Customer Profitability Management

Statements on Management Accounting

B U S I N E S S P E R F O R M A N C E M A N A G E M E N T

C R E D I T S

T I T L E

IMA would like to acknowledge the work of the authorsof this SMA: Nabil Elias, Ph.D., FCMA (Canada),University of North Carolina at Charlotte; and Dan Hill,CMA, CFM, CorePROFIT Solutions, Inc. Thanks also go

to Gary Cokins of SAS and DeWayne L. Searcy, Ph.D.,CMA, CPA, CIA, of Auburn University, who served asreviewers, and Raef Lawson, Ph.D., CMA, CPA, CFA, ofIMA, who serves as series editor.

Customer ProfitabilityManagement

Published byInstitute of Management Accountants10 Paragon DriveMontvale, NJ 07645www.imanet.org

Copyright 2010 in the United States of America by Institute of ManagementAccountantsAll rights reserved

Statements on Management Accounting

T A B L E O F C O N T E N T S

CUSTOMER PROFITABILITY MANAGEMENT


Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2II. CPM Implementation Framework . . . . . . . .6III. Decision Phase . . . . . . . . . . . . . . . . . . . . . . . . . . .8IV. Foundation Basics . . . . . . . . . . . . . . . . . . . . . .10V. Customer Costs . . . . . . . . . . . . . . . . . . . . . . . . . .18VI. Transaction Data . . . . . . . . . . . . . . . . . . . . . . . .26VII. System Options . . . . . . . . . . . . . . . . . . . . . . . . .28VIII. Business Algorithms . . . . . . . . . . . . . . . . . . . .29IX. Profitability Information . . . . . . . . . . . . . . .31X. Strategic Integration . . . . . . . . . . . . . . . . . . . .32XI. Behavioral Considerations . . . . . . . . . . . . . .37XII. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41Appendix 1: Example of Applying the CPMImplementation Framework . . . . . . . . . . . . . . . . . . .43Appendix 2: Technical Considerations for the Management Accountant . . . . . . . . . . . . . . . . . .51

ExhibitsExhibit 1: Customer Profitability

Whale Curves . . . . . . . . . . . . . . . . . . . . . .3Exhibit 2: More Whale Curves . . . . . . . . . . . . . . . .4Exhibit 3: CPM Implementation

Framework . . . . . . . . . . . . . . . . . . . . . . . .7Exhibit 4: The Multidimensional

Views of Profitability . . . . . . . . . . . . . .11Exhibit 5: Customer Account Hierarchy :

Bank and Credit Union Example . .12Exhibit 6: Product Hierarchy Bank and

Credit Union Example . . . . . . . . . . . .13Exhibit 7: Customer Profitability Report . . . .14Exhibit 8: Customer Lifetime Value . . . . . . . . . . .15Exhibit 9: Cost What You Can Source . . . . . . .25Exhibit 10: Profit-Lift from Existing

Customers . . . . . . . . . . . . . . . . . . . . . . .33Exhibit 11: Profit-Lift from New Customers .34Exhibit 12: Business Rule Documentation . . . .54

E X E C U T I V E S U M M A R YManaging profitability requires not only a customer-centric focus but also a thoroughunderstanding and effective management of customer profitability. Customer profitabilitymanagement (CPM) is a strategy-linked approachto identifying the relative profitability of differentcustomers or customer segments in order todevise strategies that add value to most-profitablecustomers, make less-profitable customers moreprofitable, stop or reduce the erosion of profit byunprofitable customers, or otherwise focus onlong-term customer profitability.

Managers are often surprised to find out that asmall percentage of customers generate substan-tially more than 100% of profits, and the remaining customers are either breakeven orunprofitable. Using a customer profitability management system replaces intuitive impressions of customer profitability with fact-based information and supporting analysis.

The backbone of a CPM system is a costing system that is focused on tracing and causallyassigning costs to each customer or customersegment without arbitrary broadly averaged costallocations. Assigning revenues to customers orcustomer segments can present a few issues, butthe major challenge in implementing a CPM system is the selection and implementation of anaccurate and informative costing system. A costing system should not only accurately assignproduct costs and gross margin to customers orcustomer segments, but it should also assign thecosts to serve.

Cost accuracy and visibility are important inCPM. Using time-driven activity-based costing(TDABC) provides costs that identify resourceconsumption by customers or customer seg-ments. The signals provided by the CPM system,

based on full costing of traceable costs to cus-tomers and making visible business-sustainingcosts, will lead management to consider strategiesto increase profits. The signals do not provideanswers in themselves, but they could lead to gen-erating alternative courses of action. Decisionsrelated to customer profitability strategiesrequire tailor-made analysis.

There are system issues that must be consideredin the design and implementation of a CPM system. Awareness of the commitment of time,financial, and personnel resources required by aCPM system is critical to its success.

Investments in customers should be consideredin view of an estimate of customer life value. Thatis, in addition to current customer profits, thepotential of generating future profits from a customer should also be considered. Managing customer life value is a means to enhancing long-term profitability.

Essential to the success of CPM is the buy-in byemployees and managers who will be affected byits implementation. Resistance to change is a phe-nomenon that applies equally to CPM as it doesany other organizational change. To develop theCPM system and then seek the support ofemployees and managers is not likely to result indeveloping a sense of ownership, nor will it guar-antee an effective CPM system. To get employeesand managers to buy in at the outset, they shouldbe involved in its development and their ideasmust be sought. Only with a sense of ownershipwill the organization be able to navigate the trou-bled waters of change.

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I . I N T R O D U C T I O NMany companies and managers are unaware thatthe secret to improving profitability is to measureand manage customer or customer segment profitability. Companies that implement cus-tomer profitability management (CPM) systems are able to see which customers contribute to profits, which customers do notcontribute to profits, and which customers erodeprofits. CPM is a strategy-linked approach toidentify the relative profitability of different customers or segments of customers, to devisestrategies that add value to most-profitable customers, make less-profitable customers moreprofitable, stop or reduce the erosion of profit bycustomers, and otherwise focus on long-term customer profitability.

A CPM system is a profitability measurement andmanagement system, and its backbone is a costingsystem that is focused on assigning costs to eachcustomer or customer segment. A CPM systemalso assigns net revenue to each customer or customer segment. The resulting profit is identified with each customer or customer segment. As can be expected, customer-relatedcosts are more problematic to trace or assign thancustomer-related revenues. It is important toemphasize that the quality of the CPM cost information is critical for the quality of CPM. Ourapproach is to focus on a cause-and-effect costingsystem, such as activity-based costing (ABC), thatis relatively accurate in assigning costs to products, customers, customer segments, or otherrelevant cost objects. We briefly discuss a simplification of ABCtime-driven activity-basedcosting (TDABC).

The CPM Whale CurveOnce profitability is measured for each customeror customer segment, they are ranked from mostprofitable to least profitable and are plotted on aprofit graph, popularly referred to as a whalecurve (WC) or profit cliff chart, where 100% ofprofits are the sea level (see Exhibit 1). The Y-axisof the graph shows profits in dollars or as a percentage of profit from all customers, and theX-axis shows cumulative customers or customersegments ranked from high to low in terms ofprofitability. Typically, about 20% of customersgenerate anywhere from 150% to 300% of compa-ny profits (50% to 200% above sea level), about70% of customers are at breakeven, and 10% ofcustomers reduce or destroy anywhere from 50%to 200% of company profits, bringing cumulativeprofit to sea level (Kaplan and Narayanan 2001).

Exhibit 1, Customer Profitability WhaleCurves, shows customer profitability in dollarsor percentages plotted on a whale curve. As canbe seen, the potential improvement in profit inthis case is $47 million, or a 112% increase in current profit level.

Exhibit 2, More Whale Curves, shows anothertypical customer profitability whale curve, wherethe highest tip of the curve is higher than inExhibit 1. The potential improvement in cus-tomer profitability increases with the distancebetween the highest tip of the whale curve andsea level. In this case, the potential improvementin profitability is $96 million, or a 200% increasein current profit level.

The improvement in profit depicted in these fig-ures is predicated on the assumption that thepotential profitability is the highest level of profiton the graph, which is contributed by a small per-centage of customers before being eroded byunprofitable customers. In fact, with CPM, the

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3B U S I N E S S P E R F O R M A N C E M A N A G E M E N T

$100

$90

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$40

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$20

$10

$0

Customer ProfitabilityWhale Curve$

Number of Customers (RankedMost to Least Profitable)

Cum

ulat

ePro

fits

($M

illio

n)

0 5 10 15 20

250%

200%

150%

100%

50%

0%

Customer ProfitabilityWhale Curve%

Number of Customers (RankedMost to Least Profitable)

Perc

ento

fCum

ulat

ive

Profi

ts

0 5 10 15 20

Top eight customersprovide 212% ofbottom line

All other customerseither dont add tothe bottom line orsubtract from it.

Eight customersare profitable

Five customersbreak even

The remainingseven are unprofitable

Sea Level

Customer ProfitRanking1234567891011121314151617181920

Cumulative %

52%100%143%179%198%205%210%212%212%212%212%212%212%210%202%190%171%150%126%100%

Cumulative Profitinmillion $2242607583868889898989898988858072635342

22201815832100000-1-3-5-8-9-10-1142

Data for Above ChartsCustomer Profitinmillion $

EXHIBIT 1: CUSTOMER PROFITABILITY WHALE CURVES

4B U S I N E S S P E R F O R M A N C E M A N A G E M E N T

$160

$140

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Customer Profitability Whale Curve$

Number of Customers (Ranked Most to Least Profitable)

Cum

ulat

iveP

rofit

s($

Mill

ion)

0 5 10 15 20

CustomerProfit Ranking

123456789

1011121314151617181920

Cumulative %

67%125%175%217%250%275%292%298%300%300%300%300%300%298%296%277%256%215%163%100%

Cumulative Profitin million $

326084

104120132140143144144144144144143142133123103

7848

Customer Profitin million $

322824201612

8310000-1-1-9

-10-20-25-3048

Data for Above Charts

$160

$140

$120

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$80

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Customer Profitability Whale Curve %

Number of Customers (Ranked Most to Least Profitable)

Perc

ento

fCum

ulat

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rofit

s($

Mill

ion)

0 5 10 15 20

Potential profitimprovement of$96m

Sea Level

{

What's the potential if the break-even and unprofitable customers are turned into profitable customers?

EXHIBIT 2: MORE WHALE CURVES

potential improvement in profit is even greaterthan indicated on the whale curves by turningmarginally profitable customers into more profitable customers and turning profit-erodingcustomers into profitable customers or otherwiseeliminating the profit erosion.

Organizational Types That Benefit from CPMCPM is suited for all types of profit and not-for-profit organizations where products (or servicelines) and customers are not homogeneous. Incompanies where products and customers arehomogeneous, using the same distribution chan-nels and pricing policies, there would be littleneed to use CPM other than to increase visibilityto types of activities and their costs. But there arefew if any companies that meet this description.CPM is thus suited to organizations where products or service lines are different, customersor customer segments are heterogeneous, and pre-sale or post-sale customer service requirements vary.

These latter nonproduct or nonstandard service-line costs are commonly referred to ascosts to serve. As products and service linesincreasingly become more commodity-like, withcomparable cost levels among competitors, thereis a shift toward activities to serve customers asthe basis for gaining a competitive advantage.Hence, identifying activity cost drivers, tracingthem to customers, and measuring the costs to serve forms a key benefit of CPM.

Service organizations such as banks, insurancecompanies, and other financial service companiesnaturally fit the circumstances that benefit fromthe application of CPM. Manufacturing compa-nies can apply the same concepts in business-to-business settings and in repeated, more frequentproduct purchase environments. Not-for-profitorganizations that are customer-based can also

benefit from applying CPM. For example, creditunions can successfully apply CPM to make mem-bers (what credit unions call their customers/owners) more profitable, and in turn, reduce thefees or rates to their members.

Organizations that may not benefit from CPMinclude those whose costs to serve are small andpre-sale and post-sale services are not importantin gaining a competitive advantage. This would bethe case in organizations whose customers arerelatively homogeneous or indistinguishable. Insuch rare cases, customer gross margin may besufficient to obtain CPM benefits. Because of therelatively low costs to serve, CPM in these organizations could be referred to as CustomerGross Margin Management. The strategic impli-cations are the same as in CPM nonetheless. Onthe other hand, organizations whose customersare not homogeneous, and who compete or cancompete on pre-sale or post-sale activities, areprime candidates for reaping the benefits of CPM.

Impediments to CPM ImplementationIf CPM offers such competitive and sustainableadvantages, why is it not more widely imple-mented and used? We do not have any surveydata to offer as an answer to this question, but wecan speculate on the most likely reasons for thelack of CPM implementation.

First, it is clear that many companies are traditionally managed as functionally structuredorganizations without the customer focus. Thistypically would exist in organizations that rely onsupply push rather than demand pull strategies. In such situations it is difficult formanagement to appreciate the effects of applyingCPM. Even in organizations that utilize demandpull strategies, it is not clear that managers fullyappreciate the potential benefits of CPM. It is also

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possible that some managers may not have a clearidea of what to do if they identified profitable andunprofitable customers.

Second, driver-based costing applications can betime consuming and costly, thus making theapplication of CPM difficult. In other cases thelack of available data (e.g., outsourced IT systemsor not collecting cost driver data) may hinder theinterest in gathering and implementing new systems.

Third, some of the available material on CPMmakes it hard to understand and implement (seeCokins 2008). One of the purposes of this SMA isto provide guidance as to how to effectively imple-ment CPM. Applying CPM requires not only adesire and commitment by management to CPM,but it will also require an investment of resources.It is not easy to quantify the personnel effort andcosts, on the one hand, and the benefits of CPM,on the other. But, the incremental investment,efforts, and costs of organizations that have suc-cessfully implemented CPM are justified byincreased profitability and enhanced customervalue. The well publicized success of CPM at BestBuy is just one example.

The value that CPM brings to an organization willdepend on the quality of the information devel-oped for managing customer profitability and onits ability to become customer-centric. Becomingcustomer-centric requires the buy-in by decisionmakers and their ability to forge effective imple-mentation teams.

CPM implementation and profitability reportingshould not be seen as a one-off system.Information should flow on a regular basis, trig-gering a process of customer profitability assess-ment, feedback, analysis, decisions, and imple-mentation. This process enables management to

tap the potential for increasing profitability bydevising different customer targeting strategies,implementing differentiated services or servicelevels to customers, and making operating, mar-keting, or pricing adjustments in its attempt tomake all customers profitable and manage overallcustomer profitability.

The potential benefits result from identifyingcustomer or customer-segment profitability andthen developing appropriate differential strate-gies for different customers. Held perceptionsand biases in an organization may be shattered inlight of facts and analysis. Armed with new infor-mation about customer profits, managers canfocus on appropriate actions related to profitablecustomer retention and acquisition, makingunprofitable customers profitable and reducingor eliminating profit erosion resulting from customers who destroy shareholder value.

I I . T H E C P MI M P L E M E N TAT I O NF R A M E W O R KImplementing a CPM system requires a frame-work as displayed in Exhibit 3, The CPMImplementation Framework. This frameworklays out the phases for implementation, withsome phases being highly interrelated and run-ning in parallel while other phases proceedsequentially.

The major phases to implement a CPM system: 1. Decision Phase2. Foundation Basics3. Customer Costs4. Transaction Data5. System Options6. Business Algorithms7. Profitability Information8. Strategic Integration

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The decision phase, required for any strategicinitiative, is where the value and reasons for pursuing a CPM system are explored, the finan-cial consequences analyzed, and a go or no-godecision is made. Another important componentof this phase is establishing the purpose of theCPM system to guide its development and implementation.

The next three phasesfoundation basics,customer costs, and transaction dataare highlyinterrelated. A decision in one of these areasdirectly impacts decisions in the other two.

The foundation basics phase establishes the costobject and ultimately what will be measured.This phase also includes establishing the systemscosting principles, how profitability will be calculated, and how contentious accounting

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Decision Phase

Foundation Basics

CustomerCosts

TransactionData

SystemOptions

Business Algorithms

ProfitabilityInformation

Strategic Integration

EXHIBIT 3. CPM IMPLEMENTATION FRAMEWORK

issues (e.g., capitalizing marketing costs) will behandled. Lastly, this phase is where customers,products, and channels are defined.

The customer costs phase is where considerationis given to the extent to which cost assignmentscan accurately be made to products or servicelines, and the costs to serve can accurately beassigned to customers based on causality. Thisphase is where traditional general ledger unit-based cost allocations are replaced with cus-tomer, or cost object, costs. CPMs need for rela-tively accurate customer-level costs points to theuse of some form of activity-based costing (ABC).

The transaction data phase poses many chal-lenges. Although most companies have vastsources of disparate data buried in their variousIT systems, harnessing it to serve a CPM systemis costly and time consuming.

The reason these three phases are so interde-pendent is that decisions about which activities toinclude in costing are dependent on what transac-tion data is available (or obtainable). On the otherhand, the transaction data to seek for availabilityis dependent on what activities are to be costed.And the cost object and costing principles estab-lished in the foundation basics must be compati-ble with both the available transaction data andthe proposed costing activities.

The system options phase involves selecting thecosting and profitability IT systems. This phaseruns parallel to and is interrelated with the foundation basics, customer costs, and transac-tion data phases. IT resources, data sourcingrequirements, and costing considerations must befactored into the selection of the appropriate ITsystems.

Once the first five phases are complete, then thedesign and build of the business algorithms, orrules, will begin. The business algorithms mustintegrate with the IT systems and be consistentwith the principles established in the foundationbasics. Testing of the business algorithms runsconcurrently with their design and build, followedby a total and thorough testing of the completedsystem.

The profitability information phase follows testing, where monthly or quarterly results areproduced and distributed. This phase is where theCPM system enters production, system maintenance and upgrades occur, and the qualityof results is guaranteed.

Finally, and most importantly, is the strategicintegration phase, where CPM information isintegrated into the companys strategic and tactical decisions. For example, CPM resultscould be incorporated into the organizationsperformance measurement systems. The ultimategoal is to use customer-based information toimprove company performance and profitability.

Each phase of the CPM implementation frame-work is discussed in this SMA. A separate discussion of the behavioral considerations whenimplementing a CPM system is also provided.Appendix 1 is an example of the implementationframework applied in the financial servicesindustry, and Appendix 2 covers technical considerations for the management accountantnot discussed in the main body of the SMA.

I I I . D E C I S I O N P H A S EThe decision phase is when senior managementbecomes aware of CPM and attempts to under-stand its potential benefits, costs, and strategic

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implications. It is important that managementunderstands CPM, how it will benefit the organi-zation, and how to develop and use the informa-tion to run a more profitable customer-centricorganization. The benefits and costs are discussedin the next subsection. In order for managementto be more effective, managers should obtainsome training in CPM. Once a decision is made toimplement CPM, as with any project, manage-ment should apply appropriate project manage-ment techniques with the full support andendorsement of senior management.

Benefits and Costs of CPMIt is important to estimate the costs and benefitsof implementing CPM. If management is aware ofhow CPM can improve customer profitability, arough estimate of the recurring benefit is the dif-ference between actual profitability and the peakof the whale curve, although the benefits canoften exceed this amount. The problem is that inthe absence of a customer profitability system, itis difficult to arrive at a precise estimate of thebenefits of implementing CPM. Judgment mustbe made in the absence of precise information.

The cost of implementation will depend on theexisting costing system and its appropriatenessfor CPM. If a company has a variant of an ABCsystem, the cost of implementation may relate torefinements necessary to capture data related tocustomers as the cost object to track their consumption of resources. The extent to whicharbitrary cost allocations characterize the costingsystem might indicate the need to redesign thecosting system, which of course can become acostly proposition. On the other hand, there aresimplifications that may prove less costly, such astime-driven ABC.

An accurate CPM system requires an accuratecosting system that assigns costs to cost objectsbased on the cost objects consumption ofresources. Implementing activity-based costing insome form or another may be required to obtainaccurate customer profitability estimates. Itshould be kept in mind that in a competitive environment, an accurate costing system isrequired whether or not a CPM system will beinstalled. Given that cost accuracy supports survival in a competitive business environment,the incremental cost of adapting a costing systemto suit the needs of CPM could be relatively marginal. Without customer profitability infor-mation, customer profitability management is ashot in the dark.

Management must appreciate that effective CPMimplementation integrates customer profitabilityinformation into a companys strategic decisionsrelated to exploring profit opportunities witheach customer or customer segment. Such strategic decisions affect financial outcomes, butthey could require operational or marketingadjustments to meet customer needs as shaped byCPM strategic decisions. In this fashion, CPMprovides long-term competitive advantages thatcan be sustained as long as it is periodically calcu-lated, reviewed, evaluated, and used.

Obtaining CPM Buy-InIt is important for management to pave the wayinternally for CPM implementation by dispellingthe myths and existing perceptions of customerprofitability. Senior managements unquestion-able support is required, and they should obtainthe support of all those who are likely to beaffected by the CPM system. Once the decision ismade to embark on implementing CPM, it isimportant to pay attention to the behavioralissues that can make a difference in its success orfailure. These issues are discussed more fully

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below. Briefly, any change creates resistance dueto the uncertainty it creates, particularly by thosewho might be adversely affected by it. Buy-in canbe obtained by getting affected employeesinvolved from the beginning. Successful CPMimplementation requires a team approach. Aswith any major organizational change, tact, com-munication, education, training, and excellentleadership skills can make the differencebetween the success or failure of CPM.

The Role of Data in CPMTo make the decision to implement CPM requiresan appreciation of the role and importance oftransaction data. The reason that many compa-nies currently find improving profitability elusiveis that the customer-detailed information theyneed is buried in transactional databases. If all acompany does with its customers is manage theaccounts receivables, and all it focuses on is over-all customer profitability as reinforced by high-level, general ledger (GL)-based performancemeasures, it is missing important strategic opportunities to manage customer profitabilityand to increase the lifetime economic value of itscustomers. CPM measurements will replace theoften erroneous impressions, guesses, or hunchesabout the relative profitability of customers withmore objective information. For example, Searcy(2004) reports cases where entrenched perceptions about sales volume and profits wereshattered when a company properly calculated itsprofitability measures by customer and channelsegments.

I V. F O U N D AT I O N B A S I C SThe foundational design of the CPM system isdriven by the purpose established in the decisionphase and starts with the definition of the costobject: customer, customer segment, product,channel, customer account, etc. The cost objectdetermines what will be measured and managed.Clarity of purpose and thoughtful and clear definition of the cost object will lead the way to aneffective CPM system.

Establish the Cost ObjectThe cost object chosen must be compatible withboth the transaction data available from the com-panys core application systems and the costingprinciples. Compromises may be required asdesired features may not be available in thetransaction data. The cost object chosen mustalso support the CPM systems purpose asdefined in the decision phase.

For example, in the financial services industry,the customer account often becomes the costobject and the platform on which to attach allcosts consumed. This approach works for thatindustry because information is already main-tained for every customer account. Individualcustomer accounts belonging to the same customer are combined for customer-levelreporting and management. Thus, customer Asprofitability is the sum of the profitability of herindividual accounts, such as her checkingaccount, CD accounts, auto loan account, andhome equity line of credit account.

An important consideration in establishing thecost object is whether its revenues are measura-ble. The ease or difficulty of collecting revenuedata for the cost object depends on the industryand the companys core application systems. Incases where revenue is not measurable for thecost object (e.g., fast food), then the cost object

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will need to be aggregated to the level at whichrevenues are measurable (e.g., customer segment).

The cost object as the basic building block of theCPM system has a major advantage: multidimen-sional profitability. In the financial servicesindustry every customer account (the cost object)is not only identified with a customer, but alsowith a product (or service line), the sales channel,the organizational unit assigned, the geographiclocation, the age of the account holder, and anynumber of other data tied to a customers account.Although the CPM systems main purpose is tomanage customer profitability, a customeraccount cost object allows profitability to bemeasured by any of the dimensions attached to acustomers account, such as product profitability,branch profitability, profitability by region, andprofitability by age. These are different ways ofmeasuring the same thing from different perspec-

tives, and from which arise the profitability identity. Exhibit 4, The Multidimensional Viewsof Profitability, shows the profitability identityas follows:

Total Customer Account Profitability = Total Product Account Profitability = Total Organizational Account Profitability

Although not all industries have customeraccount cost objects that can be used in this manner, those that do can take advantage of themultidimensional approach. For example, product profitability that includes customer costsis far more reliable than product profitabilityderived from average GL-based allocationassumptions. As another example, data summedby channel will yield channel profitability, possi-bly available for the first time to the company.

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CUSTOMERPROFITABILITY

Account #Account 1Account 2Account 3Account 4

:

CustomerSmith FamilySmith FamilyABCAutoJack Cove

:

ProductChecking AcctMrtg LoanChecking AcctAuto Loan

:

Org CenterBranch 1Branch 1Branch 1Branch 2

:

Revenue$ 10$ 125$ 1,500$ 36

:

Total Exp$ 8$ 35$ 1,530$ 23

:

NIBT$ 2$ 90$ (30)$ 13

:

If profitability iscalculated atthe account orlowest level,then di!erentviews ofprofitabilityflow fromexisting data

S Customer Profitability =

S Product Profitability =PRODUCTPROFITABILITY

ORGANIZATIONPROFITABILITYS Product Profitability =

EXHIBIT 4. THE MULTIDIMENSIONAL VIEWS OF PROFITABILITY

A word of caution when selecting the cost object:The cost object determines the detail availablewithin the CPM system, which further deter-mines the ability of the system to drill down anduncover underlying problems or answer specificquestions. There is always a tendency to add asmuch related data as possible to provide deeperdrill-down and the ability to answer questions notyet considered. Detail does not come withoutcosts, however. The one-size-fits-all informationsystem that can answer all questions posedrequires more complex costs and transactiondata, which adds significantly to the cost of developing and maintaining the CPM informationsystem.

Define Customer, Product, and ChannelDuring the foundation basics phase it is impor-tant to precisely define what constitutes a cus-tomer and whether customers will be combinedinto households or relationships. If so, a customerhierarchy table can assist in these combinations.

A hierarchy table is simply a document or data-base table showing how subgroups roll up, or arecombined, into groups, which can further be com-bined into higher-level groupings. See Exhibit 5,Customer Account Hierarchy, for an example ofa customer hierarchy for a bank or credit union.

Another foundational basic is the definition ofproducts or service lines. A product hierarchydefines the products and how they are combinedinto groupings. It is often practical to roll upproducts with similar processes into a higher-level product for costing purposes. If the like-kind products appear to be homogeneous in theirconsumption of activity costs, then combiningthem into one costing product will reduce systemand report complexity. Exhibit 6, ProductHierarchy, shows a product hierarchy for a

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Mr. Smith Checking AccountMr. Smith Savings AccountMr. Smith Auto Loan

Mrs. Smith Checking AccountMrs. Smith Auto Loan

Mr. &Mrs. SmithMortgageMr. &Mrs. Smith Certificate of Deposit

ABCAuto Checking Account Store 1ABCAuto Checking Account Store 2ABCAuto Checking Account Store 3ABCAuto Checking Account Store 4

ABCAuto Parts On-Line

ABCAuto Checking Account Store 1ABCAuto Checking Account Store 2ABCAuto Checking Account Store 3ABCAuto Checking Account Store 4

Mr. Smith

Mrs. Smith

Mr. &Mrs. Smith

ABCAuto Parts

ABCAuto Parts On-Line

Account Level Customer Level Relationship Level

Smith Family

ABCAuto PartsCorporation

EXHIBIT 5. CUSTOMER ACCOUNT HIERARCHYBank and Credit Union Example

typical bank. The column titled Costing Productindicates the product level at which cost driverrates are developed.

Other foundation basics include the organization-al hierarchy and the definition of delivery chan-nels, if applicable. The organizational hierarchydefines general ledger cost or profit centers, displaying the relationship of the centers ordepartments where work or activities take placeand resources are consumed.

A customer delivery channel may be includeddepending on the industry and other considera-tions. The customer delivery channel is where

customers interact with the company, or the cus-tomers touch-point. Large retail stores offersales venues through their stores or on their website. In this case, there are two customerdelivery channels: physical stores and a website.

Costs can vary significantly between customerdelivery channels. It is likely that physical storesales require relatively more resources and aretherefore more costly than website sales. A retailcompany may therefore consider strategies toencourage their customers to buy through itswebsite rather than visiting its physical stores, a

13


Core Product

Commercial Loan - PrimeCommercial Loan - LIBOR

Auto Loan - NewAuto Loan - Used

Regular CheckingInterest CheckingPremier Checking

Regular SavingsMoneyMarket Savings

ABCCosting Product

Commercial Loan

Auto Loan

Noninterest Checking

Savings

Core products using the sameprocesses with similar costs aregrouped together. Revenuecomponents are assigned at theaccount level since theymay di!er(e.g., Prime versus LIBOR rates).

The activities for these products arecosted in the ABC system. Combininglike-costed core products reducescomplexity and improves usefulness.

Develop ABCcosts forthese products

Revenuesdi!erent,costs the same

EXHIBIT 6. PRODUCT HIERARCHYBank and Credit Union Example

process called channel migration. A channeldimension included in the CPM system wouldhelp with these strategic initiatives.

In addition to defining who the customer is, it isalso important to consider identifying relevantcustomer segments. Customer segments definepatterns of customer characteristics and behaviorthat drive customer profitability (Epstein et al.2008). In some cases it may be necessary to segment customers to obtain measurable costobjects; otherwise, it may be more appropriate tocombine customers by segments once customer

profitability information has been obtained. Thiswill be discussed further in the section on strategyintegration.

Calculating Customer ProfitabilityThe final area to be covered during the founda-tion basics phase is the method of calculating customer profitability and how various account-ing issues are handled. Customer profitability istypically measured as net revenue less customercosts, overhead, and taxes.

Net revenue is the cost objects total revenue lessreturns, allowances, or other adjustments.Customer costs are the summation of activity

14


Customer ID / CustomerSegment

Net RevenueProduct CostsCustomer GrossMargin

Costs to ServeCustomer (or Segment)Margin

Corporate Sustaining Costs AmountPre-tax Customer Profit

IncomeTaxes (40% )

Customer Profit

Amount

$10,000$ 4,500$ 5,500

$1,200$3,300

$2,000$1,300

$ 520

$ 780

Percent ofNet Revenue

100%45%55%

12%33%

20%13%

5.2%

7.8%

Costs to Serve include sales, order filling,customer support & service, and othercustomer identifiable costs.

EXHIBIT 7. CUSTOMER PROFITABILITY REPORT

15


Year 0 1 2 3 4 5 6 7 8 9 10

($5,0

00)

$900

$1,000

$1,200

$1,300

$1,400

$1,400

$1,500

$1,500

$1,500

$1,500

($5,0

00)

($4,100)

($3,100)

($1,9

00)

($60

0)$8

00$2

,200

$3,700

$5,200

$6,700

$8,200

($5,0

00)

$833

$857

$953

$956

$953

$882

$875

$810

$750

$695

($5,0

00)

($4,167)

($3,30

9)($2,35

7)($1,4

01)

($44

8)$4

34$1,309

$2,12

0$2

,870

$3,565

Investmen

tRe

covery

Payb

ack

PVof

Investmen

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covery

Net

Presen

tVa

lue

TimeV

alue

ofCu

stom

ers

$10,00

0$8,0

00$6,00

0$4,00

0$2,00

0 0($2,00

0)($4,00

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0)

01

23

45

67

89

10

Payb

ack

Net

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tValue

Atyears5

-6investmen

tisrepa

id

Atyear

7target

return

isachieved

Payb

ack

Ittakestim

etorecoverthe

investmen

tinacqu

iringn

ewcustom

ers.

EXHIBIT 8. CUSTOMER LIFETIME VALUE

costs that are assigned to the customer as the costobject. If ABC is used, then each cost objects costis the activity driver rate times the quantity orother measure of the activity driver consumed bythe cost object.

Costs are discussed below in Section V: CustomerCosts. In general, costs assigned to cost objectsinclude product costs and any costs to service thecustomers. The difference between net revenueand product or service line costs is the costobjects gross margin. The costs to serve appearbelow the product gross margin line, and includecosts of such activities as order getting, order fill-ing, and customer support and service. The coststo serve are assigned to the customer as the costobject and then subtracted from the cost objectsgross margin to obtain customer margin.

Customer margin contributes to corporate-sustaining costs (or corporate overhead). Incomebefore taxes is thus equal to customer marginless corporate-sustaining overhead. Incomebefore taxes less taxes provides customer netincome or profit. Exhibit 7, CustomerProfitability Report, provides an example ofsuch a report.

Return on Capital ConsiderationsWhile customer profitability provides valuableand oftentimes never-before-available informa-tion, only goes so far. Ultimately, what is mostimportant is the return on the capital invested toachieve those profits. Linking customer profitswith capital can be done in several ways, such asreturn on investment (ROI), return on equity(ROE), residual income (RI), or some variant ofthese approaches.

Linking customer profits and capital requires anassignment of capital to the cost object. This canfundamentally be done in two ways. One way is to

assign capital based on capital usage or capacityutilization. Adjustments are then made to thecapital charge to reflect higher customer risk byusing a rate higher than the average cost of capital and conversely to reflect lower customerrisk by using a rate lower than the average cost of capital. The types of customer risks to considerwill vary by industry.

A second approach, commonly used by financialinstitutions, is to assignbeyond capital usagemore capital for riskier investments or customersand less capital for less-risky investments or cus-tomers. In this case the cost of capital rate is heldconstant and not adjusted for risk; risk is account-ed for in the amount of capital assigned to eachcost object or customer.

A partial application of RI in manufacturing is tocalculate only the cost of direct investments inassets related to the customere.g., imputed capital cost on inventories and accounts receiv-able. A complete application of RI would requireassigning direct and indirect investments inassets financed through long-term capital.

Cost object return on capital, however measured,can be plotted on a whale curve similar toExhibits 1 and 2 in order to gain insights intomanaging customer profitability. Using ROI or RIadds to the tools of managing customer prof-itability by accounting for the cost of capitalneeded to serve the customer or customer seg-ment. A full discussion of attributing capital andmeasuring ROI and RI lies beyond the scope ofthis SMA.

Customer Lifetime Value (CLV)Customer profitability results and return on capital measures will, by definition, cover a specific time period, such as a month, a quarter, ora year. Snapshot views of any dynamic system can

16


be misleading. As such, trends of customer profitability results over several time periods provide more meaningful information and shouldbe designed into the report library requirements.

Measuring customer profitability over an expected tenure is known as Customer LifetimeValue (CLV). Pfeifer, Haskin, and Conroy (2005)refer to CLV as the discounted future cash flowsrelated to a customer. When a decision is made toacquire a customer, such as through a proposedmarketing campaign, a company should projectthe discounted future cash flows resulting frommaking the acquiring investment. It should continuously monitor the changes in customervalue that result from the ongoing interactions orlack thereof between the customer and the company. A discount factor such as the cost ofcapital can be used to discount the projectedfuture cash flows over the customers expectedtenure with the company. Depending on the riskof the investment made in a specific customer orcustomer segment, the discount rate can beadjusted higher or lower to reflect that risk. If therelationship between specific customers and thecompany is uncertain, probabilistic models can beused to estimate the discounted CLV of thesecustomers.

Exhibit 8, Customer Lifetime Value, shows anexample of an investment in a customer. Thecumulative cash flows are negative at the time ofmaking the investment. As the customer con-tributes revenues and incurs product costs andcosts to serve, however, the difference results incustomer margin as the measure of customerprofit. The investment will be recovered whenthe customer margin or profit equals the cus-tomer investment. Beyond that point, the cus-tomer value is positive.

Other Accounting IssuesIn addition to the costing issues that will arise,thorny accounting issues should be addressedduring the foundation basics phase to avoid laterdiscord and manipulation. Two thorny accounting issues that create heated debate inthe financial services industry are:

Unsuccessful sales efforts. A loan officer mayapprove six loans out of the 10 loan applica-tions he takes in a day. The time spent onreviewing and declining the four unapprovedapplications represents unsuccessful saleseffortstime and effort expended where noproduct is sold nor customer created. In anoth-er example, credit card direct mail campaignscan cost tens of thousands of dollars, yet aresponse rate of 5% is considered stellar. The95% of direct mail pieces that resulted in nocredit card applications are unsuccessful salesefforts. Unsuccessful sales costs can be spreadamong the sales that were successfulin thiscase unsuccessful sales being part of the cost of successful sales. Another approach spreads theunsuccessful sales costs across all accounts ofthat product typein this case unsuccessfulsales being a cost of offering that product to themarketplace. (This approach is often preferredby marketing executives since it reduces thecost driver rate for the sales activity.) The bestapproach for the company should be selectedearly to avoid misunderstanding, maneuvering,or gaming the system.

Controllable versus uncontrollable costs. Notall costs are controllable by a departmentsmanager. How much control does a branchmanager have on the storefront rental expensefrom a contract negotiated by the banks facilities group five years ago? The branch manager will argue that customer profitabilityshould exclude facilities costs because they are

17


uncontrollable. This is refuted on the groundsthat the purpose of the CPM system is to meas-ure customer profitability and all costs shouldbe includedcontrollable and uncontrollable (corporate-sustaining costsbeing the possible exception). This choice elevates the purpose of managing customerprofitability over that of employee performancemeasurement, although the two are not necessarily incompatible.

V. C U S T O M E R C O S T STo know customer profitability, one must knowcustomer costs. How customer costs are meas-ured is critical for the effective application anduse of CPM.

The Trouble with Conventional CostingConventional cost accounting systems, with theirfocus on product or service line, cost centers, andfunctional cost classifications are neither ade-quate nor helpful for CPM purposes. These costsystems generally derive directly from the generalledger (GL) where some form of unit-based allo-cation of GL costs to the cost object is made (e.g.,by number of employees, by number of PCs maintained). The GL data tracks only cost occurrencewhat was spent rather than why itwas spent (activity specification) or how activityresources are consumed by cost objects. Thesesystems do not provide costs based on customeror customer segment behavior.

Conventional cost allocation methods imply thatall customers or customer segments are homoge-neous. When support costs (indirect or shared,commonly called overhead) are assigned on thebasis of a unit-based common denominator, suchas units, revenues, or number of customers, support costs are averaged and do not reflect theresource consumption patterns by individual

customers or customer segments. This typicallyresults in a misallocation of costs. Unless all customers or customer segments are homoge-neous in their pattern of consumption of manu-facturing and nonmanufacturing support costs,some cause-effect cost assignment system such asactivity-based costing (ABC) should be employed.Before exploring this topic, it is first important toidentify the different types of costs involved inCPM.

The Types of CostsCustomer costs consist of all costs necessary toprovide the product or service line to the customer, not only to the point of sale and delivery but over the entire life cycle of the product or service line. These costs include coststhat add value for the customer, such as productor service-line costs and the costs to serve. Theyalso include costs that do not add value for thecustomer but are necessary for the business.

1) Product costs

a. Direct material and direct labor, if applicable.These include the typical product or service-line costs, often referred to as direct costs.

b. Manufacturing or service-line support costs.These support costs include indirect costs,which are typically assigned as product costsusing unit-based allocation schemes (e.g.,labor hours), but preferably assigned usingcause-and-effect relationships (e.g., activity-based costing).

2) Costs to serve

a. Marketing, selling, and distribution costs,typically assigned using unit-based allocationschemes (e.g., sales or product costs), butpreferably assigned using cause-and-effect

18


relationships (e.g., activity-based costing).These costs also include order-getting andorder-filling activities.

b. Post-sale service, such as warranty or coveredrepair costs, and in some cases disposal costs,typically assigned using unit-based allocationschemes (e.g., sales or product costs), butpreferably using cause-and-effect relationships (e.g., activity-based costing).

3) Business (or corporate) sustaining costs

Not all costs are related to customer productcosts or costs to serve (Cokins 2006). Forexample, the cost of landscaping, accounting,IT services, patents amortization, and executive salaries are not incurred for a customer or customer segment but areincurred to sustain the business. These costsmay or may not be assigned to customers.Caution should be used in interpreting theresults if they are assigned to customers,however, there is likely no cause and effectrelationship. On the other hand, not includ-ing these costs means that decisions basedon customer profits may in fact translateinto business or corporate losses.

Customer costs are the sum of the customersproduct costs and the customers costs to serve.Ideally these customer costs are assigned on thebasis of cause and effecte.g., using activity-based costing or some variation. Each activitycost is based on its activity cost driver rate andthe customer-related consumption of that activi-ty. As mentioned above, whether or not toinclude business-sustaining costs is situational.Regardless, the resulting information should beinterpreted in light of whether business-sustaining costs are included in customer costsor not. Refer to Exhibit 7, Customer

Profitability Report, for an example of a multi-stage customer profitability statement.

Costing SystemThere are at least three cost system options. Thefirst is unit-based traditional costing, whichassumes that products, customers, and other costobjects are homogeneous in their consumption ofactivity resources. Since homogeneity is not avalid assumption, the second option is to useactivity-based costing (ABC). Because ABC imple-mentation requires time and resources, Kaplan(2004) suggested the use of a simplified approach:time-driven activity-based costing (TDABC). Weadvocate a form of causal cost assignment, whichlargely means ABC or TDABC. A brief comparisonof these methods is provided below. A full discus-sion of the application of ABC lies outside thescope of this SMA. (See the IMAs Statement onManagement Accounting titled ImplementingActivity-Based Costing, 2006.)

Conventional CostingDirect product and customer costs do not raisequestions about the utility of their assignment tocustomers or customer segments as the costobject. The same cannot be said for assigningindirect product or shared customer costs.

Unit-based conventional costing systems assignfunctional costs (e.g., salaries or insurance) on thebasis of unit-based cost drivers (e.g., direct laborhours, dollars of customer revenue) that assumehomogeneous consumption of indirect or sharedcosts by cost objects (e.g., products, customers).The most profound criticism of conventionalcosting relates to not assigning support costs tocost objects on the basis of their consumption ofactivity resources, resulting in simplified butoften misleading results.

19


A CPM system attempts to capture the differentresource consumption patterns of different cus-tomers or customer segments so that manage-ment is better able to manage the profitability ofeach customer or customer group. In the absenceof such measurement, management is unlikely tomanage customer profitability appropriately, asconventional costing systems ignore the con-sumption patterns of activities by cost objects.

Activity-Based Costing (ABC)Activity-based costing (ABC) provides an answerto such criticism. In ABC, activities must be iden-tified, activity cost pools established, cost driversselected, and cost driver rates developed. Thecost driver rates are then applied to differentcustomers or customer segments in order toassess their profitability.

ABC requires first that activities be identified,and the costs of resources consumed by thoseactivities are assigned using resource drivers. Thisfirst step requires converting the general ledgerfunctional accounts into activity costs. The costsof support activities may be assigned to higher-level activities based on their consumption ofsuch support activities. (See multistage ABC inCokins 2008). Costs of activities that are con-sumed homogeneously by all products or servicelines are also combined into activity cost pools.

At this stage, organizations can see the cost ofeach activity, which often raises issues related tomanaging activities to minimize their costs.Activity-based management (ABM) requires re-evaluating, re-examining, and re-designingprocesses and activities for better cost manage-ment. While ABM enhances corporate profitabili-ty and supports the objectives of CPM, it is notdirectly an integral part of CPM.

After identifying the activities and their costs, thenext step is to select appropriate cost drivers fromavailable transaction data for each activity oractivity pool. An estimate is then made of thequantity or capacity of each cost driver for a peri-od of time (usually a year).

Cost driver rates are developed by dividing activity costs or activity cost pools by the estimated cost driver quantity. The cost driverrates are then applied to cost objects, such asproducts, channels, customers, or other costobjects (usually decision points), by multiplyingthe quantity of the cost driver consumed of eachactivity by the cost object times that activitys costdriver rate. The sum of activity costs thusassigned to a cost object represents the costobjects total product and customer costs.

Customer costs in this way include the sum of allassigned product or service-line activity costs forthe product or service line purchased by the customer or customer segment (product costs), aswell as the costs to serve the customer or customer segment using cost driver rates.Corporate-sustaining costs may also be assignedto customers or customer segments, but linkingsuch costs to customers is necessarily arbitrary.

It should be noted that ABC is not necessarilybound by the GL. For example, inventory-carrying activities generate costs that are not recognized as expenses in GAAP, such as imputedinterest, cost of capital charge, or replacementcost depreciation. Such costs may be included inABC for management purposes.

ABC often requires survey information to assignresource costs to activities and to assign activitycosts to cost objects. Such survey informationmay not be accurate and may often need to beupdated as operations or activities change. There

20


are different levels of precision that are attainablein applying ABC. The most accurate informationmay require too many cost drivers with compli-cated data to be developed and captured in thecosting system. A high level of precision, there-fore, may be too costly to attain. A balance shouldbe struck for the optimum level of precision, tak-ing both accuracy and costs into consideration.

Time-Driven Activity-Based Costing (TDABC)Because several applications of ABC in the questfor cost accuracy became cumbersome and costlyto develop, Kaplan and Anderson (2003) developed a simplified application of ABC theycall Time-Driven ABC (TDABC). Two majoradvantages of this simplified approach are (1)avoiding extensive surveys, re-surveys, and survey subjectivity, and (2) highlighting capacityutilization or lack thereof. Two parameters arenecessary to apply TDABC. The first is the practi-cal capacity of a resource determined in units oftime, and the second is the time required to perform a unit of each identifiable activity. Thecost of the resource is divided by the capacity ofthat resource to determine the cost per unit oftime. This is then assigned to cost driver rates bymultiplying the cost per unit of time of theresource by the amount of time a unit of activitytakes to perform. The cost driver rate is thenapplied to the cost object based on the quantity ofcost driver units consumed by the cost object.

As a special case of ABC, TDABC is relatively newand the evidence seems to support its advantages.But evidence about its disadvantages is alsobeginning to emerge. For example, direct observa-tion of the time to perform a unit of activity maybe affected by the observation process itself, bysampling error, or by defining when the unit ofactivity begins and ends. It is also unclear thattime is the driving force of many resources

(Adkins 2008). For further discussion on ABC, seeIMAs Statement on Management Accounting,Implementing Activity-Based Costing (2006).

The choice of a costing system is critical to CPM,and the tradeoffs in the choice between conven-tional unit-based costing, ABC, and TDABC willdepend on the circumstances of the organization.It is important to recognize that there exist different forms, adaptations, and simplificationsof ABC to provide satisfactory cost information ata reasonable cost. Pursuing precise cost informa-tion dramatically increases the cost of developingand maintaining an ABC system. We tend to favorABC due to its focus on cost assignments based oncausality. Arbitrary cost allocations that do notattribute causality may be marginally beneficial,but they can also lead to misguided decisions.

Cost Driver Types, Quality, and Data AvailabilityThere are three general types of cost drivers. Costdrivers may be based on transactions (counts),duration (time), or intensity (direct tracing). Forexample, the setup activity costs may be assignedusing the number of setups if setups are similarbetween products (transactions or counts), usingthe number of setup hours if setups vary by prod-uct in the time they consume (duration), or bytracking the size of the setup crew required, thelength of time it takes to complete a setup, and theactual shop supplies required (intensity).

The quality of selected cost drivers is critical inCPM. For example, customers that place large butinfrequent orders might be assigned more thantheir proportionate share of the costs to serve ifcosts are assigned on the basis of sales volume orsales dollars, making them appear less profitableand hiding the lack of profitability of customersthat place small and frequent orders and drive upthe costs to serve.

21


The application of ABC requires that activity costdriver data be available or can be developed andmaintained. For many organizations the activitycost driver data at the customer level, particular-ly for the costs to serve, is not directly available,although it may have been captured in transac-tion data and can be sourced by the CPM system.

Issues with Using ABC Costs in CPMThere are a number of issues related to usingABC or a variant in CPM applications. These areaddressed below.

a. Cooperation between finance and otherdepartments One issue in developing CPM is that thefinance function and customer-level management must communicate clearly sothat cost information aimed at measuringresource consumption is captured correctlyin the system. This requires more coopera-tion between finance and other functionsthan is typically observed in many organiza-tions. If the company is currently using ABC,the application may have to be modified toinclude all customer-related costs and toapply ABC costs to customers as the costobjects. If the company is not using ABC, thenits subsequent design must be driven by therequirements of the CPM system.

b. Accuracy of costs Cost accuracy results from accurate costclassification, activity definition, activitycost pool determination, cost driver selection, data collection, and cost objectassignment. A successful installation of CPMrequires an accurate and functional costingsystem, preferably based on ABC or somevariant.

In developing customer cost information, it isimportant to keep in mind that complexity iscostly, not only in the development of the costinformation, but also in maintaining the cost driv-er information. A balance must be struck betweeninformation accuracy and complexity. As manyimplementers have discovered, attaining a highlevel of accuracy in costing may not only chal-lenge the comprehension of those who use thesystem, but it also increases the cost of developingand maintaining the system.

c. Capitalization and amortizationGAAP accounting currently requires theexpensing of costs considered period costs,such as marketing and R&D costs. A questionarises in costing for CPM purposes ofwhether such costs are capitalized as assetsand amortized over a reasonable period oftime. Other candidates for capitalization andamortization include unsuccessful salesefforts and large marketing campaigns.Whether a company decides to expense orcapitalize these expenses in the CPM systemwill depend on its particular circumstances;regardless, these decisions should be madeduring the foundation basics phase when thefocus is on the best CPM system for the company.

d. Arbitrary cost allocationsIt is important to recognize that some costassignment is arbitrary in nature. Even whenABC is used, some cost assignment may stillbe arbitrarynamely facility and business-sustaining costs. Examples include: 1) facilitysustaining costs in manufacturing, which aretypically assigned as product costs; 2) facilitysustaining costs of marketing, sales, distribu-tion, and post-sale services, which are typically assigned as costs to serve; and 3)business-sustaining costs of research and

22


development, landscaping, corporate head-quarters, and senior executives salaries.While the cost assignment for some of thesecosts using ABC can be arbitrary, it is impor-tant to realize that conventional costingresults in arbitrary cost assignments, not onlyof facility and business-sustaining costs, butalso of most other indirect and shared costs.In ABC, the allocation of facility and business-sustaining costs is necessarily morearbitrary than activity costs based on causality.

e. Cost controllabilityOne question that typically arises in theimplementation of a CPM system is this:What is the systems primary purpose (aquestion addressed in the decision phase)?Some stakeholders may prefer that the system focus on measuring employee perfor-mance rather than customer profitability.This SMA is concerned with customer profitability management, and employee performance is certainly related to CPM. Butthe primary focus of a CPM system should beon having the best available information tomanage customer profitability.

The issue of cost controllability arises in connection with employee performancemeasurement. This would require some modification or adaptation of CPM informa-tion that is focused on controllability andemployee performance measurement.Separating costs as controllable or uncontrollable is tricky and difficult to capture in the costing system, as controllabil-ity is dependent on managerial hierarchy andtime horizon. It is less difficult to deal withthe controllability issue in the reporting system than it is in the costing system. Forexample, it is possible to deal with this issue

in a multiple performance indicator systemsuch as the balanced scorecard rather thanembedding controllability as a primary criterion for the CPM costing system.

f. ABC provides full absorption costsABC is often implemented as a full-absorption costing system that ignoresthe difference between fixed and variablecosts in assigning costs to the cost object. InCPM, this full cost is only partial, as customercosts may or may not include business-sustaining costs.

The reasons for the full-costing focus of ABCare twofold. First, cost trends in recentdecades are toward cost structures that areheavily loaded with fixed costs. To assigncosts to cost objects, fixed costs cannot beignored, and the case is no less compelling forcustomer activity-based costing. Second, thetraditional approach toward managing fixedcosts is through long-term decisions thatchange the levels of fixed costs.

Supporters of ABC claim that fixed costsmust be managed through the managementof capacity. Any unutilized capacity costshould be highlighted so that managementcan either improve profitable capacity utiliza-tion or decrease the level of capacity. Ineffect, capacity costs are considered to besomewhat flexible, and that view contributesto corporate agility that is necessary for survival in a dynamic economic environment.If not, management is likely to accept the current level of fixed costs as uncontrollablein the short term, thus deterring managersfrom searching for alternative options to utilize or to decrease capacity.

23


On the other hand, it is important to realize thatlong-term performance measures, such as cus-tomer profitability using ABC, can only providesignals for management about long-term prof-itability. Any decision that might be considered asa result of these signals requires an entirely dif-ferent analysis related to the differential effect ofthe decision on cash flows and company prof-itability. Customer profitability indicators tell management where to look but not what to do.For example, to delete an unprofitable customerbased on ABC may result in decreasing ratherthan improving profits, since some of the fixedcosts may not be avoidable, at least in the shortterm.

g. The cost behavior dilemmaFixed costs are typically included in ABCassigned customer costs, and the resultingcustomer profit does not represent the effecton company profits if a similar customer isadded or this customer is lost to the company.This raises the question of whether customer profitability should be measured intwo ways: full-absorption ABC and variable-costing ABC. In other words, the idea is to usevariable costing in addition to full-absorptioncosting.

The behavior of resource costs is challengingas it relates to the ability to adjust capacity ofany resource. This adjustability criteriondepends on the planning horizon and the easeor difficulty in adjusting capacity (resourcecost stickiness). In addition, decision makingis future-oriented while cost accumulationand assignment using any costing system arenecessarily historical. Any decision related toadding or dropping a customer or customer

segment, or modifying a customer relation-ship, necessarily requires special decisionanalysis related to the differential effects ofthat decision.

The application of ABC is sufficiently com-plex and challenging. To develop two sets ofABC costs, variable and full, is cumbersome.Even if both systems were developed, theresults of each system will only provide signals but will not directly help in decisionsrelated to customers without further analysisthat focuses on those specific decisions.Accordingly, developing a dual ABC system isa possibility that should only be considered inlight of the resulting complexity and cost.Regardless of the choice of a full ABC only, avariable ABC only, or a dual ABC system, theresults should be viewed as providing signalsthat require further decision-specific analysisto evaluate any proposed action.

h. Reconciliation of cost information with the general ledgerCustomer cost information is derived fromcost driver quantities and cost driver con-sumption. Such information is derived fromactivity cost pool information, which in turnis derived from the general ledger (GL) ordirectly from GL subsystems that feed the GL(e.g., accounts payable, payroll). The customer costs assigned to all customers orcustomer segments should reconcile withactivity cost pools, which in turn should rec-oncile with the GL accounts or their expensetransaction sources of functionally classifiedexpenses. Customer costs for a time period, intotal, should be the same as the GL functionalcosts unless the ABC system includes imput-ed costs not recognized in the financialaccounting system.

24


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EXHIBIT 9. COST WHAT YOU CAN SOURCE

i. Unutilized capacityIn applying activity-based costing, there aretwo main approaches related to the selectionof capacity to use in the development of costdrivers: ABC and TDABC. Early applicationsof ABC tended to ignore unutilized capacity.These applications estimated usage orexpected capacity utilization as the denomi-nator in developing activity driver rates. Thecost of unutilized capacity was thus not isolated, and activity driver rates were usuallyhigher than if the cost of unutilized capacitywas isolated. While it is possible to use practical capacity of each cost driver in deter-mining each activity cost driver rate, whichwould isolate the cost of unutilized capacity,supporters of time-driven ABC tout theirapproach not only because of its alleged simplicity but also because it isolates thecost of unutilized capacity and assigns onlythe costs associated with utilized capacity inthe activity driver rates.

Supporters of time-driven ABC claim that itis simpler to use than traditional ABC andthat it avoids the subjectivity of extensivesurveys. Both traditional ABC and TDABCcan use practical capacity in determining costdriver rates. Incorporating practical capacitydoes add a layer of complexity, as well as anelement of subjectivityand possiblyattempts to game the system. Nonetheless,incorporating practical capacity has the dualbenefit of keeping cost driver rates constant;as the denominator, the practical capacitylevel of each cost driver does not frequentlychange. It also isolates the cost of unutilizedor unused capacity, which can be helpful inmanaging capacity costs by evaluating alter-natives for the utilization of unused capacityor for the reduction of capacity.

It should be noted that practical capacityusage is not unique to TDABC and can beused in connection with any application ofABC. All that would be required in ABC is touse practical capacity, instead of expectedusage, of each cost driver in the denominatorin determining the activity cost driver rate.This would have the effect of showing theunused capacity of each cost driver and thecost of unused capacity of each activity. Thusthe argument for TDABC reduces fundamen-tally to its simplicity.

Regardless of whether practical capacity isincorporated in ABC or not, it is clear thatcosting issues dominate in the measurementof customer profitability. The careful devel-opment of the costing system and its mainte-nance are critical in customer profitabilitymeasurement and management. It is no exag-geration to describe costing as the Achillesheel of CPM.

VI. TRANSACTION DATAThe two preceding sections discuss the founda-tion basics and costing for a CPM system, both ofwhich are highly dependent on the availability oftransaction data. In the foundation basics, thecost object is established, but measuring the prof-itability of the cost object requires transactiondata be available for it. Likewise, other foundationbasics, such as the product and the channel, aredependent on the availability of transactioncounts (cost driver quantity) for those items.Regardless of the desirability of a particular costobject, that cost object cannot be used withouttransaction data to support it.

For example, in the banking industry an impor-tant component of customer account profitabilityis the number of times an account holder cashes acheck. Developing activity driver rates for cashing

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checks requires data at two levels: (1) how manytotal checks were cashed to use as the denomina-tor in the ABC cost calculationspractical capacity could be used instead; and (2) how manychecks were cashed by each customer account(the cost object) to apply in calculating customeraccount profitability. Knowing how many totalchecks were cashed enables the calculation of costdriver rates, but this is of little value if the numberof checks cashed is not available for each andevery customer account (the cost object).

Data SourcesThe sources of the transaction data used in theCPM system will vary by industry and come fromdisparate computer systems within each compa-ny. Some data will come from the financial systems, such as general ledger data. Other data,such as transaction driver data, will come fromcore application systems such as sales and ERPsystems. Some companies are fortunate enough tohave built a data warehouse depository, whichmay contain much of the needed data and provides one-stop data shopping.

The elemental concept that transaction data mustbe available for an activity driver can be expressedin the maxim, Cost what you can source, andsource what you can cost. This says to include anactivity cost only when its driver data can besourced for the cost object, and not to source driver data for the cost object when there are norelated activity cost pools from which to developcost driver rates.

It is not uncommon to find situations whereactivity cost pools can be built, but activity driverusage data (the number of times an activity is performed) is not available for the cost object. Forexample, it may be observed that an employeespends 5% of her time answering customer questions, but the core application systems

cannot tell which customers asked questions andwhich did not; the activity driver data is not available for the cost object. In this case, the activity cost pool will require another approach,such as combining it with a more general customer-sustaining activity cost pool. The resultis the activity cost pool, although disproportion-ately consumed by a subset of customers, ischarged to all customers using the more generalactivity driver.

Exhibit 9, Cost What You Can Source, provides agraphical representation for a bank or creditunion of tracing the cost of resources from functionally classified general ledger costs toactivities, forming activity cost pools, that arethen traced to the individual cost objects usingcost driver rates. The cost driver rates are multiplied by the activity usage counts to yieldcosts for individual customer accounts (the costobject).

Add Demographic DataThe analytical robustness of the CPM system isenhanced with the addition of cost object datathat is not cost- or revenue-related. Customerdemographic data, for example, can provide information such as age, address, Zip Code,income group, and purchasing preferences. Otherdata may be internally generated, such as thelength of the customers relationship with thecompany, the customers sales representative, andthe customers payment history.

Once profitability is determined for the costobject, then profitability can be viewed not onlyfor the cost object (e.g., customer account), butalso by the demographic data added. For example,one can analyze customer profitability by agegroup or generation, or by the length of a customers relationship, if this data is sourced forthe cost object. Demographic data is another take

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on the concept of multidimensional profitabilitydiscussed earlier (refer to Exhibit 4, TheMultidimensional Views of Profitability).

Accurate, repeatable, and timely sourcing oftransaction and other data to the CPM database isdifficult and requires great diligence to design,implement, and maintain. Sourcing data posesone of the greatest risks of failure to a CPM sys-tem. See Appendix 2, Technical Considerationsfor the Management Accountant, for additionalinformation on sourcing and maintaining data ina CPM system.

VII. SYSTEM OPTIONSThe selection of the information system infrastructure needed to support the CPM systemwill be dependent on the decisions made in thehighly interrelated foundation basics, costing, anddata phases. Once the groundwork has been laidfor these three phases, then selection of the information system infrastructure can begin.

Selection of the Database EnginesIn general, there are two separate calculationengines needed for CPM: one for costing, whichcalculates the cost driver rates; the other for costobject profitability, which applies those cost driv-er rates to the cost object. Some commercialproducts combine the cost system and the profitability system into one CPM database infrastructure, but most often the costing andprofitability systems are two separate modules orapplication systems.

There are three basic choices when selecting aCPM application system, whether for costing,profitability, or both:

1. Develop in-house2. Purchase3. Outsource

Developing an in-house application providesmaximum opportunities to custom design theCPM system. Customization comes at a cost, however, including significant managementaccounting and information technology resourcesand long implementation timelines. Further,internally developed applications often becomeoutdated as they have difficulty keeping up withthe technology of commercially developed off-the-shelf products. A large bank a few yearsago developed its own costing system in-house atgreat expense, only to abandon it three years laterfor lack of features available in commercial products.

Although purchasing a commercial off-the-shelfsoftware application will reduce the ability to customize, it will also reduce the cost and time toimplement a CPM system. Even with a purchasedapplication, though, it will not start generatingcost driver rates and customer profitability theday it is installed. These applications are morelike Excel when first opened: a blank worksheet.It is left to the purchasing company to input allthe necessary data, establish their relationships,write the formulas that perform the calculations,and generate the companys cost driver rates andcustomer profitability. Advanced commercialCPM systems do some of this internally; nonethe-less, products, channels, relationships, transac-tion usage data, and model specifics must beestablished by the purchaser.

The third system option is an outsourced or hosted solution. Often referred to as anApplication Service Provider (ASP) or Software asa Service (SaaS), the approach entails providingcompany data to a third-party vendor, which runsthe costing and/or profitability system on itscomputers and returns output tables and reportsto the company. A hosted solution provides thefewest opportunities for customization, but it also

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provides the lowest initial costs and fastest timeto implement. Ongoing periodic payments aregenerally required as the monthly or quarterlyprofitability reports are produced and delivered.Data security and customer privacy require special attention with a hosted profitability solution.

Other Application System ConsiderationsInformation systems and databases external tothe CPM system will be called upon regardless ofthe system option chosen. These external systemsmay already exist or may need to be developed.Two basic types of external systems are thosethat: (1) provide information to the costing orCPM systems and (2) receive information fromthe costing or CPM systems.

First, external systems will provide informationthat is used by the CPM system in calculatingactivity driver rates and customer profitability.The accounts receivable system would likely pro-vide data to the CPM system, as would an order-ing or sales tracking system. Transaction datafrom core application systems is an example ofdata sourced from external systems.

The second type of external system is the end-result reporting system used to deliver the calculated costing and customer profitabilityinformation to employees. Examples wouldinclude summaries on departmental balancedscorecards, the profitability of specific customersreported to sales staff, or data warehouses withquery tools for costing or customer profitabilityanalysis. How the costing and customer profitability results are disseminated throughoutthe organization will have a big impact on thesuccess of the CPM system.

One final system consideration is the ongoingmaintenance and occasional upgrades and

refinements that the costing and profitabilitysystems will require. Customer profitability systems, whether purchased or internally devel-oped, will have software upgrades requiringinstallation and testing. Refinements to the system will also be required when processeschange that affect the cost driver rates or whendata not available before can be sourced. Anyrefinements or upgrades need to be designed,documented, installed, and tested.

V I I I . B U S I N E S S A L G O R I T H M SThe formulas and calculations used to generatecost driver rates and cost object profitability arereferred to as business algorithms or rules. Thebusiness algorithms must be designed, docu-mented, input to the costing and profitabilitysystems, and tested. The model builder tells theapplication system how to manipulate data tocalculate cost driver rates and cost object profitability, much like an Excel user programsformulas into a spreadsheet.

The degree to which the company is involved inthe design and implementation of the businessalgorithms depends on decisions made in the system options phase. The in-house developedsystem and, to a lesser extent, the purchasedapplication system provide almost unlimited customization of the business algorithms. Theoutsourced solution, while providing the purchaser little control over the business algorithms, normally uses industry best practicesbusiness algorithms.

To the extent possible, line and back-officeemployees should be involved in the design of theCPM system; they are sure to know more abouthow their areas work than do the model builders.Including employees in the design of the CPMsystem, or at least providing them an understand-ing, will go a long way in obtaining their buy-in.

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Employee acceptance will encourage using thecustomer profitability information in construc-tive and creative ways that add value to the organization. Section XI, BehavioralConsiderations, discusses this subject further.

Customization and CostsWhile the in-house developed or purchased CPMapplication systems provide plenty of opportunityto customize the business algorithms, this customization comes at a cost and produces several unavoidable pitfalls. Situations arisewhere there is more than one approach to calculating activity driver rates and cost objectprofitability with the different approaches yield-ing different results. As a consequence, control ofthe business algorithms will spawn politicalinfighting over which methodology to use, witheach department manager encouraging whichev-er methodology benefits his department the most.For example, the cost of marketing campaignsmay be assigned to current sales or capitalizedand amortized; the marketing department willgenerally favor capitalization since it lowers thecost driver rate of making a sale.

The way to avoid political infighting over businessalgorithms and accounting methodologies is tomake the difficult accounting choices during thefoundation basics phase, when the focus is ondesigning an accurate and strategic CPM system.

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