When to Drop Unprofitable Customer

HTN019 June 21, 2017

TEACHING NOTE

When hen to t o Drop an Unprofi Unpro fitable table Customer Introduction This Teaching Note was prepared for the sole purpose of aiding classroom instructors in the use of the Harvard Business Review (HBR) case, “When to Drop an Unprofitable Customer” (HBP No. R1204L). The R1204L). The case is available in three formats: case plus commentary (HBP No. R1204L), case only (HBP No. R1204X), and commentary only (HBP No. R1204Z). The commentary consists of short analyses of the situation by experts in the industry, as well as recommendations from practitioners and observers. It is recommended that instructors assign the case-only version for class preparation. Note that the HBR case is based on a much longer and richer r icher HBS field case, ““Elkay Elkay Plumbing Products Division” (HBS No. 110-007), written by Robert S. Kaplan. That cases focuses on a broader array of issues and covers them in more depth than “When to Drop an Unprofitable Customer” does. does. A Teaching Note (HBS No. 110-089) is also available for Kaplan’s case. Kaplan’s case.

Summary 1 Egan & Sons is a United Kingdom– Kingdom– based supplier of building products, specifically specifically stairways and doors. Tommy Bamford is a company director, and Jane Oldenburg is a regional director of sales at Egan. The case focuses on a visit by the two executives to a customer, Westmid Builders. There, the two meet with Steve Houghton, Westmid’s purchasing executive. The executive. The two companies have a 63-year-long relationship, and Jane is naturally an ally of her customer. But a rec ent cost analysis (activity-based costing [ABC] analysis) has shown that Egan loses money on its Westmid account. Indeed, it lost 28 cents on every dollar of sales to this very large customer. The case is set just after Bamford has led a four-month four- month study of Egan’s costs. That costs. That ABC analysis has revealed that Egan has 6,000 stock-keeping units (SKUs) and 2,500 customers, but loses money on 90% of its customers and 80% of its SKUs. The top 1% of customers and SKUs account for 100% of profit. Gains made on other profitable customers and SKUs are cancelled out by losses on the bottom 80% or 90% of customers and products.

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This Teaching Note draws considerably on the Teaching Note for the original HBS case “Elkay Products Plumbing Division— Division — Teaching Note,” by Robert S. Kaplan, June 29, 2010 (HBS No. 110-089). 110 -089). This Teaching Note was prepared by writer Mike Roberts, for the purpose of aiding classroom instructors in the use of theHarvard Business Review (HBR) case, “When “When to Drop an Unprofitable Customer ” (HBP No. R12104L) R12104L) by Robert S. Kaplan. It provides analysis and questions that are intended to present alternative alternative approaches to deepening students’ comprehension of business issues and energizing classroom discussion. HBR cases are developed solely as the basis for class discussion. They are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

COPYRIGHT © 2017 HARVARD BUSINESS SCHOOL PUBLISHING CORPORATION. ALL RIGHTS RESERVED.

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This Teaching Teaching Note is authorized for use only by VINOTH S, Bharathiar University until Jul 2018. Copying or posting is an infringement of copyright. [email protected] [email protected] or 617.783.7860.

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WHEN TO DROP AN UNPROFITABLE CUSTOMER

The case centers around the dilemma faced by the company, exemplified by the two protagonists in the case, Bamford and Oldenburg. Should the company simply “fire” Westmid, who is among the least profitable 1% of customers, or is there another way to salvage the situation and turn the account into a profitable one?

Learning Objectiv es The case illustrates the application of activity-based costing in an actual company. It allows students to recognize when and why a company needs a more accurate costing system, as well as some of the practical implications and challenges of a new cost system. To implement effectively not just the system but also the decisions such a system raises, managers must act to transform or eliminate unprofitable products and to manage better the relationships with individual customers. The case shows how an accurate cost and profit measurement system can enhance a company’s process improvement efforts; inform its product design decisions; modify its inventory and distribution processes; and, most important, create an effective tool for bonding more closely with attractive, profitable customers and confronting the decisions and difficult discussions required to change relationships with the most unprofitable customers. The specific teaching objectives include: 

Exploring the differences between standard “ overhead allocation” based cost systems versus ABC.

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Understanding the insights that can come from ABC.

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Thinking through the difficult choices stimulated by ABC type of analysis.

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Developing alternative strategies for changing the dynamics that produce unprofitable customers and products.

Use of the Case The case can be used to introduce a unit on ABC in an introductory finance or managerial accounting course. The case lacks any data for students to practice the basics of ABC, but it introduces the notion of why ABC is important and the kinds of decisions it will raise in an organization. Many cases are available that do present actual data for practicing the actual implementation of an ABC system (see the cases described below in “Other References”). The case can also be used in a module in a managing grow ing companies course dealing with the importance of having accurate costing information as a basis on which to make pricing and market selection decisions.

Related Research If students have not been previously exposed to ABC, the instructor may assign one (but not both) of the first two readings: Kaplan, Robert S. “Time-Driven Activity-Based Costing.” (April 25, 2006, revised May 15, 2009), HBS No. 106-068. Kaplan, Robert S., and S. R. Anderson, “Time Driven Activity-Based Costing,” Harvard Business Review (November 2004): 131 – 138. Kaplan, Robert S., and V. G. Narayanan, “Measuring and Managing Customer Profitability,” Journal of Cost Management (September/October 2001): 5 – 15. (An additional reading that would be useful for the case; unfortunately,

however, the publisher of the journal usually asks for a high royalty to reprint this article.)

As an alternative, instructors can use this case to introduce the concept and can then follow up this discussion with more focused readings and more detailed case studies. Instructors who want, for themselves, a more complete introduction to time-driven ABC can read the first three chapters in Robert S. Kaplan and Steven R. Anderson, Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher


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This Teaching Note is authorized for use only by VINOTH S, Bharathiar University until Jul 2018. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860.

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Profits (Boston, MA: Harvard Business Publishing, 2007). In addition, a good interview with John Hrudicka, chief financial officer of Elkay , appears as the cover story, “A Total Remodel,” in Business Finance (Spring 2010).

Other References (HBP Catalog) Jean, Melissa, and Courtney Young. “ Asante Teaching Hospital: Activity-Based Costing.” September 14, 2016, HBS No. W16558. Kaplan, Robert S. “ Activity-Based Costing and Capacity .” March 4, 2005, revised March 20, 2006, HBS No. 105-059. Kaplan, Robert S. “Classic Pen Co.: Developing an ABC Model.” April 10, 1998, revised S eptember 17, 1998, HBS No. 198-117. Kaplan, Robert S. “Dakota Office Products.” August 7, 2001, revised February 18, 2005, HBS No. 102-021. Kaplan, Robert S. “Kemps LLC: Introducing Time-Driven ABC.” August 3, 2005, revised April 13, 2006, HBS No. 106-001. Kaplan, Robert S. “Sippican Corporation (A).” February 16, 2006, revised September 21, 2006, HBS No. 106058. Kaplan, Robert S. “ Wilkerson Co.” March 7, 2001, revised August 5, 2003, HBS No. 101-092. Kaplan, Robert S., and Steven R. Anderson. “Evolution of Time-Driven Activity-Based Costing: Introduction.” Februar y 22, 2007, HBS No. 2221BC. Kaplan, Robert S., and Bjorn N. Jorgensen. “Borealis.” December 3, 2001, revised February 25, 2008, HBS No. 102-048.

Teaching the Case The discussion of this case can cover several main areas depending on the time available and the instructor’s desired focus. These areas of discussion include the themes and lines of questioning outlined below and listed in the board plan shown in Exhibit TN.1. Each of these discussion themes is discussed at length below, along with its supporting analysis. Suggested Time Allocation for Classes of Various Lengths 1. Understand the current cost and pricing system. How are products typically costed? Relationship between cost and price? Problems with typical approach? How does ABC address these problems? 2. Analyze the Westmid account. Why is Westmid unprofitable? Why are some accounts highly profitable? Should Egan fire Westmid?

30 –40 minutes

60 minutes

80 minutes

5 5 5 5

10 5 10 10

10 10 10 –15 10 –15

5 5 5

5 10 10

10 10 10 –15

Assignment Questio ns 1.

What is activity-based costing (ABC), and how does it differ from the normal approach to costing and pricing products?

2. What are the problems with the typical approach, and how does ABC attempt to solve these problems?


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3. Why does a more accurate cost for a product matter? Shouldn’t the price be set based on market and competitive factors? 4. What causes a product or customer to be highly unprofitable? When would a product or customer be highly profitable? 5. What actions, if any, would you suggest Egan take with respect to its most profitable customers? 6. What actions should Egan take with respect to Westmid?

Analysi s of t he Case Theme 1: Overview of Activity-Based Costing v ersus Typical Costing and Pricing Ap pr oac hes How are products typically costed? As the case describes, products are typically costed as follows: Egan “. . . allocated factory overhead to products as a percentage markup over direct labor costs, and corporate overhead as a percentage of sales. Thus, the company could not accurately identify its costs for serving individual customers or for designing and producing all the new goods it had recentl y brought to the marketplace.” Get students to under stand what is happening with Egan’s costing system. First, factory overhead costs consist of all the nondirect labor and material costs that occur at the factory level. This would include everything from supervisors and management to utilities, packaging and shipping costs, to the staff labor like design, cleaning crews and inventory managers. These costs are allocated on the basis of direct costs, which include labor and materials. Direct means the observable, variable costs associated with each product. For instance, we can observe that the manufacture of a staircase might require 10 hours of labor at $14 per hour, plus 30 board feet of lumber at $1 per foot. That would be a total of $170. However, a company has lots of costs that are not the direct (observable or variable or incremental) costs associated with any particular products. They are indirect and overhead costs. Many companies, including Egan, take the total amount of indirect or overhead costs and compare that total to the total amount of direct cost borne in a given year. If the ratio is, let’s say , 2:1, then every dollar of direct cost is doubled to get a cost factor that is added to the direct costs. This results in a tripling of direct costs to get a total cost for the product. This is the so-called factory cost. The nonfactory overhead cost is allocated on the basis of revenues, that is, as a percentage of sales. This would include all the corporate items, for example, advertising, research and development, and corporate management. If corporate overhead is 20% of sales, then every $1 of factory cost bears an additional $0.20 of corporate overhead. ( Note: This slightly blurs costs and price in the sense that we are spreading some items in proportion to factory costs and some items in proportion to revenues. In a system where prices are based on costs, these proportions end up being equal. If prices are not based on cost, then some items that are spread in proportion to revenues may be spread in slightly different proportion than items that are spread in proportion to costs. For our purposes, this distinction is immaterial.) Of course, before this segment of the discussion ends, it is worth establishing that costing is not the problem, per se. The problem is that most pricing decisions are made on the basis of cost; thus, an inaccurate picture of costs leads to an inaccurate perspective on pricing.


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Why do costs figure into pricing decisions? Doesn’t the market set the price? In economic theory, markets set prices (supply and demand) and companies are price takers. This may be true in markets for pure commodities like oil or steel, but we know from our everyday experiences that this is not true. In the industrial (as opposed to the consumer) sector, companies have all sorts of reasons to prefer to work with certain other companies. These reasons range from working relationships to timeliness and ease of ordering and d elivery, to quality differences. Certain companies may need customization or design for certain products, or extra time to pay. Companies have to make pricing decisions all the time, and they can’t simply look to the market, although they may certainly take market data into account. In practice, an easy way for companies to set prices is based on costs. They believe that by marking up their costs with a desired profit margin, they can ensure their desired level of profitability. As the case shows, this may indeed be true on average, but the system obscures all sorts of costs that may in fact not be spread proportionally among all products. It is worth asking students to dig deeper to understand what circumstances might make these nondirect costs not be in true proportion to the bases on which they are allocated. That is, the tacit assumption of the overhead allocation schemes we have been talking about are that costs are really incurred in proportion to direct labor and materials. Why would this not be so? What circumstances might create distortions where estimated costs are not an accurate representation of true costs? First, this situation depends a bit on what costs are actually in the buckets that are being spread based on either revenues or direct costs. As far as the direct-cost-based spreading of factory costs, this could include items like customer-specific design and development, tweaking standard designs into semicustom or even custom work, and shipping, packing and delivery expenses that are disproportionately large. As far as the revenue -based spreading of overhead costs, this might include items like corporate R&D as well as marketing and advertising. One can imagine why these expenses may well not be incurred in direct proportion to either direct factory costs or revenues. Some products simply take more energy and effort to sell, market, ship, and/or install. And some customers are more demanding, desiring more handholding, more customized work, or more help post-sale. If this “spreading” approach produces the desired profit margin, on average, what is the problem with it? We see the effect of this approach in the data presented in the case. Namely, that 1% of SKUs and 1% of customers account for 100% of the company’s profit. As the case explains, there are other profitable products and customers, but that profit is more than offset by the 80% to 90% of unprofitable products and/or customers. The clear implication is that the target level of profitability may be simply a bad target. Profits could be considerably higher if Egan could rationalize its product line and customer base or improve its internal processes: 

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Raising prices where it can, and increasing profits. Simply eliminating unprofitable customers and/or products, where that can be done without jeopardizing relationships or profitable lines of business (see more on this below). Changing its internal practices to reduce costs where they are out of line with the prices the company can achieve.


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What was the ABC system that was introduced? ABC assigns costs based on actual flow and run and setup times in production centers, and on process times in distribution centers. The ABC system starts by mapping all the processes: design and development, production and finishing, and storage and distribution. It drives resource costs to each process (or production department) and measures the time each order or product uses on each process. The times become the mechanism by which process costs are assigned down to products and orders. The ABC system assigns freight and delivery costs, and revenue deductions (trade deals, promotions, rebates, returns, discounts) directly to individual orders and customers. The previous system aggregated all these delivery costs and revenue deductions into large pools that were allocated arbitrarily (in proportion to direct costs) and inaccurately. As the case explains, “. . . the basic ABC process w as straightforward: Calculate the hourly (capacity) cost of the resources that performed e ach sales, production, administrative, storage, and distribution process and the time that each order required at each stage. Before long, the team could pinpoint the cost of every process performed for every customer and could trace revenue deductions—discounts, allowances, promotions, and returns— back to individual customers. Those deductions, which totaled 12% of sales, had previously been collapsed into a single line item in the P&L for each customer.” This approach attempts to avoid the inaccuracies that come from averaging or spreading by developing an accurate picture of the costs that are truly attached to products and customers.

Theme 2: What’s Going on with the Westmid Accoun t? This general discussion pasture is oriented toward the question of how to manage accounts once you know where they sit on the profitability spectrum. The general approach is shown in Exhibit TN.2, where customers are mapped as a function of their cost to serve and net margin (when calculated using ABC costs). What factors have made Westmid an unprofitable account? This can be a good opportunity to review the history. Westmid had been, apparently, Egan’s b iggest account at one time. While that is no longer the case, “. . . it still retained considerable clout.” Westmid and Egan have a decades-long relationship, and Westmid is now suffering a bit because there is a housing market slump in the United Kingdom. The case lays out other reasons why the profitability of this account has slipped: Hardly an objective observer, Jane had been instrumental in creating that “great” partnership, by encouraging Egan to meet Westmid’s requests for c ustomized products and services, special allowances, and discounts. The larger Egan’s sales to Westmid, the bigger Jane’s monthly commission, to say nothing of the annual bonuses and award trips for the salespeople with the largest accounts. Tommy had to restrain himself from congratulating Jane for transforming one of Egan’s oldest customers into one of its most unprofitable. . . . Indeed, the case goes on to describe Egan’s practice of delivering Westmid “one-offs and custom work at a fraction of the real cost, and . . . rush-delivering products in half-empty trucks just to hit Westmid’s deadlines.” We can see the organizational dynamic that has led to this unprofitable situation for Egan. Without accurate data on customer profitability, all manner of sales and account managers may have acceded to requests for additional discounts, allowances, and rebates that were unrelated to the customer’s profitability. This could be a good opportunity to refer to Exhibit TN.2, which shows in the lower right-hand cell the danger of offering discounts to customers with whom you are earning low margins.


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Note that there seems to be some tension in the case with regard to Bamford’s view of Oldenburg. On one hand, he is clearly frustrated that she has been acting in a way that “favors” Westmid and seems to disfavor her own employer, Egan. On the other hand, it seems as though she is merely acting rationally in the system in which she has been placed, namely, that of a commissioned sales representative being paid based on sales revenue. If you choose, you can delve into the dimensions of the corporate systems and structures that seem to be creating these problems (e.g., Oldenburg’s seeming ability to approve small runs and shipments and one-offs, or the lack of any administrative process for doing so). In addition, Egan could move to a commission system where sales representatives are paid a commission based on margin as opposed to revenues; of course, Egan needs a system like ABC in order to know what its margins are. To begin to draw out more general points that have nothing to do with the Westmid account, ask the question heading the next section. We know there are very profitable customers as well. How should Egan handle those accounts? First, it’s worth drawing out what would make a customer very profitable. As we can see from the 2 × 2 matrix we’ve begun to draw in Exhibit TN.2, it is some combination of high margin (usually a result of high price) and low cost to serve. The instructor can begin to draw out some of the factors that lie behind this situation as well as the factors that lie behind the opposite scenario. This will be fully articulated in the next section (see below). For its most profitable customers, Egan could assign a full-time account representative to understand the customers’ future needs and work cooperatively to develop customized solutions for them. This could include co-creating new or semicustom products. As long as the customer is willing to pay for these services, they can represent a great investment for the manufacturer. It may also make sense to develop a customer loyalty program, based on volume or longevity or both, as a way of further cementing the relationship. What distinguishes a low-cost-to-serve customer from a high-cost-to-serve one? As the student discussion should have demonstrated, a variety of factors distinguish a low-cost-to-serve customer from a high-cost-to-serve one. They are summarized below and in Exhibit TN.3. High-cost-to-serve customers usually involve one or some of the following: 

Custom products

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Small order quantities

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Unpredictable order arrivals

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Customized packaging and delivery

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Changeable delivery requirements

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Manual processing

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Large amount of pre-sales support (marketing, technical, sales resources)

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Large amount of post-sales support (installation, training, warranty, field service)

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Specialized inventory

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Slow payment schedule (high accounts receivable)

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High discounts, and sales and promotions allowances


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Low-cost-to-serve customers usually involve one or some of the following: 

Standard products

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High order quantities

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Predictable order arrivals

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Standard packaging and delivery

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No changes in delivery requirements

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Electronic processing (EDI)

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Little or no pre-sales support (standard pricing and ordering)

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No post-sales support

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Little inventory support required

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Payments on schedule

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List price (no revenue deductions)

Should Egan fire Westmid? This is the key action question in the case. As described in the case, the account representative Oldenburg is naturally allied with Westmid, and she has taken her boss, Bamford, to meet with Westmid executive Steve Houghton. During that meeting, Bamford’s eyes are opened to some of the intangible benefits Egan gets from its relationship with Westmid, including: 

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A defense of working with higher-priced local suppliers compared to cheaper offshore suppliers. Westmid’s CEO apparently delivered an impassioned speech asking for the opportunity to work with local suppliers. Egan’s products are displayed prominently in Westmid’s showrooms, which are apparently located in many high end areas of London. Westmid is in negotiations to build a large tract of homes outside London (near the A19), which demonstrates potential for future growth.

Some of these factors, while d ifficult to quantify, undoubtedly have value to Egan. Egan’s products appearing in showrooms can only help burnish Egan’s brand name with consumers, potentially allowing the company to obtain higher revenues or prices, or both. On the other hand, “firing” Westmid might not bring all of the expected profit impact to the bottom line. A rough cut at the expected impact would be the 28% negative operating profit margin × the revenues associated with the Westmid account. But the following should be noted: 

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While the revenues would disappear immediately, many of the costs associated with producing and serving Westmid would not disappear immediately, so short-term profits and cash flow might actually decrease. For example, it might not be possible to fire the drivers who currently deliver products to Westmid, or the designers who develop semicustom products for them. While Egan has “charged” for these services on an hourly basis, it may not be possible to buy them in reality on an hourly basis; that is, you either have a full-time employee or you don’t. It is important to push back a little on this line of reasoning, however, because over time the resources associated with these currently unprofitable customers could be eliminated or reassigned to higher-margin alternatives. Some of the losses associated with Westmid may be self-inflicted in the sense that Egan may have granted high discounts and allowances without realizing how unprofitable they were. A possible course of action could be to cut back on special deals and then gauge the impact on the account’s profitability.


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Egan may have overdesigned the products it is selling to Westmid and therefore may be incurring high manufacturing costs for these products. It needs to examine whether it has the appropriate design features for the customer. Perhaps it can streamline the products that Westmid buys, raising average volume and lowering inventory and other stocking costs. Finally, of course, Egan could simply raise the price to that required to help it meet its profitability target (which may be lower than average, given some of the intangible benefits outlined above). If Westmid balks, this is an opportunity to explore why the price is untenable for Westmid and what other steps might be taken.

What Do You Make of the Experts’ Advice ? The case includes advice from two experts, one of whom, Timothy J. Jahnke, is the president and CEO of Elkay Manufacturing Company, on which the original source case is based. Jahnke suggests many of the strategies that have been articulated in the text of this Teaching Note. He rightly points out that there is a lot of room to maneuver between putting up with the unprofitable status quo and simply “firing” Westmid. He points out the potential for changes in pricing as well as in product mix. Jacquelyn S. Thomas highlights the benefits of an open conversation, where the customer can describe what features and benefits are truly valuable to him or her, and Egan can be honest about what kinds of product and service choices really have an impact on its bottom line. Perhaps Westmid can accept less in the way of high-cost services while still maintaining what is key for them in the relationship. She points out the potential for benefits that might stem from an exclusive relationship, in which Westmid might agree to funnel more of their volume to Egan. Finally, Thomas makes clear that raising prices is a more effective way to send a signal than simply firing a customer.

What Happened? Listed below is a description of what actually transpired as it relates to the real case, “Elkay Plumbing Products Division” (HBS No. 110-007), on which this HBR case was based. After the case was taught for the first time at Harvard Business School with Chris Gast, Elkay ’s controller and project leader, in attendance, he offered the following comments: 

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The customer sets the price; you have to decide whether and how to participate. Without valid cost data, salespeople trusted only the revenue numbers. So they drove revenues to fill up the plant, and this caused the extreme shape of Egan’s cumulative profitability curves, with large losses associated with the division’s unprofitable products and customers. New CEO Timothy S. Jahnke led the move to shift the company from a product orientation to solution selling with customers. Elkay salespeople now work closely with customers to learn how to get Elkay’s products onto the customers’ shelves at the lowest possible total cost, allowing more margin for both companies to share. Elkay plans to extend the ABC system into its other lines of business and also to use the ABC information to increase penetration in international markets.


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Exhibit TN.1 Board Plan


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Exhibit TN.2 Options for Managing Customers

Source: Adapted from Shapiro, Rangan, Moriarty and Ross, “Manage Customers for Profits (Not Just Sales ,)” Harvard Business Review (September – October 1987), as shown in the Teaching Note for “Elkay Products Plumbing Division,” by Robert S. Kaplan, June 29, 2010, HBS No. 110-089.


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Exhibit TN.3 Measuring Customer Profitability

Source: Teaching Note for “Elkay Products Plumbing Division,” by Robert S. Kaplan, June 29, 2010, HBS No. 110-089.


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When to Drop Unprofitable Customer

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