A number of business assumptions are extremely wrong because an important piece of information that is missing is leading us to them.
Many think, for example, that all business is good business, or that the biggest customers are the best customers and that small customers are less important customers, just because they don’t have the real representation of the margin, the profit derived from each transaction in mind. Intuition simply fails us all in these cases.
Gross margin is easy to determine, but understanding what components determine gross margin is not as easy, even though it’s important to understand how different customers influence your margin, how resources are consumed, and this helps you make informed decisions. For this we need some managerial accounting.
You know by now that financial accounting is something that we “have to do” because this is what law says in order to ensure transparency and control. Managerial accounting is what we want to do in order to gain insights for informed business decisions. Both types of accounting are essential, but for different purposes.
80-20 rule shows that 80% of a company’s revenue comes from 20% of its customers and this makes the focus on margin not on sales necessary in order to make sound decisions. There is the so called differential resource consumption which shows that different customers force us to consume different resources in our business.
Average costing is lacking in accuracy and insights and it implies that all inquiries are equally resource intensive and that not all of our customers consume resources equally. Which is not at all true. Companies that rely on average costing subsidize their most taxing customers, and they are not necessarily the most profitable.
This is why a cost-to-serve analysis is more useful because it identifies and it expresses the costs of serving specific customers or groups of customers. To do this, first get a handle on business resources and expenses buy understanding its financials. Then examine the activities performed in the business.
It’s important to know what processes and activities are performed in order to serve customers. Hone in on activities that are unique or involve different types or levels of resource consumption. And, lastly determine costs to serve for each customer. Different cu customers need different levels of activity.
To do this properly don’t quibble over every penny, a 90% solution would be fine and you avoid paralysis by analysis. Only include costs that would go away if the cost object went away and revisit figures from time to time, you know where you win and lose on a customer-by-customer basis.
By doing this analysis many companies realize that 15 – 40% of their customers are losing them money and are subsidized by the others. That’s to confirm that “opinions are fine, but data is better!”. This allows to make internal changes that make doing business with underperforming customers more lucrative.
So, replace assumptions with knowledge and bring the lights back to your business. Just measure what really matters in your business, and you’ll know what to do.