Here’s one you may not have heard: A business owner walks into a bar and gives away 66% of the profit he had made in that year to all the drinkers in the room. Astounded, but delighted, one of the bar patrons asks, “why are you giving away your hard earned profits?” to which the business owner responds, “It seemed easier than going through all the trouble to turn you into customers, satisfy your needs, and cater to your every demand only to wind up with the same financial result.” You’re right if you’re thinking “that’s not funny.” It isn’t. But it is what happens to a lot of businesses.
In our recent Executive Breakfast Series seminars we have been discussing cash, pricing and customer profitability – three tightly intertwined concepts. As part of that discussion, we brought up the 20-225 Rule. Since enough people are unfamiliar with it, I thought I would outline the principle here. Essentially, it says that 20% of the customers in any business generate 225% of the profits. The rest of the customers eat 125% of the profits, reducing the profit kept and recorded at year end to just 100%, or 44% of the total amount generated throughout the year. Sounds ridiculous or a lot like gross mismanagement doesn’t it? Let’s take a brief look at this.
Robin Cooper who co-taught a Kellogg course on activity-based costing I took and his research partner, Robert Kaplan, wrote an article in 1991 that outlined key tenets of activity-based costing: “Profit Priorities from Activity-Based Costing.” The article shows how common allocation approaches, which allocate costs like smooth peanut butter across all units or hours, are almost always flawed. The truth is, they are consumed in hierarchies and groups of products or lines or facilities; these groupings are critical in understanding the cost of a product or service. If you’re interested in this, you really should read the article (it’s short), but the interesting conclusion that we’re exploring here is embodied in this quote from the article:
“… 20% of customers were generating 225% of profits. The middle 70% were hovering around the break-even point, and 10% of customers were losing 125% of profits.”
I have had discussions with more than one distribution client that could not understand how its competitors were winning business at rates or prices that my clients believe cannot be profitable. They bought from the same sources and they had roughly the same logistical costs, yet their competitor was consistently winning work these clients felt they were good at. If this is an exception or infrequent occurrence, you might chalk it up to a hungry competitor buying business to get a toe hold. But if their pricing is consistently mysterious in this way, you need to determine the facts. Who is out of touch with the correct costs and pricing at work here?
In the article, the authors discuss the fact that conducting profitability analysis, particularly of customers, products and services at an aggregate level, obscures critical differences in the way these things consume resources. For example, a manufacturing drive shaft costs $1,070 to produce according to traditional costing and allocation techniques, but actually consumes $1,700 worth of costs as determined through activity based costing. This shows the potential magnitude of the problem. The business could be selling the drive shaft at $1,500 thinking it’s making $200 per unit when, in fact, it is losing over $400 per unit. The more you produce of that product, the more behind you get. Traditional allocation schemes hide the detail needed to differentiate the attractiveness of products and customers.
So now that you know “the rest of the story,” join us on July 29th as we talk some more about customer profitability and the 20-225 rule.