Maybe…but maybe not.
For clients that are struggling to turnaround a troubled business, one of the first projects I undertake is to analyze their customer base and then FIRE THEIR HIGHEST MARGIN CUSTOMERS.
This sounds crazy, but it works. Let’s take a look at why…
First you have to analyze your customers and the jobs you do for them. Try to segment them into four distinct buckets along the following lines:
[ico_arrow]Standard Product/ High Volume[/ico_arrow]
[ico_arrow]Standard Product/ Low Volume[/ico_arrow]
[ico_arrow]Custom Product / High Volume[/ico_arrow]
[ico_arrow]Custom Product / Low Volume[/ico_arrow]
What do I mean by “custom”? I mean a product or service that requires extra time or extra management attention, extra handling, or specialize packaging. Anything that requires the organization to do something “different”. As for the segmentation between high/low, you can play with this demarcation and chose one that feels right.
Now allocate your Revenues dollars into each customer segment. A typical client will look something like this:
In this example, 25% of the revenue comes from “custom” or “special” products or services, while 75% comes from standard products and services. And we chosen a demarcation between high volume and low volume so that roughly 65% of all revenue comes from high volume orders.
When I inspect client’s operations, and ask how jobs/products are priced for each segment, I frequently hear that prices are set according to target margins. A typical client’s targets are as follows:
Now this makes sense. A customer who asks for a customized solution, and where the volumes are low, should expect to pay more. No argument there. But in calculating these margins, the sales force uses Standard Costing. And since they are used to competing for 25% gross margin orders, of course the company can make money at 50% gross margin!
Now comes the fun part. Now we attempt to allocate Gross Margin dollars to each segment. My allocation is based on the fact that I have found (in spite of client’s arguments to the contrary) that Gross Margin allocation actually looks like this:
What this is saying is that LOW VOLUME, CUSTOM PRODUCT customers COST you money. When you peel the layers back on this analysis, what you find is that standardized costing is meaningless for custom orders. These custom order take a LOT of management time (can you say OVERHEAD).
A typical gross margin allocation breaks out to be:
Once the client has come to grips with this fact, what to do about it is fairly straightforward. For low-volume, custom orders, you raise prices 50%. This is an effective way to FIRE YOUR HIGHEST MARGIN CUSTOMERS. They scream, they yell, and then they take their business to one of your competitors. Now your competitor is losing money on these clients instead of you 😉
For low-volume, standard order customers, you try to get them to increase their purchase volumes (larger order size) or you increase their prices. For Custom orders that are large order sizes, you focus your management attention on making these Standard orders. Improve your processes or purchase specialized tooling that makes these jobs STANDARD and reduces your costs.
So that’s it. Analyze your customers, figure out which ones make you money, and fire the rest. Simple? No. Necessary? You bet.
Give us a call at (401) 390-3801 if you think you need help. These techniques work, and they can save your business.