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Managerial Auditing Journal

Customer profitability analysis:: an activity-based costing approach

Malcolm Smith Shane Dikolli
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Malcolm Smith Shane Dikolli, (1995),"Customer profitability analysis:", Managerial Auditing Journal, Vol. 10 Iss 7 pp. 3 - 7
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Customer profitability analysis:

an activity-based costing approach
Malcolm Smith and Shane Dikolli
A systematic approach is essential in attempting to develop an ABC analysis

The impact of activity-based costing (ABC) on customer automatically. Time and information management
systems can be added to smaller telephone systems to
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profitability analysis (CPA) has attracted relatively little

attention in the management accounting literature. Bellis- collect statistics relating to the frequency of calls to
Jones[1], Howell and Soucy[2] and Smith[3] have customers’ telephone numbers.
examined the importance of customer profitability
without exploring the potential usefulness of ABC in Sales representatives’ planning sheets or an associated
developing an accurate CPA. computerized system could provide statistics regarding
the number and distance of customer visits. Alternatively,
CPA is justifiable if the cost-benefit of compiling the an estimated number of calls per customer, weighted
information is favourable and the outcome of any according to the distance of the visit, might be used as a
subsequent strategic decision leads to income increases. basis of allocation of sales-support costs. Ultimately,
Strategic decisions may range from changing the delivery significant purchasing pattern dollars revealed in a
terms of a customer’s contract to terminating business customer profitability analysis should focus
dealings with an unprofitable customer. management’s attention towards attempting to modify a
customer’s purchasing behaviour.
Smith[3] observes that strategic consideration of
customer-related costs can lead to a cost-effective change A consideration of distribution costs and frequency and
in the way customers’ needs are satisfied. Figure 1 special delivery requirements allows a further distinction
encapsulates the range of possible customer expense to be made, as shown in Table II.
categories and identifies four key factors which impact
on customer profitability. Even with ABC, the split of the distribution cost between
customers on a common delivery run is difficult.
Further embellishment of this figure for each of the key Assuming each delivery consumes the same amount of
factors allows the development of characteristics which time, the most logical allocation of distribution cost is an
distinguish profitable from unprofitable customers. even split between all customers to reflect capacity-
consuming packaging or, more commonly, significant
A consideration of discounts, commissions and sales distances from the distribution point.
support allows the impact of purchasing patterns to be
specified, as shown in Table I. The number of customer deliveries should be extractable
from the sales ordering system and will be a useful input
Discount and commission data, sorted by customer, is to the process of allocating distribution and shipping
frequency costs to customers. Resource costs associated
likely to be readily available in most computerized
with shipping frequency might be split between standard
accounting systems. However, the determination of field
and non-standard shipping activities, the latter requiring
service and sales support costs for each customer will
some form of manual monitoring. However, such a
necessitate some form of ABC. For example, the average
process will be worthwhile if it highlights those
length of time spent taking a customer’s order might be
customers who place abnormal resource-consuming
measured and then applied as a weighting factor to the
demands on the organization.
number of telephone calls made. Large switchboard
systems are capable of providing such statistics The impact of differential ordering and debt-handling
procedures on the cost of the accounting function further
Managerial Auditing Journal, Vol. 10 No. 7, 1995, pp. 3-7 specifies the characteristics typical of the unprofitable
© MCB University Press Limited, 0268-6902 customer, as shown in Table III.

Figure 1. Expense categories impacting on customer Table II. Delivery policy and customer profitability
Characteristics of Characteristics of
Purchasing patterns Expense profitable customers unprofitable customers

Delivery policy
Distribution Located close by, Located long distance,
expenses standard packaging, unique capacity-
profitability barcode reading consuming packaging
Shipping Infrequent large-lot Daily deliveries with
Accounting procedures frequencies deliveries additional deliveries
on demand
Inventory holding Freight fleet No special Require purchase or
requirements requirements conversion of custom-
made delivery trucks

While the value of sales credits per customer is easily

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determined, the consumption of resources associated

with administering the number of sales credits can only apparent arbitrariness of such weighting factors, the final
be determined only with analysis and measurement of analysis resulting from their implementation may
occurrences of the activity driver. provide a number of opportunities with which to alter the
management of customer accounting activities.
The activity costs of processing customer remittances can
logically be allocated to customers on the basis of the Inventory-support and holding requirements, too, are
number of remittances received, but those customers who often customer-specific with a direct impact on their
pay late might be assigned a weighting factor to reflect a relative profitability, as shown in Table IV.
greater consumption of organizational resources (for
example, through follow-up telephone calls) than by on- Customers requiring immediate deliveries will necessitate
time customers. A further weighting factor might also be the organization holding greater inventory levels. The
applied to customers who receive settlement discounts on increased costs of storing inventory can be assigned to
accounts greater than, say, seven days. such customers using weighting factors. Determination
of such weighting factors per customer requires an
Order entry and processing would similarly be allocated accumulation of statistics relating to required delivery
to customers based on the number of invoice line items, promptness. These statistics may necessitate manual
with customers with standing orders or complex orders collection, or could be modelled from computerized
assigned an appropriate weighting factor. Despite the systems to reveal the average number of days between a
customer’s order and the corresponding delivery date.
Table I. Purchasing patterns and customer profitability Decisions can be made to change the characteristics of a
customer from profitable to unprofitable, but the success
Characteristics of Characteristics of of such decisions depends on the accuracy of the
Expense profitable customers unprofitable customers information provided in the CPA. While ABC can
improve the accuracy of such information, conventional
Cost of Nil to low discounts Large discounts ABC systems have limitations that need to be addressed.
discounts Not all ABC systems will analyse cost drivers in the area
Size of agent’s Low commissions High commissions of customer-related costs, despite the likelihood of their
commissions not being volume-dependent. More sophisticated ABC
systems may manage customer-related costs effectively,
Cost of field Infrequent, successful Lengthy delays in
service to order-getting obtaining daily orders but this depends largely on the objectives of the ABC
maintain telephone calls by telephone system and/or the nature of the production process.
Where the primary objective of the ABC system is to
Cost of sales Few visits Frequent calls,
support assistance with
determine product profitability, then the cost drivers
administrative selected will probably be quite different from those
operations, help with selected for customer-related resource consumption
in-store displays analysis. Delivery costs, for example, might be assigned
accurately to customers based on distance travelled to the

Table III. Accounting procedures and customer profitability requires tracing of the distances travelled by each
product to each customer. The nature of such a task,
particularly in an environment with a diverse product
Characteristics of Characteristics of
Expense profitable customers unprofitable customers range, would be extremely onerous. An alternative, but
less accurate, way of allocating the cost would be to use a
capacity or volume-based measure. This may be feasible
Sales credits Collates any sales Initiates separate sales
from a cost-benefit standpoint.
credits and claims credits for each item of
monthly product returned
By contrast, in environments where custom-made
Settlement Discounts, if any, Receives discounts on products dictate the nature of the production process, the
discounts apply to cash sales accounts greater than
activity drivers from both a product-profitability and a
seven days
customer-profitability perspective are likely to be similar
Debtor Pays on time Pays late because the custom-made product is delivered to a
collection customer and the associated distance travelled will be the
support same for either the customer or the product as the cost
Order Maintains regular Requires immediate object.
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processing bulk orders crisis deliveries

resulting from In mass-manufacturing environments, it would seem
stockouts, but whose more likely, then, that the activity drivers selected for a
order details are so
complex that multiple
customer profitability analysis would differ from the
queries result before activity drivers selected for a product profitability
the transaction can be analysis.
Johnson[4] suggests that activity-based concepts are
being oversold and that focus on total customer
satisfaction is of paramount importance. He argues that if
customer premises; but where product profitability is the customers really want frequent deliveries in small-lot
ultimate objective, it is simpler to assign delivery costs sizes, and an alternative supplier can meet the customer
based on the volume or weight of the product delivered to needs, then activity analysis might be misleading the
customers, irrespective of where the product was supplier. This assumes that the supplier is prepared to
delivered. decline the customer’s business and allow a competitor to
supply that customer. Using ABC in a customer
For example, to allocate accurately delivery costs of profitability analysis, the supplier may indeed accept that
$10,000 over a total distance travelled to customers of the customer is unprofitable and be willing to meet the
2,000 kilometres, it is necessary to trace the distances customer’s needs. Kaplan[5] discusses three types of
travelled to each customer and assign costs at the rate of potentially unprofitable customer who might be retained:
$5 per kilometre. In many cases the individual distances (1) new and growing customers, who promise
could reasonably be estimated without too much profitable business in the future and may provide a
difficulty. From a product-profitability perspective, stepping stone for penetrating lucrative new
allocating accurately the $10,000 over different products markets;
(2) customers providing qualitative rather than
financial benefits, including customers at the edge
Table IV. Inventory holding and customer profitability
in the development of new markets who provide
valuable insights into likely trend movements in
Characteristics of Characteristics of consumer demand;
Expense profitable customers unprofitable customers
(3) customers providing increased capability because
of their status as recognized leaders in their
Inventory Predictable delivery Requires delivery on
markets or fields of expertise.
support and inventory demand at irregular
requests times Thus, where a CPA reveals that a particular customer is
Distribution Collects sales orders Requires free delivery unprofitable, it does not necessarily follow that this
support to a remote or customer should be eliminated. Nor does it follow that the
long-distance location customer must be persuaded to accept terms and
Holding Compatible with Will take business conditions that will reduce the customer’s level of
requirements your JIT scheduling elsewhere if required satisfaction. Negotiations with a customer might well
inventory is not held reveal that less frequent deliveries would actually benefit
the customer (i.e. less workload for the receiving officer,

fewer purchase orders, fewer transaction input entries, customers easier. In particular, the associated on-costs of
less paperwork) without causing costly stockpiles. employing sales staff and motor vehicles would be
analysed in detail and be readily available. This would
Clearly, there is scope for negotiating with customers to embrace vehicle operating costs (depreciation, petrol,
influence their behaviour (so that they act in ways which licensing, insurance and vehicle signage) as well as
are more profitable for the firm) without compromising superannuation, fringe benefits and payroll tax, holiday
the customer’s level of satisfaction. Some aspects of and long-service leave entitlements, worker’s
improved negotiation might include: compensation insurance, mobile telephone and training
● non-cash incentives from sunk-cost investments –
costs. Several of these items might conveniently be
for example, sponsoring a season of a major omitted from a non-ABC customer profitability analysis
cultural event primarily yields advertising because of the complex analysis required to divide the
benefits; however, seats in the accompanying general ledger amounts between the activities of different
corporate boxes might also yield enticing salespersons.
customer incentives. Similarly, a company’s
accumulated frequent-flyer points may perhaps be Resource to activity allocations (e.g. gas, water,
spent on customers, new or existing; electricity) provide a more accurate representation of
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resource consumption by customers. A non-ABC

● restructure of delivery runs to create a more timely alternative is likely to cause customer-cost distortions in
but less frequent service for the customer; such translations. Additionally, activity drivers will
● capacity maximization on delivery runs that are assist in the assignment of activity costs to customers,
required for profitable customers by offering a more where otherwise arbitrary allocation methods would be
frequent service for the potentially unprofitable employed. Thus, distribution costs might be assigned on
customer with unpredictable demands; a zone basis depending on the delivery destination
● purchase of equipment on behalf of customers
activity, rather than being spread across all customers in
an arbitrary fashion.
which they can use rent-free, in lieu of discounts
and/or agent’s commissions. The cash saved on
A systematic approach is essential in attempting to
reduced discounts/commissions potentially should
develop an activity-based costing CPA. Lewis[6] outlines
exceed the cost of the asset. Additionally,
a simple ABC system for recognizing marketing costs by
ownership is retained and a stronger bond is
product line. He also indicates how these ideas can be
forged with the customer, thereby generating
easily transferred into a profitability analysis statement
greater negotiating power in future;
by territory. It follows that Lewis’s ideas could be
● free short-term financial advice which will create extended further to a full CPA, or at least provide a useful
efficiencies for the customer, leading to reduced starting-point for developing a CPA.
internal workload and consumption of resources;
● new products at no cost in return for reduced For more sophisticated models, Turney and Stratton[7]
discounts, to serve a dual purpose: improving present an activity-based model using micro and macro
customer profitability while providing a useful activities which lead to assignment of cost to final
vehicle for the promotion of new products; products. This two-tiered activity structure could apply
just as well to an assignment of cost to customers as it
● a trade-off between quantity discounts and
does to final products. The primary advantage of this
settlement discounts that minimizes the costs of type of model is that dual objectives may be satisfied, as
cash overdraft and maximizes long-run production follows:
● customer costing objective – depicting the
The overriding consideration with a CPA is that profitability of a customer using the cost of macro
management will at least be armed with information activities;
about unprofitable customers and can focus attention on
developing those innovations/strategies that might ● performance improvement objective – isolating
reduce the lack of profits of a particular customer, detailed areas for potential improvement by
without reducing that customer’s satisfaction. focusing on micro activities.
Alternatively, provided a shift of thinking is possible, The two-tiered activity model reduces many of the
management can restructure the manufacturing process difficulties associated with conventional ABC systems
that will ultimately lead to a shift in the results of a where the activity drivers to the final cost object are so
customer’s profitability. aggregated that the level of accuracy is potentially
The role of the mechanics of ABC in developing a CPA
should not be underestimated. With ABC, general ledger Detailed analysis of customers, and associated service-
amounts are dissected, making the assignment of costs to cost differences, may be justified if the cost of obtaining

and maintaining information is not excessive, or if the examine each in a blinkered fashion. They must be
information so generated is useful in the making of employed simultaneously so that all aspects of customer
strategic decisions. focus can be considered, with projected costs and
revenues appropriately quantified.
Analysis of the revenue streams generated by customers,
relative to their service costs, may lead to some customers
being eliminated from the business or, at least, a change References
of emphasis in the way in which resources are allocated 1. Bellis-Jones, R., “Customer profitability analysis”,
between customers. Management Accounting (UK), February 1989, pp. 26-8.
2. Howell, R.A. and Soucy, S.R., “Customer profitability: as
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demand must be examined and a customer loyalty profile Accounting (US), October 1990, pp. 43-7.
established to determine sensitivity to prices or to the 3. Smith, M., “Customer profitability analysis revisited”,
levels of service provided. How will our internal costs Management Accounting (UK), October 1993, pp. 26-8.
change in response to variations in the level of service 4. Johnson, H.T., “It’s time to stop overselling activity-based
provided? A fundamental analysis of customers, and the concepts”, Management Accounting (US), September
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effect of variations in service on internal cost structures, 1992, pp. 26-35.

will provide the information to support strategic 5. Kaplan, R.S., “In defense of activity-based cost
decisions relating to the customer base. A more accurate management”, Management Accounting (US), November
ABC model, tracking resource consumption by 1992, pp. 58-63.
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distortions than are non-ABC alternatives. Management Accounting (US), November 1991, pp. 33-8.
7. Turney, P.B. and Stratton, A.J., “Using ABC to support
The need for a strategic approach is evident. We must not continuous improvement”, Management Accounting
be tempted to pigeon-hole TQM, ABC or CPA and (US), September 1992, pp. 46-50.

Malcolm Smith is Associate Professor of Accounting in the School of Economics and Commerce, Murdoch University,
Murdoch, Western Australia and Shane Dikolli is Lecturer in Accounting in the School of Accounting, Curtin University
of Technology, Perth, Western Australia.
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