activity driver with several dif-ferent types (such as color) may be available inthe core application system, but if the businessalgorithm uses the activity driver’s total transac-tion count and not its count by type (by color),then the activity driver’s total transaction countshould be calculated and loaded into the CPMdatabase and not counts for each of its myriadtypes (colors). This reduces the size of the CPMdatabase and eliminates the need for the calcula-

tion engine to sum the activity driver’s typecounts into the activity driver’s total transactioncount.

Sequencing the Business Algorithms The profitability calculation engine must executethe business algorithms in a specified order,referred to as sequencing or scheduling. Largerprofitability systems generally use some sort ofrule-scheduling software, such as mainframe ormid-range computer scheduling packages.Smaller CPM systems are generally designed forlinear execution.

The execution sequence for the business algo-rithms will be provided to the IT team by themanagement accountant. It’s best to establishthe sequencing of the business algorithms as theyare designed and documented. Although anincorrect sequencing of the algorithms can befatal to profitability results, thorough testing ofthe costing and CPM systems should uncoverthese mistakes.

Larger profitability systems that use schedulingsoftware are provided an advantage through theflexibility such software offers to rearrange algo-rithm execution based on production con-straints. Sophisticated scheduling software willmaintain the dependencies of the business algo-rithms while it rearranges their execution basedon the receipt of core application data or otherconsiderations.

Documenting Business AlgorithmsThe management accountant will carry the bur-den of documenting the business algorithms andall business logic. The IT team will use estab-lished documentation policies and procedures todocument the IT side of the CPM system. Thiswill include the relational database design, but itwill generally exclude the business algorithms

52


and profitability logic. Consider the similaritywith Excel, where the documentation on howExcel works is voluminous. Yet any spreadsheetdesigned in Excel that will be used by othersshould have its calculations and formulas documented.

The hundreds of costing and business algorithmsare complicated, and their relationships to thesourced data tables and fields add to the com-plexity. Proper documentation will ensure thesoundness of the business algorithms and theirsequencing and will provide an invaluable aid forsystem maintenance, system upgrades, and sys-tem testing. An example of documenting busi-ness algorithms and their dependencies is pro-vided in Exhibit 12, Business RuleDocumentation.

System Maintenance, Upgrades, andRefinementsOnce in production, the CPM system will requireongoing maintenance and occasional upgradesand refinements. The commitment of resources

required to keep the CPM system in productionshould be considered and budgeted during thesystem’s decision phase.

Maintenance of the CPM system requires constant diligence. Changes in core applicationor GL systems that provide data to the CPM database must be considered and, if necessary,adjustments to the costing and CPM systemsmade and tested. All CPM hierarchies estab-lished in the foundation basics must be kept current, such as the product, delivery channel,and customer hierarchies. Likewise, referenceand lookup tables must be kept current anderror-free.

Customer profitability and costing systems,whether purchased or internally developed, willhave software upgrades requiring installationand testing. Refinements to the system will alsobe required when processes affecting the profitability calculations change or data notavailable before can now be sourced. Any refinements must be designed, documented,implemented, and tested.

53


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Documents

Customer Profitability Management - Arkonas.comarkonas.com/wp-content/uploads/2014/11/Customer...costs, will lead management to consider strategies to increase profits. The signals