Don’t fire that customer!

by Scott Benfield and Rich Vurva

Distributors should correct their service and pricing policies before firing unprofitable customers

In the perennially low-profit environment of durable goods distribution, a growing contingent of experts recommends firing the customer. The logic is seemingly straightforward.  In essence, the customer does everything wrong in buying from the distributor, including: placing numerous small-dollar orders, demanding specialized inventory, delivery and low prices, and cherry picking products with the best prices. This becomes especially evident when the distributor uses activity-based costing to measure the true cost of serving the customer. Too often, the customer yields a low or negative activity profit, so the experts recommend two possible courses of action. Either raise the price until the customer ceases doing business with you, or tell the customer their method of conducting business is no longer welcome.

Activity costing problems and negative activity accounts
Some years ago, we ran across a distributor that implemented a new activity costing system. The activity costing logic went into great detail using activities, cost drivers and a logic of assigning costs to lines, invoices, or other measurable work proxies. The problem we had with the logic is that all costs were divided over lines or invoices. All costs included the mostly fixed costs of branch locations and executive base salaries. These costs, which amounted to 25 percent of operating expenses, were more or less fixed. In essence, in the normal cyclicality of the business cycle, these expenses were constant. Dividing these expenses by lines or invoices had the effect of inflating the activity costs by 25 percent or more. It makes little financial sense to divide fixed costs over volume.

We urge distributors to assign normal step costs — such as delivery, warehouse labor, accounting labor and sales — to cost drivers.¹ Other costs that are more or less fixed should remain out of the equation, as they have the effect of inflating the activity threshold or the minimum amount of sales/margin dollars needed to produce a positive activity profit.

In our consulting practice, we use activity approximations to yield detail about customer and segment profitability. The logic is somewhat coarse compared to the detail in many activity-costing models. However, we have found the logic quite useful and accurate for the majority of service and marketing decisions regarding low/no activity profit accounts. For a workable activity approximation logic, we refer you to Chapter 3 from our new text Restructuring the Distribution Sales Effort.² 

Typically, costs that step up when serving the customer are 60 percent to 70 percent of operating expenses. Using these costs from the year-end expense ledger with simple assignment logic works quite well in approximating the costs of serving customers. Overly detailed activity costing programs too often divide fixed costs over volume or fall into the trap of measuring with a micrometer only to cut with an axe. In short, the detail of the activity calculations is wasted, as the solutions aren’t as finite as the measures. So, check your activity logic before you fire a customer and make sure you are not dividing historically fixed costs by volume.

The model is the problem
A major issue in controlling service costs is the model of sales compensation. Most distributors reward on generated gross margin dollars. Margin dollars, however, aren’t all the same, and some customers cost more to serve than others. Also, many salespeople cut price and promise special services, driving up margin dollars for greater commission or bonus income. Unfortunately, in the low-margin business of distribution, the lower price and extra services can cause bottom-line misery, as the extra top-line volume too often doesn’t cover the increased operating expenses of the service. In five years of study of distribution sales forces compensated on margin dollars, we find the following issues:

• Salespeople hoard activity negative accounts that don’t grow, yet still receive commissions on the generated margin dollars.

• Distributors provide numerous special services for low-activity or activity negative customers. The services become a bottleneck because salespeople make too many service promises the company can’t keep.

• Salespeople earn large salaries even while the company experiences record low profits. Our research in numerous distribution industries discovered falling productivity and capital returns over the past 10-, 20-, and 30-year time frames. One review of vertical industry PAR reports found return on net worth declining from more than 20 percent in the late 1970s to less than 10 percent by 2004.

In the future, we believe distributors will be much more attuned to the costs and freedoms of outside salespeople. Many accounts can’t afford a sales call and should be solicited by lower-cost options including a catalog or e-commerce. Plus, salespeople should not be able to promise extraordinary services without proper controls. Most salespeople don’t understand the relationship of service costs to the overall efficiency and profitability of the firm. It is a management prerogative to identify, plan and control service promises of the sales force.

Bad marketing karma
Many activity negative accounts got that way because of poor cost estimates, loose controls on pricing and special services, sales management rewarding based on margin dollars, and their failure to use lower-cost models of solicitation. If this is true, many distributors may be firing customers over issues where the customer has limited control. These firing events create bad marketing karma. In the aftermath of bad marketing karma, the offended customer is likely to tell 10 other people of their negative experience.³ In short, firing a customer for something that is the distributor’s doing has a high probability of inciting a negative word-of-mouth campaign.

As a general rule, we don’t recommend firing customers overtly or covertly until management has a chance to review the causes for the action. In some instances, customers will cherry-pick products and services, pay late and hassle salespeople over small issues. In these situations, firing the customer is warranted. For many distributors, however, firing is a last resort and management should consider removing services, streamlining services or raising prices to make the account a contributor to operating profits. The idea that some customers can and should be fired is sound business. Firing the customer before reviewing full cause and responsibility for the customer’s negative/low activity profit is foolish and potentially damaging to the firm’s reputation.

The illogic of “do business my way”
Too often, once salespeople learn the activity profit of their accounts, they inform the customer of their profit status in an attempt to improve the use of the company’s service(s). For many customers, these conversations smack of “do business my way or hit the highway.” If pushed too far, these conversations can jeopardize account relationships. The difference between a model of business that directs a profit and instructing current customers to change their transaction habits can be subtle. Too often, customers are over served, under priced, or given sales promotion inducements with no expiration, which can lead to an unprofitable relationship. Making the account profitable again can be difficult. In the pursuit of profits, it’s better to work on areas to improve profitability across segments of customers including:

• Service charges for special freight requests

• Reducing outside call frequency

• More surgical pricing on slow-moving or special-order items

• Engaging cost-recovery pricing, and separating and charging for extraordinary services

• Moving perennially unprofitable customers to lower-cost solicitation methods including catalogs, telesales or e-commerce

These actions can be done as policy decisions, avoiding the need to negotiate with individual customers. We strongly advocate standardizing services by market segment wherever possible. In this way, the firm can capture value from over serving, while sidestepping issues of negotiating services with individual accounts. When engaging cost recovery and pricing efforts to right low-activity profit customers, the old adage “it’s easier to get forgiveness than permission” applies in spades.

The bad economics of firing customers
As previously mentioned, distribution is a step cost business. Most costs step up with volume, and it’s difficult to estimate when these costs will reach a vertical step. To deal with step costs, distributors must carefully decide if the service is needed and if the process in question is efficient. In their zeal to eliminate some unprofitable relationships, some distributors fire customers, only to learn they cannot eliminate the step costs as quickly as the margin dollars disappear. In these instances, the distributor would be better off reducing service costs or carefully raising prices to select customers. The reality is there will always be activity costly and activity negative customers, and making them less unprofitable is a profit-making move.

Firing customers is a legitimate strategy for accounts that abuse services, intimidate salespeople and don’t pay on time. Of the 30 percent to 40 percent of low or negative activity accounts, however, firing is not a first line strategy. Limiting services, aligning services to segments, surgical pricing, cost-recovery pricing, and attaching the appropriate solicitation models are better moves than clumsily firing customers. In the end, low-activity profit customers have many causes, and much of the causality resides within the distributor’s business practices and is controlled by distributor management.

Scott Benfield is a consultant for industrial distributors and manufacturers and Rich Vurva is editor of Progressive Distributor. Their new book, Restructuring the Distribution Sales Effort, can be purchased at progressivedistributor.com, nawpubs.org, or benfieldconsulting.com.

1. See “Distribution Pricing Limbo: How low can you go?” at www.progressivedistributor.com. Scott Benfield, Fall 2005.

2. See Restructuring the Distribution Sales Effort, 2006 Benfield and Vurva, Brown Books Publishing at progressivedistributor.com, nawpubs.org, or Benfieldconsulting.com.

3. See Services That Sell, 2004 Benfield and Baynard, NAW Publications, nawpubs.org.

This article originally appeared in the May/June 2006 issue of Progressive Distributor. Copyright 2006.

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