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The Importance of Customer Profitability

Seek out those customers who value your product and allow a return on investment.

Customers are the lifeblood of every business. To support these vital resources, businesses spend a significant amount of time and effort maintaining customer satisfaction. Within the automotive supplier sector, many, if not most, of these relationships have been strained by the incessant need for annual cost reductions. As companies continue to scramble to react to this pressure, the fundamental economic issue becomes whether or not there is room in the supply chain for profitability and return on investment. At some point, every supplier faces the following question: Does the revenue from existing customer “X” fall short of the costs and investment needed to provide continued exceptional service?

The Profit Dilemma

Formal surveys and word of mouth continue to provide a changing evaluation of conflicting opinions regarding which OEM or Tier 1 is the best/worst to have as a customer. This is certainly influenced by a number of factors, including the speed at which engineering changes are approved, how professionally problems are addressed when they arise, and how easy it is to be considered for new programs. However, the most significant issue is whether the suppliers feel as though they have a reasonable shot at making money in this sector.

Many automotive suppliers have had to face the possibility that a valued customer isn’t generating revenues equivalent to the resources required to provide the best possible product. Such an evaluation can cause disagreement between management and staff. The sales and plant managers maintain that the income and productivity realized from the customer merits the business’s further expenditure of time and effort. The CFO contends that a continued relationship is unprofitable based on data he has compiled. The shipping clerk cites the numerous requests by the customer for expedited orders as disruptive and costly and the owner is left in the middle trying to sort out the facts. What’s needed is a logical approach to help a supplier determine what can be one of the most difficult decisions it faces as a supplier.

Determining Profitability

Most suppliers’ accounting systems generate reports that calculate the cost and profitability by part numbers and then summarize this information to determine customer profitability. Unfortunately, the value of these reports varies greatly. Some profitability reports only include information on direct costs. Others apply the same “burden” rate to all activities. Activity-based cost accounting has been in en vogue for many years, and yet some companies still stick to the same methodology used since the 1970s and 1980s.

To properly determine the accuracy of any cost/profit report, the management team should conduct a thorough assessment of it. Verifying that bills of material and routings have been updated to reflect current production and ensuring that all direct costs are accumulated is just the first step. The rise in raw material costs, e.g., steel and resins, has caused many cost reports to have significant overstatement of profitability. Given the growth in overhead expenses relative to direct costs, evaluating whether burden is allocated consistently with what drives these costs is paramount. Without this rigorous periodic evaluation of direct costs and overhead, a supplier can be short-sighted in its evaluation of where it is making or losing money.

Generally (though not always), the findings of a thoroughly vetted report will be relatively consistent with the owner’s intuitive sense. To the extent there are inconsistencies, a re-evaluation of the assumptions is necessitated. An accurate cost report will quantify and weigh all costs associated with doing business with a particular customer, enabling a true evaluation of whether a further investment of resources is justified.

Developing Alternatives

If a comprehensive review of the business relationship reveals that a further investment in the customer is no longer profitable, what can be done? While terminating the relationship is an option, it’s important to consider the full effect that this action will have on other customer relationships. Would it be more beneficial to reduce the costs associated with serving the customer in question? What alternatives exist?  Consider the following options:

  • Eliminate non-valued costs and/or identify savings that don’t impact the end customer.
    Companies frequently provide the same part over the course of the entire product cycle. Many suppliers focus their efforts on re-evaluating whether the original specifications (materials, product dimensions, packaging) can be changed. There are numerous instances where suppliers have improved their profitability by reducing material content or by substituting or eliminating packaging requirements resulting in no appreciable impact to reliability, safety or quality.

  • Source components or tooling to Low Cost Countries (LCCs).
    Most suppliers are at least considering whether an LCC strategy will benefit them in the short run. Many suppliers have recognized this possibility for years and have embraced this change in their business model. While the cost savings appear enticing, a supplier must compare the existing costs of producing domestically with the full costs of an LCC product, including additional non-production costs to ensure the savings aren’t illusory.

  • Increase prices
    The fear of losing a customer can make a business reluctant to raise prices. However, such a loss could actually bolster a business’s bottom line, particularly if the departing customer isn’t generating sufficient profits. This alternative is most often embraced by companies in financial distress. While the threat of resourcing is real, the supplier may want to consider how supplier-owned machinery, the number of tools that would need to be resourced, and end-customer demand might make the OEM or Tier One less apt to take such actions. Under certain circumstances, additional funding in the form of tooling assistance and prospective and retroactive price increases are (temporarily) available for distressed suppliers. Assistance may also be available when the supplier can clearly demonstrate that even under the best of circumstances, the costs exceed the piece price. Frequently, the supplier who won the original bid was significantly below market due to a mistake or because they were too aggressive.

  • Expand product or service penetration
    As most business owners are aware, the cost of acquiring a new customer can be much higher than the cost of retaining an existing one. If a current customer is unprofitable, perhaps the existing product mix could be modified or expanded to change this situation. Don’t assume an existing customer is familiar with all of your company’s product capabilities. Asking customers about their needs can often result in an opportunity to cross-sell additional, more profitable, products and/or services.

Implementing Changes

Once these alternatives have been explored, the difficulty of choosing the most appropriate action remains. While a supplier might be able to utilize one or more of these strategies to improve the profitability of a specific customer, it may not always be possible. If one is unable to make a profitable return on investment, refocusing on different customers is the only solution for the long-term viability of today’s automotive supplier.

Timothy Weed is a Partner in the Restructuring and Operations Improvement Practice at Plante & Moran, PLLC in Southfield, Michigan.

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