WHAT WE DO KNOW CAN HURT US

by Donald V. Potter

“A little knowledge is a dangerous thing.” Taking this adage one step further: For the North American business leader, the very abundance of knowledge poses a danger.

Knowledge Put to Wrong Use

North American business enjoys the best financial and management information systems in the world. For example, it has more information on costs, and greater ability to track costs, than its peers in Europe or Asia. This information is invaluable when it comes to tracking success in cost control over time.  But this information is not good for strategic decisions. When used to develop strategy, this “knowledge” can lead to mistakes.

Mistake 1: Dropping “Unprofitable” Products

Product profitability analyses will often show certain products that are “unprofitable” when all costs are allocated. The “logical” decision, especially in hostile markets, is to cut costs by dropping those products.

What happens, though, when a product is dropped? The customer need which that product met does not go away. Customers turn to other suppliers for that product — and usually for other products as well. The original supplier loses volume across his product line and weakens his customer relationship.

Mistake 2: Dropping “Unprofitable” Customers

Customer profitability analyses will often show customers who are “unprofitable.” In hostile markets, these are often the highest volume customers, who account for the greatest share of allocated costs yet are able to gain price discounts. The “logical” decision is to drop those customers and focus on serving smaller customers with more attractive margins.

When a large-volume “unattractive” customer is dropped, though, the supplier’s economics change. Contribution dollars fall. Not all “direct” costs will magically disappear; those plus indirect costs must now be allocated across a smaller volume. In fact, high volume customers underpin the economics that make smaller customers appear more attractive.

Perhaps worse, competition sows discord with the remaining large customers. Competitors create uncertainty by asking your customers: “Will you be the next to be dropped?”

The Problem With Information

Why can an abundance of good information on cost be harmful when making strategic decisions?

First, it can lead to a false sense of understanding of the market. Allocation systems are always somewhat arbitrary. In fact, costs don’t really move exactly as allocated.

Second, it can focus the decision too narrowly. Detailed information tempts us to make a decision about a product when we should look at the role of that product in a customer relationship. It tempts us to make a decision about a customer when we should consider the importance of that customer in overall company economics.

Implication: Focus on Customer Relationship

In most businesses, companies are competing not to sell products as units, but to secure long-term relationships with customers, many of whom want to buy a range of products.

When those conditions apply, a company:

• Should not drop a product without considering the impact on customer relationships. Do customers still want this product? If so, who will supply it to them? Can we risk inviting that supplier into our client relationships?
• Should not drop a customer without considering the loss to be permanent. Might we ever want to serve this customer again? If so, do we want to make a major investment down the road to try to buy back a customer who by then will “belong” to one of our competitors?
• Should not downsize without considering how the lost contribution will be replaced. A “right” decision in an accounting sense must be “right” in a cash sense as well.

Closing Thought

A company does not make long term high returns because of its product mix or its customer mix. Companies make high returns because their competitors cannot find a way to take their customers away.

(Note: This Perspective was written in the context of the economy in 1991. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)

Recommended Reading

For a greater overall perspective on this subject, we recommend the following related items: Analyses: Analysis 29: Index Comparison of Company and Industry Volatility on the Custmer Size/Role Matrix Analysis 30: Returns By Position Analysis 42: Target Customer Purchases By Price Point Analysis 59: Economies of Scale by Type of Employee Analysis 64: Customer Mix by Long Term Return of Customer Relationship Symptoms and Implications: Symptoms developing in the market that would suggest the need for this analysis. Price wars are spreading in the industry The market structure is changing as shares shift in the channels of distribution Large customers are getting higher discounts The industry leaders are losing share The industry is consolidating through mergers and acquisitions ***