Why Your “Best” Customer is Losing You Money: A Case for Activity Based Costing

Posted On : Mar 14, 2014

Congratulations! You caught the big fish. Your sales team worked months, or even years, on cultivating relationships in hopes of landing the customer of your dreams. High fives all around. You’re mentally spending your bonus on a vacation to Tahiti. Right?

One of my favorite customer quotes is this one:
“The best day of your life is when you land a contract with the Mega Store.
The 2nd best day of your life is when you cancel the contract with the Mega Store.”

Actually, I have nothing against Mega Stores, per se. With the right arrangement, they can be fantastic customers. But we tend to jump through hoops for our biggest and “best” customers, customizing our service to them that can add up to financial failure in one crucial area: Labor Costs.

Labor consumes a substantial part of total costs in every organization. Yet most companies generalize their labor costs, only comparing time clocks data to customer revenues and cost of goods. In today’s competitive, global business climate, this simple calculation is not enough.

Big Box, Little Box

Do you know your cost by SKU? You need to. It costs more to move a heavy/large/far away box than it does to move a light/small/close by box. Unless you know what your labor costs are on each box, it’s impossible to know what your profit or loss is for that box.

Customers Are Not Equal

Are you charging your customers the same, as if they are equal? Servicing customers that require deep customization, lots of SKUs, and special processes, results in higher labor costs for you. Are you passing on those costs to that high-maintenance customer, or are you eating the costs?

Orders Are Not Equal

A small order of 100 units and a large order of 1000 units might require the same labor hours in set-up and tear-down. Let’s say set-up and tear-down takes 2 hours, and every 100 units requires 1 hour of labor. Labor for 100 units totals 3 hours (33 units/hour). Labor for 1000 units totals 12 hours (83 units/hour). Let’s say the labor is $300 / hr for the production line. The small order costs you $9 of labor/unit, while the large order costs $3.6 of labor/unit. At a 150% increased labor cost/unit, the smaller order needs to be priced accordingly.

20% of Your Customers Are Losing You Money

Do you know your labor costs by customer? You might be surprised to discover which are your “best” and “worst” customers. When Harvard Business School dissected customer profitability in a case study, they discovered 20% of customers, on average, are money losers. If you discontinue service to the bottom 20 or 30%, and thus reduce the labor workload, your total profit can go up by 50% as seen in this video.

Volume Won’t Help

When your margins on a certain customer are negative, you cannot make up for the losses by cranking up volume. It’s a mathematical impossibility. The dot-com era mentality of grow it bigger and faster despite losses doesn’t apply to real, physical products.

Visibility Solves The Problem

Why do we generalize labor costs, and why don’t we drill down to get the real data that exposes profit and loss on labor? Because it’s difficult, that’s why. But not impossible. We are in the age big data, and with it we have access to better, more powerful tools and strategies to reveal financial information on your customers never before possible.

Activity Based Costing to the Rescue

Activity based costing, applied to labor, reveals highly valuable information that directly affects your bottom line. When modeled correctly, it reveals:

  • Which customers are making / losing you money
  • Which products are making / losing you money
  • Which processes are making / losing you money
  • Which service costs are killing you, and which aren’t

Now you have the visibility to make the right choices. You can spend more time nurturing your real “best” customers. You might need to adjust your prices, or even sever the relationships with some of your customers. The data tells you the story. It’s up to you to decide what to do next. But at least the choices you make will be based on reality, rather than the new-customer euphoria that can cloud it.

Stay tuned for Part 2 of this article, where I will detail simple steps to get you started with activity based costing for labor.

Please share in the comments section:

  • What surprising ways have you discovered your customers losing you money?
  • What kind of hoops does your company jump through for your best customers?
  • What questions do you have about labor costs? I’ll answer them.

……………

Dan is CTO of and co-founder of Easy Metrics. He has over 17 years experience in managing complex labor-intensive distribution environments, and information systems development.

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