Managers today have a huge unaddressed opportunity to engage and manage their large, profit-draining customers, creating win-win relationships that rapidly increase profits and lock in these key customer relationships. As yesterday’s mass markets fragment, managers must shift from broad-based product management to highly focused management of target customer segments — and even individual customers.
The potential profit increase from turning around money-losing customers is huge. For example, in one midsize distributor, 18% of customers produced 140% of profits, and 28% of customers drained 47% of those profits. (The remaining 54% of the customers accounted for the balance.) Transforming 20% of the profit-drain customers into profit peaks produced a 40% increase in overall profits. In other words, focusing management on a mere 7% of their customers produced a beginning 40% profit increase. Here’s how managers can turn their profit-drain customers into profit peaks.
Reduce Costs on Both Sides
Your profit-drain customers are an important potential source of profit. Engaging and managing these large, low-profit customers requires a very different process than you use for your profit-peak and profit-desert customers.
The essential first step to turning around your profit-drain customers is to identify them. This seems obvious, but most companies focus solely on growing all of their large customers. For profit-drain customers, this means bringing in more losses. Transaction-level profit metrics are necessary for this because, surprisingly often, the gross margin doesn’t capture the most important profit-draining factors.
In our experience, customers are rarely profit drains because of below-market pricing; they’re profit drains because of an excessively high cost to serve, generally caused by relatively minor factors that are unseen and unmanaged. The good news is that this is often relatively easy to fix: You can create a win-win solution for both companies, increasing the customers’ own profitability while converting many into profit peaks. We call this process of joint cost reduction — increasing profitability by lowering the cost to serve rather than raising prices — conditional pricing.
For example, a distributor we’ll call Harbor Supplies (not its real name) recently decided to install vending machines loaded with their products in their large customers. Harbor’s financials showed that this business produced strong revenue growth and gross margins.
When the company implemented its new digital transaction-level profit metrics, however, the managers saw that the vending business was actually draining net profits. The vending segment’s detailed P&L clearly showed that the problem was that the customers were ordering replenishments several times a week. The cost of picking and shipping an order was higher than the gross margin — a common problem that went undetected by the traditional financials but became visible immediately with the new transaction-level segment P&Ls. This was just as costly for the customer as it was for Harbor.
The managers found that the sales reps were earning installation bonuses by telling prospective customers that they could set the machines to carry minimal inventory, and even order every day. (The customers’ purchasing managers were responsible for inventory cost, not the related cost of ordering and restocking the machines, so this looked like a good deal to them.) This was making these large customers profit drains.
Fortunately, this was easy to remedy: The sales team inserted a replenishment frequency clause into the contracts and met with the customers to explain how this would lower the customers’ ordering and put-away cost, creating a win-win. Virtually all of these profit-drain customers became profit peaks.
Assign the Right Teams to the Right Customers
Once you’ve identified your profit-drain customers, the next step is to engage and manage them with specialized, multi-capability teams focused solely on building ongoing relationships in order to lower the cost to serve them — and often lowering the customers’ costs in the process. Since the profit-draining problems are most often lower-level operating issues, such as order patterns, the team should be comprised of specially trained operating managers.
New digital transaction-level metrics are critical for identifying opportunities for win-win cost savings because virtually all of the operating cost improvements are non-price. Most companies engage their large customers with the implicit objective of raising prices, creating a zero-sum relationship. Profit-drain teams, on the other hand, have the explicit objective of lowering costs for both vendor and customer, creating a win-win relationship.
For example, Natco Distributors (not its real name), a national industrial distribution company, had always provided next-day service to its customers. Many times, this involved costly expediting and shipping from a central warehouse if a local distribution center had run short of stock on a product. This was very costly, and in fact, caused several major customers to be profit drains.
When Natco’s dedicated profit-drain team spent time with these customers, they saw that in many cases, the company didn’t need overnight service. The team partnered with counterpart managers from these companies to identify the shipments that really required overnight service. This change reduced the expediting and cross-shipping costs for Natco, turning these customers into profit peaks. In return, Natco guaranteed 100% order fulfillment on the scheduled dates (which eliminated inefficient backorders). This was an important benefit to these customers.
Profit-drain customer teams have visibility into best practices across the full range of their customers, which enables them to compare similar companies, identify which customer cost factors are problematic and how to improve them, and quantify the potential profit improvement.
Consider Three Cost Items
In our experience, a small number of cost items offer many of the best opportunities for improvement:
Order pattern. Like the vending machine example, this factor is rarely managed. It’s relatively easy to change in most cases (although some orders need to be shipped at a fixed time), and it offers important gains for both the supplier and the customer.
For example, we recently worked with a major hospital system to optimize their replenishment order pattern, considering the joint costs of both the supplier and hospital. In this well-known, efficient hospital, we were able to lower their supply chain costs by over 40%, with an increase in service levels.
Product mix. In companies without digital transaction-level metrics, the sales and product managers don’t know each product’s actual net profit. Some customer orders are for a specific named product, but most are for a generic need, such as wrap-around safety glasses. The alternative products that meet this need at a similar price point usually have widely varying net profits. Transaction-level metrics reveal each product’s net margins, enabling product managers and sales reps to optimize product mixes profitability at no cost to the customer.
This creates a new opportunity to create an internal “profit catalogue” for sales rep use. The new catalogue has the traditional list of products but adds the all-in net profit of each. At one company, the sales reps get monthly reports on the profitability of each customer’s product mix, with suggested higher-profit product additions and substitutes.
Order channel. Most companies are rapidly moving toward EDI (electronic data interchange, or electronic ordering) because it offers significant cost saving. However, companies with EDI orders lose the ability to cross-sell, up-sell, and probe for important customer information.
The solution. Use EDI for your small customers to lower your cost to serve, but for your important profit peak and profit drain customers, selectively call back once the EDI order is received to cross-sell, up-sell, and keep the relationship close.
In working continuously with profit drain customers, your multi-capability teams will gain a deep understanding of the profile and development pathways of these customers — as well as the operating cost problems that can be fixed. This will enable your profit-drain teams to identify which prospective customers are likely to become intractable profit drains.
This knowledge is invaluable. Your profit-drain teams need to partner with your sales managers to incorporate these profiles into your account selection and management processes, allowing them to laser-focus on bringing in the accounts that will be profit peaks or that could be converted into profit peaks and avoid those that will be irreversible profit drains. Bringing all your knowledge and expertise to bear on ensuring that your sales reps systematically avoid those who will irreversibly erode your hard-earned profit is the biggest hidden profit lever of all.
-Harvard Business Review