CUSTOMER PROFITABILITY
AND
SHORT RUN PRODUCT MIX DECISIONS
LECTURE 3 - AGENDA
• Traditional and costs-to-serve approach to customer
profitability
• What is customer value and how it is different form
profitability
• Theory of Constraints and why the definition of variable
cost matters
Prof. Teemu Malmi 2016
I – TRADITIONAL WAY
• Product sales price less variable costs (less some fixed
costs) = product (contribution) margin
• Sum up customer purchases and resulting total
(contribution) margin per customer
• Sometimes adequate enough method to assess
customer profitability! In which circumstances?
Prof. Teemu Malmi 2016
CUSTOMER COSTS ?
How our customers are different
what comes to costs they impose
on us?
Prof. Teemu Malmi 2016
II – COST-TO-SERVE
Prof. Teemu Malmi 2016
Typical ABC model
Product profitability
Production margin
Product level costs
Customer profitability
Customer margin
Delivery costs
Company profitability
Net profit
Unused capacity
R&D costs
Batch level costs
Direct Materials
&
Packaging
Prof. Teemu Malmi 2016
Customer service
Sales activities
Facility sustaining
activities
Sum of production
margins of all orders
Total customer
margin
WHAT DO ABC TELL US?
CONCLUSIONS?
SO WHAT?
Prof. Teemu Malmi 2016
COST VS. VALUE
• Customer value builds up from all such things we are able
to generate cash flow!
• Customer costs do not reflect:
–
–
–
–
Prof. Teemu Malmi 2016
III – CUSTOMER VALUE
• How would you calculate customer value? This might be
of importance in situations where some of the largest
customers appear unprofitable based on your customer
profitability analysis
Prof. Teemu Malmi 2016
CASE: CUSTOMER VALUE AT ONE
MAJOR BANK
• Based on idea of Economic profit / Return on Economic
Capital
• Discounts future cashflows to present value
• Is used e.g. for pricing in corporate banking
• Inputs:
–
–
–
–
–
–
Product mix, for example loan, cash limit, transaction volumes
Assumptions about the use / change in use per year
Banks margin per product
Transaction fees per product
Process / activity costs per year
Funding cost
Prof. Teemu Malmi 2016
CASE: CUSTOMER VALUE AT ONE
MAJOR BANK
• As a first step, estimated cash revenues from each
product (margins + fees) for the lifetime of a loan are
calculated
• Similarly, both process and funding costs are estimated
for each year
• This ends up to a net cash flow from this customer
• If we would discount these to present values, would this
be enough for a bank to estimate the profitability or
value of its customer?
Prof. Teemu Malmi 2016
CASE: CUSTOMER VALUE AT ONE
MAJOR BANK
• The issue with banks is that certain products (e.g. loan,
limit) tie up capital where as some do not (e.g.
transactions)
• This also brings in risks
• Further inputs based on Basel II
– Probability of default (PD, is based on internal rating)
– Exposure at default (EAD, luottovasta-arvo in finnish)
– Risk Weight (RW, is based on rating information and how
economic capital is calculated)
– Cost of capital
– Funding cost
Prof. Teemu Malmi 2016
CASE: CUSTOMER VALUE AT ONE
MAJOR BANK
• For both loan and limit, bank calculates Risk Weighted
Assets (RWA), which equals EAD x RW.
• As Basel requires Banks to have at least 8% of equity, it
can now be calculated how much these products tie up
banks own funds. (Capital required = RWA x 8%)
• This is then multiplied by the cost of capital to end up with a
capital charge for these products ( e.g. 10% of cost of
capital x capital required)
• When these capital charges are deducted from net cash
flows computed earlier, bank ends up with economic profit
(excluding taxes) this customer generates each year.
Prof. Teemu Malmi 2016
LECTURE 3 - AGENDA
• Traditional and costs-to-serve approach to customer
profitability
• What is customer value and how it is different form
profitability
• Theory of Constraints and why the definition of
variable cost matters
Prof. Teemu Malmi 2016
AN EXAMPLE OF SHORT TERM PRODUCT
MIX DECISION UNDER CONSTRAINT
Question: What products to produce in order to maximize firm profitability?
CONVENTIONAL
VARIABLE COSTING
THROUGHPUT
ACCOUNTING
Income
- Direct materials
- Direct labour
- Variable overhead
= Contribution margin
Income
- Direct materials
= Throughput (margin)
Prof. Teemu Malmi 2016
Production Process
Capacity
Sawing-activity
300 h
Packaging-activity
100 h
Loading time in activity
Product A
Product B
Sawing-activity
0,0005 h/pcs
0,0005 h/pcs
Packaging-activity
0,001 h/pcs
0,0005 h/pcs
Product A
Product B
Direct material costs
1 EUR/pcs
1 EUR/pcs
Sales Price
2,5 EUR/pcs
2,5 EUR/pcs
A
1000 pcs/h
2500 EUR/h
1000 EUR/h
1500 EUR/h
B
2000 pcs/h
5000 EUR/h
2000 EUR/h
3000 EUR/h
Throughput calculation
Product
Throughput in bottleneck
Generated sales per hour
Material costs
Throughput
Prof. Teemu Malmi 2016
THEORY OF CONSTRAINTS LESSONS
• Maximize contribution per unit of limiting factor
• In other words, typically which product yields highest
€/hour
• The idea is to maximize profitability of existing facilities
• Irrespective of TOC ”theory”, the truly variable costs are
of interest => In other words, you get different results
depending on how you compute your contribution
margin
Prof. Teemu Malmi 2016
USING THROUGHPUT
Production Process
Capacity
Sawing-activity
300 h
Packaging-activity
100 h
Loading time in activity
Product A
Product B
Sawing-activity
0,0005 h/pcs
0,0005 h/pcs
Packaging-activity
0,001 h/pcs
0,0005 h/pcs
Product A
Product B
Direct material costs
1 EUR/pcs
1,5 EUR/pcs
Sales Price
2,5 EUR/pcs
2,5 EUR/pcs
A
1000 pcs/h
2500 EUR/h
1000 EUR/h
1500 EUR/h
B
2000 pcs/h
5000 EUR/h
3000 EUR/h
2000 EUR/h
Throughput calculation
Product
Throughput in bottleneck
Generated sales per hour
Material costs
Throughput
Prof. Teemu Malmi 2016
USING TRADITIONAL CONTRIBUTION MARGIN
Production Process
Capacity
Sawing-activity
300 h
Packaging-activity
100 h
Loading time in activity
Product A
Product B
Sawing-activity
0,0005 h/pcs
0,0005 h/pcs
Packaging-activity
0,001 h/pcs
0,0005 h/pcs
Product A
Product B
All "variable" costs
1,6 EUR/pcs
2,1 EUR/pcs
Sales Price
2,5 EUR/pcs
2,5 EUR/pcs
A
1000 pcs/h
2500 EUR/h
1600 EUR/h
900 EUR/h
B
2000 pcs/h
5000 EUR/h
4200 EUR/h
800 EUR/h
Throughput calculation
Product
Throughput in bottleneck
Generated sales per hour
Variable costs
Throughput
Prof. Teemu Malmi 2016
SUMMARY
• How would you analyze the reliability of the product /
service / customer profitability figures your company
accounting system provides you?
• Key learning points today?
Prof. Teemu Malmi 2016