A Balanced Scorecard Approach

To Measure Customer Profitability

HBSWK Pub. Date: Aug 8, 2005
Happy customers are good, but profitable customers are much better. In this article, professor
and Balanced Scorecard guru Robert S. Kaplan introduces BSC Customer Profitability Metrics.
From Balanced Scorecard Report.

by Robert S. Kaplan

The Balanced Scorecard introduced customer metrics into performance management systems.
Scorecards feature all manner of wonderful objectives relating to the customer value proposition and
customer outcome metrics—for example, market share, account share, acquisition, satisfaction, and
retention.

Yet amid all these measures of customer success, some companies lose sight of the ultimate
objective: to make a profit from selling products and services. In their zeal to delight customers, these
companies actually lose money with them. They become customer-obsessed rather than customer-
focused. When the customer says "jump," they ask "how high?" They offer additional product features
and services to their customers, but fail to receive prices that cover the costs for these additional
features and services. How can companies avoid this situation? By adding a metric that summarizes
customer profitability.

Consider the situation faced in the 1990s by one of the nation's largest distributors of medical and
surgical supplies. In five years, sales had more than tripled to nearly $3 billion, yet selling, general, and
administrative (SG&A) expenses, thought by many to be a fixed cost, had increased even faster than
sales. Despite the tripling in sales, margins had declined by one percentage point and the company
had just incurred its first loss in decades. Rather than SG&A costs being fixed or even variable, these
costs had become "super-variable."

The experience of this company is hardly unique. Companies often capture additional business by
offering more services. The list is wide-ranging: product or service customization; small order
quantities; special packaging; expedited and just-in-time delivery; substantial pre-sales support from
marketing, technical, and sales resources; extra post-sales support for installation, training, warranty,
and field service; and liberal payment terms. While all of these services create value and loyalty
among customers, none of them come for free. For a differentiated customer intimacy strategy to
succeed, the value created by the differentiation—measured by higher margins and higher sales
volumes—has to exceed the cost of creating and delivering customized features and services.

Unfortunately, many companies cannot accurately decompose their aggregate marketing, distribution,
technical, service, and administrative costs into the cost of serving individual customers. Either they
treat all such costs as fixed-period costs and don't drive them to the customer level, or they use high-
level, inaccurate methods, such as allocating a flat percentage of sales revenue to each customer to
cover "below-the-line" indirect expenses.

Companies become customer-obsessed The remedy to this situation is to apply activity-based

costing (ABC) to accurately assign an organization's
rather than customer-focused. When indirect expenses to customers. Many companies,
the customer says "jump," they ask however, have tried ABC at some time during the past
"how high?" twenty years and abandoned it because it did not
capture the complexity of their operations, took too long
to implement, and was too expensive to build and maintain. Fortunately, a new approach is now
available that is far simpler and much more powerful than traditional ABC.

"Time-driven" ABC, introduced in a recent Harvard Business Review,1 requires obtaining information
on only two parameters: the cost per hour of each group of resources performing work, such as a
customer support department; and the unit times spent on these resources by specific activities for
products, services, and customers. For example, if a customer support department has a cost of $70
per hour, and a particular transaction for a customer takes 24 minutes (0.4 hours), the cost of this
transaction for this customer is $28. The approach has been successfully applied in more than 100
organizations and readily scales up even to companies with hundreds of thousands of products and
services, dozens of operating departments, and thousands of customers. The end result is the ability
to measure individual customer profitability accurately and in a system that is easy to implement and
inexpensive to maintain and update.

The payoff: BSC customer profitability metrics

The ability to measure profitability at the individual customer level allows companies to consider new
customer profitability metrics such as "percentage of unprofitable customers," or "dollars lost in
unprofitable customer relationships." Such customer profitability measures provide a valuable signal
that satisfaction, retention, and growth in customer relationships are desirable only if these
relationships contribute to higher, not lower, profits.

BSC customer profitability metrics are also highly actionable. If a company finds that an important
customer is unprofitable, it should first look internally to see how it can improve its internal processes
to lower the cost-to-serve. After all, we can't expect customers to pay for our inefficiencies. For
example, if important customers are migrating to smaller order sizes, the company can focus on
reducing setup and order handling costs. The company can ask the customer to use electronic
channels, such as Electronic Data Interchange (EDI) and the Internet, that greatly lower the cost of
processing large quantities of small customer orders.

Customized pricing policies should be at the heart of any strategy to manage customer profitability.
The company can set a base price for a standard product or service, with standard packaging,
delivery, and payment. The company also provides customers with a menu of options representing
variations from the standard order, such as a customized product or service, special packaging,
expedited delivery, or extended credit terms. Each menu item has a price that at least cover its cost,
as measured by the ABC model, so the company no longer suffers losses from offering customized
services. The menu prices also motivate customers to shift their purchasing and delivery patterns in
ways that lower total costs to the benefit of both the company and its customers.

Finally, perhaps a customer is unprofitable because it Customer profitability metrics provide

is purchasing only a single service. As an alternative a link, otherwise missing, between
to raising the price for this single service, the customer success and improved
company can encourage the customer to purchase a
wider range of services, expecting that the margin
financial performance.
from a comprehensive set of services will transform the customer into a profitable relationship.

Figure 1 shows how one insurance company managed its customer relationships once it understood
its full costs of serving them. It ranked customers on the horizontal axis, from most profitable to least
profitable (loss). The vertical axis represents cumulative customer profitability. The shape of the curve
in Figure 1 occurs in virtually every customer profitability study ever done, in which 15 percent to 20
percent of the customers generate 100 percent (or more) of the profits. In this case, the most profitable
40 percent of customers generate 130 percent of annual profits; the middle 55 percent of customers
break even, and the least profitable 5 percent of customers incur losses equal to 30 percent of annual
profits. With its most profitable customers, the company worked harder to ensure their continued
loyalty and to generate more business from them. For customers in the middle break-even group, it
would improve its processes to lower its cost of serving them. It focused most of its attention on the 5
percent-loss customers, taking actions to reprice services and asking them for more business in
higher-margin product lines. If the company could not transform these customers into profitable ones
by these actions, it was prepared to drop the accounts.

Customer profitability metrics provide a link, otherwise missing, between customer success and
improved financial performance. Many companies have experienced profitless revenue growth.
Scorecard measures of the incidence of unprofitable customers and the magnitude of losses from
unprofitable relationships focus the organization on managing customers for profits, not just for sales—
thus making the customer focus align with financial objectives.

Reprinted with permission from "Add a Customer Profitability Metric to Your Balanced Scorecard,"
Balanced Scorecard Report, Vol. 7, No. 4, July-August 2005.

See the current issue of Balanced Scorecard Report.

Robert S. Kaplan is a professor at Harvard Business School.

Figure 1. Customer Management Theme: Balanced Scorecard Template

Perspectives Typical Objectives Typical Measures

Financial • Create new sources • Revenue from new customers and
of revenue products
• Increase revenue per • Share of wallet
customer
• Revenue mix vs. target
• Increase customer
profitability • Profits per customer (activity-based
costing)

• Improve Sales
productivity • Cost of sales (by channel)

Customer • Increase customer • Percentage of highly satisfied customers

satisfaction (with
value proposition) • Customer retention
• Increase customer • Depth of relationship
loyalty

• Percentage of business from customer

• Create raving fans referrals

Internal Selection • Understand • Contribution by segment

Process segments • Percentage of unprofitable customers
• Screen unprofitable • Number of strategic accounts
customers
• Target high-value
customers • Brand awareness/preference

• Manage the brand

• Communicate value • Brand awareness

proposition • Number of leads/conversion rate
• Acquire new • Campaign response rate
customers
Acquisition • Customize mass
marketing • Dealer quality rating

• Develop dealer
networks

Retention • Provide premium • Number of premium customers

customer service • Percentage of revenue from sole source
• Create sole-source • Service levels (by channel)
partnerships
• Provide service
• Customer lifetime value
 excellence

• Create lifetime
customers

• Cross-selling • Number of products per channel

• Solution selling • Number of jointly developed service

Growth • Partnering/integrated agreements

management • Numbers and dollars from gain sharing

• Customer education • Hours with customers

Learning Competencies • Develop strategic • Human capital readiness

& Growth competencies

• "Regretted" turnover
• Attract and retain top
talent

• Develop strategic
• Application portfolio readiness
CRM portfolio
Information
• Increase knowledge
• Number of customer hits to knowledge
management system
sharing

• Create customer- • Customer survey

focused culture
Climate • Employee objectives linked to BSC
• Create personal goal
alignment

Reprinted with permission from "Customer Management," Balanced Scorecard Report, Vol. 5,
Issue 3, May-June 2003.

Keeping Your Balance With Customers

HBSWK Pub. Date: Jul 14, 2003
Using the Balanced Scorecard approach, Robert S. Kaplan, of Harvard Business School, and
David P. Norton analyze the four essentials of customer management: customer selection,
acquisition, retention, and growth.

by Robert S. Kaplan and David P. Norton

From product push to customer pull, technology has vastly reshaped the business transaction—and in
turn, the customer's place in the value chain. Today, managing the customer relationship has become
the single most important dimension of enterprise strategy. Here, Kaplan and Norton analyze the four-
component processes of the Customer Management theme—customer selection, acquisition,
retention, and growth—demonstrating their importance in maximizing customer value and, ultimately,
in value creation itself.

Customer management (CM) reflects much of what is new in modern business strategy. In the
Industrial Era, product innovation and operations management predominated. Product innovation
ensured the continuous flow of new products that would sustain growth or market share or both.
Operations management ensured that costs and quality were managed so that competition could be
based on price and profits could be derived from scale. Customer management was relegated to
selling and promoting the company's products. The customer relationship was seldom the issue.
 The New Economy has changed all of this. With the evolution of computer and communications
technologies, particularly the Internet and database software, the customer can now initiate the
business transaction, not simply respond to the salesperson's overture. Instead of being on the end of
the value chain ("product push"), the customer is now at the beginning ("customer pull"). Organizations
must therefore establish a "relationship" that allows them to maintain contact with their customers over
the long term. Recognizing this new reality and dealing with it proactively is the single most important
dimension of enterprise strategy. It's within the Customer Management theme that this is
accomplished.

It is not possible to be all things to The Customer Management theme is made up of four
all people, so market segmentation processes—customer selection, customer acquisition,
customer retention, and customer growth—all of which,
is the way to avoid this temptation. when strategically integrated, maximize the value of the
—Robert S. Kaplan and David P.customer, and therefore of value creation in general. Yet,
Norton when formulating any CM strategy, organizations must
consider each process individually. Each requires a
proactive approach.

Historically, organizations have viewed acquisition as the biggest challenge. But lacking a CM strategy
and able to respond to only short-term financial pressures, most organizations do an inadequate job of
selection, retention, and growth. For many years, Mobil pursued a confused pricing strategy because
the company hadn't clearly defined its market segments. Likewise, for many years, Chemical Bank
(now Chase) cultivated relationships with unprofitable customers for the same reason. Most
organizations view the sale purely as a transaction and then lose touch with the customer, without
even knowing if the customer has remained a customer. A successful CM strategy must address each
of the following processes. (Typical objectives and measures for customer management are shown in
Figure 1.)

1. Customer selection. The customer selection process begins with an understanding of the
customer, first by segmenting the market into niches with different requirements, then by selecting
target segments for which the company can create unique and defensible value propositions. It is not
possible to be all things to all people, so market segmentation is the way to avoid this temptation.

For example, in an attempt to move away from price-based competition, an engineering company
identified a market segment built on partnering with the customer, outsourcing and risk sharing. Its
challenge was to migrate its customer base in this direction. The company's "customer selection"
objective was to "focus only on strategic accounts." It measured its success by the number of such
accounts, as well as by the number of opportunities for price-based competition that it did not pursue.
In its dynamic, rapidly evolving industry, this company was clearly targeting high-value customers
(HVC's). The converse of this approach, generally found in more mature industries, involves identifying
and eliminating unprofitable customers. A consumer bank with significant and stable market share had
as an objective to "identify, upgrade, or exit unprofitable accounts." Using activity-based management
techniques, the bank measured the percentage of customers who were unprofitable.

2. Customer acquisition. Acquiring new customers is the most laborious and expensive part of CM.
Once the market has been segmented, analyzed, and targeted, the company communicates its value
proposition to target customers through its customer acquisition approach.

Communication programs must be tailored to the desired customer segments. The engineering
company, dealing with a relatively small number of customers (twenty to thirty), developed a so-called
"education program" designed to show them the benefits of a gain-sharing partnership (in which
vendor and customer share cost reductions). The company measured its success rate by the number
of requests for proposal it received that sought a sole-source relationship. The consumer bank
conducted a major sales campaign narrowly targeted to the HVC segment. It measured the number of
leads the program generated and its effectiveness in converting them to active customers (the "lead
conversion rate").
3. Customer retention. Once a customer has been acquired, the key is to keep him. A company
retains its customers by delivering on its value proposition, so that the customer has no need to look
elsewhere. Therefore, ensuring high-quality service is fundamental. The consumer bank monitored the
service levels ("request fulfillment time") for its HVCs, surveyed its customers every six months, and
monitored its performance in resolving the top ten customer issues. Another company introduced a
customer report card whereby its industrial customers could provide feedback on the company's
performance. The report card created a dialogue that strengthened the vendor/customer relationship
and improved retention. The engineering company measured the strength of its partnership by striving
for sole-source relationships. At all of these companies, customer retention strategies were based on
providing superior service, listening to customer feedback, and building relations that discouraged
defection.

4. Customer growth. Increasing the value of each existing customer is the ultimate objective of any
CM strategy. Because new-customer acquisition is difficult and expensive, it only makes sense if the
size of the ensuing relationship can dramatically exceed the cost of acquisition. Many organizations
think in terms of the "lifetime value" of a customer. Customer growth strategies generally involve
striving to expand the share of each customer's spending by expanding the company's range of
products or services. This involves cross-selling to and partnering with the customer. The engineering
company, for example, created a virtual team with the customer by setting a shared objective to
reduce the cost of manufacturing—and then by sharing in those cost reductions. The consumer bank
measured the number of HVCs who used more than three of the bank's services. Getting such
customers first required establishing a more personal, knowledgeable relationship with them,
measured by the number of hours their relationship manager spent with them. The bank attempted to
lock the customer into a sole-source relationship by creating an integrated management system.
Another company used a similar lock-in strategy by developing knowledgeable account managers who
could work, in their words, "seamlessly," with the customer because they understood the customer's
business. Their measure: the percentage of sales requiring such expertise.