158-Divorce that Customer?

Times are tough for business in many industries. Demand is off, prices are falling, and competition is fierce. Some companies have responded to these difficult conditions by divorcing their high-cost customers. Is this a good idea?

Perhaps this decision will increase profits. In a very tough market, it is not unusual for many customers to be “unprofitable.” (See the Perspective, “The New Pricing Structure” on StrategyStreet.com.) These customers may not produce a return on the company’s cost of capital through a business cycle at the industry’s current low prices. Pricing in the industry has fallen far enough that the price must discourage some of the industry’s capacity from producing. Several companies may find themselves pricing through “profitability levels” to maintain their relationship with a customer. This is more likely in an industry with low variable cash costs, such as most capital intensive industries. In these markets cash generation is more important than profits.

So, when should we divorce an “unprofitable” customer? The simple answer to that question is that you want to eliminate any customer who is not generating cash on sales to that customer. These customers are clearly unattractive in a tough market. They may also be unattractive in a better market. Certainly, today, they cost the business cash and are likely not worth keeping. (See “Video 63: Core Customers Part 1: Defining Core, Near and Non-Core Customers” on StategyStreet.com.)

There are two caveats to this rule. First, the company has to be sure that the reason the customer is unprofitable and, worse, failing to generate cash, is not that the company’s own cost structure is out of line with the competition. If the cost structure is out of line, that is, higher than competition, then it must reduce its costs or get out of the business. (See the Perspective, “The Wisdom of Salomon” on StrategyStreet.com.) It is doomed to failure over time. The second caveat is that the customer is one who always pays low prices. The company should evaluate the customer relationship over the last few years, through a business cycle, to determine whether the customer is a perennial low-profit producer. If the customer is a low-profit producer through the business cycle, there is little risk in eliminating that customer. That customer does not generate enough money to support the capital his business demands.

Posted 12/14/09

Update:

Cost reduction programs become more important in hostile markets. These programs will best serve the company if they are done with sensitivity to the customers’ needs. See HERE and HERE for short explanations.

8/22

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