StrategyStreet / Diagnose / Costs / Quantifying Cost Reduction Objectives / Increasing Margins by Improving Customer Mix




Part 1: Quantifying Cost Reduction Objectives

Increasing Margins by Improving Customer Mix
Capsule: The Company may close part of its shortfall in financial results by improving margins through selling a greater proportion of sales to Core customers.

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The end point for all of the Company's costs in this diagnostic is a customer order. As with products, customer orders have revenues and competition. They have costs and a resultant profitability. The Company uses an analysis of customer profitability to determine the customers to keep and to drop over the long-term. In turn, the improvement in the mix of customers helps the Company reach its financial objectives.

The Company’s diagnostic task is to identify its most important customers, and to determine the mix that these Core customers represent in the current and the future sales volume of the Company, and then identify the Return on Investment improvement that the improved mix of customers will produce for the Company.

We discuss each of these topics below in the following sections:

  • Types of Customers
  • Identification of Core Customers
  • Current and Prospective Mix of Customers
  • Return Improvement From Mix

There is a more extensive discussion of customer types and the identification of Core customers in Basic Strategy Guide Step 11 and in the Advanced Site at Diagnose/Segments/Final Targets. We recommend that you review these pages as part of this diagnostic.

Types of Customers

A Company has three categories of customers: Core customers, Near-Core customers, and Non-Core customers. The customer's likelihood of producing a good Return on Investment determines its membership in one of these categories.

Core Customers

A Core Customer is one whose pricing and cost-to-serve requirements allow the Company to earn its cost of capital on the relationship through the business cycle of the industry. Core Customers are the backbone of the Company's profit structure. Core Customer Examples »

Other customers would be either Near-Core or Non-Core customers, both of whom are expendable.

Near-Core Customers

A Near-core customer is one whose pricing and cost-to-serve characteristics enable the Company to earn a positive return on capital, but a return below its total cost of capital, through the business cycle. The Company maintains Near-core customers in the expectation that these customers will eventually become Core customers or to use some of the Company’s excess capacity in the medium term while its Core customers grow. Near-Core Customer Examples »

Non-Core Customers

A Non-core customer is one whose pricing and cost-to-serve characteristics allow the Company to realize a positive cash flow, but a negative return on capital through the business cycle. The Company maintains relationships with these customers only to use excess capacity over a relatively short term. Non-Core Customer Examples »

Identification of Core Customers

The identification of Core customers assumes more importance in very difficult markets. In Hostile markets, customer profitability is far more variable than in Stable markets, where Returns on Investment for the industry are at, or above, the average for all industries. In the average industry, the profitability of the customer relationship depends first and foremost on the size of the customer. The Company may often predict the expected profitability of a customer the Company does not presently serve by noting the size of the customer compared to the average customer in the market. The larger customers tend to be more profitable than are the smaller customers. On the other hand, the size of the customer is a much less reliable predictor of the expected profitability of a customer relationship in a Hostile market. In a Hostile market place, profitability of a customer relationship often may be greater with smaller customer relationships than with the larger customers. This shift in expected profitability from larger customers in the average industry to Small and Medium customers in a Hostile industry is the result of differences in prices.

The price paid by a customer is a substantial factor in that customer's profitability. In a Hostile marketplace, the largest customers pay substantially lower prices than do smaller customers. But this assertion holds only for the average customer in a size segment. Within any customer size segment, prices paid by individual customers vary widely. In a Stable market, where returns on investment for the industry are at or above the all-industry average, the price differences between large and small customers are less significant than they are in Hostile marketplaces. At the same time, the range of variability from the average in prices paid by individual customers in a customer size segment is also much smaller in a Stable market.

The individual customer price variations create a wider divergence in customer profitability in a Hostile market than in a Stable market. In a Stable market, the average profitability of a segment is a good representation of the profit expectation for a potential new customer. In contrast, the profitability of each customer in a Hostile marketplace can vary so significantly from the average that the Company must evaluate, individually, the profitability of each current customer and the likely profitability of each prospective customer relationship.

There are cases where the Company would choose to carry an unprofitable customer. Some, though few, unprofitable customers bring other business to the Company. One common example might be an industry leader. Industries where one or two companies dominate by reputation, quality and market share see smaller firms play "follow the leader." If the industry leader adopts a product or process, many others in the industry follow. This is the Industry Leader Effect.

In an industry with this Industry Leader Effect in place, the Company may find that the leading company in the industry is unprofitable as a stand-alone customer. However, if the industry leader chooses the Company as its supplier, many of the follower customers in the industry will also choose the Company as a supplier. These follower customers may be profitable, attractive customers but the Company would not have gained them were it not for the Industry Leader Effect. In such a situation, the Company should evaluate the industry leading customer's profitability in connection with the profitability of all the other sales volume that the more profitable follower customers in the industry would bring to the Company as well.

The identification of Core, Near-core, and Non-core customers may change the Company's plan for capital investment in tough markets. Before the Company would undertake capital investments to support growth in the marketplace, it would assure itself that its worst customers would enable the Company to earn an acceptable return on any new investment the Company must make. If not, the Company would choose not to make the new investment but would, rather, use the Non-core or Near-core customer volume to support the needs of the more profitable customers.

Near-core and Non-core customer returns would support only the highest return capital investment options, those that cost little and add little capacity. In a Hostile market, the Company would not undertake major capacity additions, such as a new production line or a greenfield plant expansion until such an expansion were necessary to support Core Customers.

Customer Relationships Questions

Analysis 8:
Average Price Paid by Size of Customer

Analysis 30:
Returns By Size/Role Segment

Analysis 67:
Unit Price By Customer Size

  • How many customer relationships does the Company maintain today?
  • Does each customer pay a price for each product from a list price less a discount based on the customer's purchase quantity? If not, how are price discounts allocated to the products the customer purchases?
  • What is the average price paid by customers in each customer-size segment for the industry's Standard Leader product? (Analysis 8)
  • How variable are individual customer prices around that average? The Company may express this variability as a percentage difference, below and above the average, for the size segment. (Analysis 67)
  • What economic markers, e.g. prices and cost-to-serve characteristics, would the Company use to identify Core, Near-core, and Non-core customers? (Analysis 30)
  • Do special circumstances, such as the Industry Leader Effect, apply to any customer with low-profitability for the Company?
  • Are there enough sources of profits related to the special circumstances to cause the Company to reclassify an unprofitable customer as a Core Customer?

Current and Prospective Mix of Customers

Once the Company has identified all of its current customers, it may estimate the total sales, in units or dollars, the Company makes today to each type of customer. In the ideal situation, the Company would make all of its sales to Core customers. Few companies achieve this ideal. More commonly, the dynamics of actual customer relationships enable some customers to pay lower than average prices and others to demand more than their fair share of costs. Furthermore, the Company may have difficulty adding capacity at a rate that exactly matches the growth of Core customer demand. It may need to use Near-core customer sales volume in order to provide for Core customer growth and unanticipated Core customer needs. Most companies sell some proportion of their sales to Near-core and Non-core customers.

The plans the Company makes in its segmentation efforts (see Diagnose/Segments set objectives for each current and potential customer in the market. These objectives should improve the mix of customers in the Company’s unit and dollar sales. There should be more sales to Core customers and less sales to Non-core customers. Near-core customer sales volume may also shrink.

Elimination of Unattractive Customers Examples>>

A Hostile market may present a particular difficulty. In these markets, the Company is likely to have more capacity than it needs to meet the needs even of its Near-core customers. Many companies sell the excess capacity for what it will bring in the marketplace. These sales often go to Non-core customers. Since this capacity is going to produce low returns in any event, the Company might first determine whether it can use some or all of this excess capacity to help its Core customers improve their positions in the market and pull the Company along with them.

Return Improvement From Mix

This improvement in mix of customers improves the Company’s financial performance and closes some of its financial performance gap. Selling more to Core customers improves the operating margins, or Return on Sales, of the Company. These Core customers pay higher prices than others of similar size. In a Stable market, they also may be the larger customers in the market. These Core customers may also enable the Company to improve the Effectiveness of its use of capital in the industry, enabling the Company to sell more dollars or units of sales for each dollar of capital employed. In either event, increasing the sales to Core customers will improve the Company’s Return on Investment.

The Company may make a rough estimate of this improvement in Return on Investment by making some simple assumptions and calculations. It can estimate the current operating margins for the average Core, Near-core and Non-core customers. The weighted average combination of the sales to each of these customers produces the Company’s current operating margins or return on sales. The work the Company did in the Pricing section (see Diagnose/Pricing projected the Company’s expected changes in industry and Company prices through the planning period. The Company, then, would reflect these changes in prices in the current operating margins for each of the Core, Near-core and Non-core customers. Then the Company can project its expected operating margins, or returns on sales, with the new mix of customers the Company plans to achieve by the end of the planning period. The Company may also wish to calculate its average Net Capital Employed for each type of customer, both now and at the end of the planning period. Once these calculations are completed, the Company may calculate its expected Return on Investment at the end of the planning period. From this calculation, the Company may determine what, if any, gap remains in its effort to reach its financial goals.

More Customer Relationships Questions

Analysis 64:
Customer Mix by Long Term Return

  • What percentage of the Company's current sales volume does the Company sell to Core, Near-Core, and Non-Core Customers? (Analysis 64)
  • What percentage of the Company’s sales volume at the end of the planning period does the Company plan to sell to Core, Near-core and Non-core customers (Analysis 64).
  • What is the Company’s current operating margin, or return on sales, with its current mix of customers?For the average of each Core, Near-core and Non-core customer segments, what is the current operating margin?
  • What will this operating margin be at the end of the planning horizon?
  • What will the Company’s operating margin be at the end of the planning horizon, assuming it achieves its planned mix of customers?
  • Does the shift of sales volume from Near-core or Non-core customers into Core customers affect the capital intensity (i.e., net capital employed divided by sales) of the Company?
  • If the capital intensity of the Company changes with a shift in customer mix, what is the Company’s current capital intensity and expected capital intensity at the end of the planning horizon?
  • What gap, if any, remains to be closed in the Company’s financial goals?

Basic Strategy Guide Users Return To: Step 26

Summary Points

Next: Measuring Current Economies of Scale