Which customers are costing you money?

Your largest customer may be your least profitable one. They order often and in small quantities, want everything urgently, call about every delivery and pay late. On the revenue ranking they are at the top; in reality they cost you money. Robert Kaplan, one of the founders of activity-based costing, writes that a skewed distribution of profit across customers occurs in virtually every customer profitability study ever done (source: Harvard Business School, August 2005).

That pattern is known as the whale curve: some customers generate more profit than the company earns in total, others take that profit away again. Knowing which customers sit where lets you act with precision. The analysis is just as relevant for an owner-managed wholesaler as for the commercial finance team of a large group.

Why gross margin per customer is not enough

Most companies know revenue and gross margin per customer. What they do not know is what it costs to serve that customer. Kaplan names the cost drivers that make the difference: small order quantities, special packaging, expedited deliveries and just-in-time delivery (source: Harvard Business School, August 2005). Those costs sit in overhead: in the time of customer service, the warehouse, transport and accounts receivable. They are spread over everyone, so the expensive customer looks cheap and the easy customer looks expensive.

The method: activity-based costing per customer

Activity-based costing assigns indirect costs to the activities that cause them, and then to the customers who require those activities (source: Harvard Business School, August 2005). The classic approach asked employees to estimate what share of their time went to each activity. Kaplan and Anderson call that a weak point (source: Harvard Business School, January 2005) and developed a simpler variant: time-driven activity-based costing. For each group of resources, it needs only two estimates: the cost per unit of time and the time an activity takes (source: Harvard Business Review, November 2004).

The basics of activity-based costing, with a worked example for cost price, are in activity-based costing.

The five steps

1. 01

   Gross margin per customer

   Revenue minus cost of sales per customer, over a full year, including retrospective discounts and bonuses.

2. 02

   Choose the activities that differ per customer

   Order processing, deliveries, quotes, customer contact, invoices and reminders. Only activities where customers really differ.

3. 03

   Set the cost per minute and the time per activity

   The cost of a department divided by its available time gives the cost per minute. Measure or estimate how long an order, a delivery or a reminder takes.

4. 04

   Calculate the cost to serve

   Per customer, multiply how often each activity occurred by its time and by the cost per minute. Deduct the total from gross margin.

5. 05

   Rank and draw the curve

   Sort customers from most to least profitable and add up the profit cumulatively. The shape of that line shows in one picture where money is made and where it leaks.

What to do next

The temptation is to drop unprofitable customers. Kaplan advises looking inside first: how can you improve your own processes so that serving these customers costs less (source: Harvard Business School, August 2005)? Then comes price. With menu pricing, customers pay for the services they use, and each item has a price that at least covers its cost (source: Harvard Business School, August 2005). Large customers with low profit need their own approach; Harvard Business Review calls identifying them the essential first step (source: Harvard Business Review, September 2021).

Is profit falling while revenue grows? An unprofitable customer group may be the cause. Read also revenue up, profit down.

The calculation model and the conversations

Below you will find a fully worked example with five customers, a list of fifteen cost drivers with how to measure them, a decision table by customer type and the structure of the conversation with a customer who costs you too much.