Manage Customers for

Profits (Not Just Sales)

by Benson P. Shapiro, V. Kasturi Rangan,

Rowland T. Moriarty, and Elliot B. Ross

Harvard Business Review

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 HBR
SEPTEMBER–OCTOBER 1987

Manage Customers for Profits

(Not Just Sales)

Benson P. Shapiro, V. Kasturi Rangan,

Rowland T. Moriarty, and Elliot B. Ross

H igh sales volume does not necessarily mean nance work, and expedited delivery; and a national
high income, as many companies have purchase agreement with a hefty graduated volume
found to their sorrow. In fact, profits (as a discount.
percentage of sales) are often much higher on some Customers, however, viewed the program as merely
orders than on others, for reasons managers some- a dog-and-pony show, having no substance. To con-
times do not well understand. If prices are appropri- vince the skeptics, top executives personally offered
ate, why is there such striking variation? Let’s look greater sales and service support and even more gener-
at two examples of selling and pricing anomalies: ous discounts.
Sales finally turned upward, and this “success”
M A plumbing fixtures manufacturer raised prices justified even higher levels of support. But profit
to discourage the “worthless” small custom orders margins soon began to erode; the big national ac-
that were disrupting the factory. But a series of price counts, the company discovered, were generating
hikes failed to reduce unit sales volume. A study of losses that were large enough to offset the rise in
operations two years later revealed that the most
profitable orders were these custom orders. The new
high prices more than compensated for costs; cus-
tomers weren’t changing suppliers because of high Benson Shapiro, Kasturi Rangan, and Rowland Moriarty
switching expenses; and competitors had shied from are professor, assistant professor, and associate professor
short runs because of the conventional wisdom in the of business administration, respectively, at the Harvard
Business School. All teach marketing. Elliot Ross is a
industry.
principal in the Cleveland office of McKinsey & Company.
M A prominent producer of capital equipment, He focuses on strategy formulation with industrial clients.
realizing it was losing big sales potential in its
largest accounts, started a national account pro- Authors’ note: For their help in developing this article, we
gram. It included heavy sales support with experi- thank Harvard Business School professors Thomas V.
enced account managers; participation by high-level Bonoma, Robert J. Dolan, Robert S. Kaplan, and Arthur
executives; special support like applications engi- Schleifer, Jr., and Ronald M. Whitefield of Data Resources
neering, custom design services, unusual mainte- and McGraw-Hill.

Copyright © 1987 by the President and Fellows of Harvard College. All rights reserved.
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 EXHIBIT 1
Wide Gross Margin Dispersion for a Pipe Resin Manufacturer for One Month

Net
price

Cents $ .39
per pound

4%
.37 of sales

.35

.33

.31

.29

.27
t
in
po 13%
n
eve of sales
a k-
re
B
$ .25 .27 .29 .31 .33 .35 .37 .39

Cost to Cents
serve per pound

volume and the profitability of smaller, allegedly less Many companies make this mistake. Managers pay
attractive accounts. little attention to account profitability, selection,
and management. They seldom consider the magni-
Clearly these two companies discovered that it tude, origins, and managerial implications of
costs more to fill some orders than others. The profit dispersion. In this article we examine three
plumbing fixtures executives raised prices precisely central aspects of this important factor: costs to
because they knew it was costing them more to fill suppliers, customer behavior, and management of
small custom orders. The capital equipment com- customers.
pany willingly took on extra costs in the hope of
winning more sales. Management in both companies
recognized that their price tags would vary, the first COSTS TO SUPPLIERS
from boosted prices on custom orders, the other be-
cause of volume discounts. But executives in both Profit, of course, is the difference between the net
companies failed to see that the cost and price vari- price and the actual cost to serve. In terms of individ-
ations would cause profound differences in the prof- ual accounts and orders, there can be dramatic differ-
itability of individual accounts and orders. ences in both price and cost.

HARVARD BUSINESS REVIEW September–October 1987 3

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 Off-peak orders cost less than those made when de-
EXHIBIT 2
Customer Classification Matrix mand is heavy. Fast delivery costs more. Some orders
call on more resources than others. A company that
inventories products in anticipation of orders, how-
Net High Passive Carriage ever, will have difficulty tracing production costs to
price trade
particular orders and customers. Accounting policies
and conventions, furthermore, often cloud the dis-
tinctions in product costs.
Distribution costs naturally vary with the cus-
tomer’s location. It also costs more to ship via a
preferred transportation mode, to drop ship to a sepa-
Bargain Aggressive rate receiving location, to find no back-haul opportu-
basement
nity, or to extend special logistics support like a field
inventory.
Postsale service costs also differ. Sometimes cus-
tomer training, installation, technical support, and
repair and maintenance are profit-making operations,
Low but businesses often bundle such services into the
Low High product price, and the buyer pays “nothing extra” for
Cost to them. For some items, including capital equipment,
serve
postsale costs are heavy.
Thus there are variations among customers in each
of the four components of cost: before-the-sale ex-
penses, production, distribution, and after-the-sale
service. Moreover, if prices and costs do not correlate,
Despite legal constraints that encourage uniform- the distribution of gross income will have a disper-
ity in pricing, notably the Robinson-Patman Act, sion that is the sum of the individual price and cost
customers usually pay quite different prices in prac- dispersions and thus much greater than either. Of
tice. Some buyers can negotiate or take advantage of course, prices and costs are often viewed as corre-
differential discounts because of their size or the lated, but our research suggests that they usually
functions they can perform themselves, like in-house aren’t—which produces a broad dispersion of account
maintenance or technical support. And some cus- profitability.
tomers exploit deals and promotions more than oth- With real cost-plus pricing, profitability could be
ers. Moreover, the costs of serving customers and uniform across customers despite wide variations in
filling orders can vary significantly. both costs and prices. But there is evidence that prices
Presale costs vary greatly from order to order and seldom reflect the actual costs in serving customers
account to account. Geography matters: some cus- (though they may be somewhat related to production
tomers and prospects are located far from the sales- costs). In many businesses, the difference between
person’s home base or normal route. Some customers the highest and lowest prices realized in similar
require seemingly endless sales calls, while others transactions for the same product is as much as 30%,
place their orders over the telephone. Some must be not including quantity discounts.1 Consider, for ex-
courted with top-level executives backed up by so- ample, the relationship between prices and total costs
phisticated account management techniques, while in one month’s orders for a manufacturer of pipe resin
others need little special effort. Such variations in (see Exhibit 1). The diagonal line indicates a price
cost reflect differences in customers’ buying proc- level equal to costs. If gross margin were the same on
esses or the nature of their buying teams. (Some all orders, the orders would all lie along a line parallel
teams are large and geographically and functionally to the diagonal line. Instead, they are widely dis-
dispersed; others are small and concentrated by loca- persed. Nearly 13% of sales volume resulted in losses
tion and/or function.) Finally, some customers de- of about a nickel a pound, while about 4% of volume
mand intensive presale service, like applications en- generated an eight-cent profit. The rest fell some-
gineering and custom design support, while others where between.
accept standard designs. This pattern is not unusual. In a wide variety of
Production costs also vary by customer and by situations, we have consistently observed a lack of
order. Order size influences cost, as do setup time, correlation between price and the cost to serve. Some
scrap rate, custom designs, special features and func- orders and customers generate losses, and in general
tions, unusual packaging, and even order timing. the dispersion of profitability is wide.

4 HARVARD BUSINESS REVIEW September–October 1987

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CUSTOMER BEHAVIOR EXHIBIT 3
Customer Matrix of an Industrial Packaging Materials
It is useful to think of customers in terms of two Supplier
dimensions: net price realized and cost to serve. To
show graphically the dynamics of the interplay be-
Net High
tween seller and buyer, we have devised a simple price
Passive
20%
Carriage
trade
matrix (see Exhibit 2). The vertical axis is net price, 15%
low to high, and the horizontal axis is cost to serve,
low to high. This categorization is useful for any
marketer. The carriage trade costs a great deal to
serve but is willing to pay top dollar. (This category
would include the customers of our introductory
example, who placed small orders for high-cost cus- Bargain Aggressive
basement 31%
tom plumbing fixtures.) At the opposite extreme are 34%
bargain basement customers—sensitive to price and
relatively insensitive to service and quality. They can
be served more cheaply than the carriage trade.
Serving passive customers costs less too, but they
are willing to accept high prices. These accounts Low
generate highly profitable orders. There are various Low High
reasons for their attitude. In some cases the product Cost to
serve
is too insignificant to warrant a tough negotiating
stance over price. Other customers are insensitive to
price because the product is crucial to their operation.
Still others stay with their current supplier, more or
less regardless of price, because of the prohibitive cost A supplier of industrial packaging materials re-
of switching. As an example from another industry, cently analyzed the profitability of its large national
many major aircraft components cannot be changed accounts. For each one it calculated approximate
without recertifying the entire aircraft. And in some indicators of net price and cost to serve, based on
cases vendor capability is so well matched to buyer averages of the aggregate values of a year’s transac-
needs that cost to serve is low though the customer tions. Top officers expected to find most of its cus-
is receiving (and paying for) fine service and quality. tomers in the carriage trade quadrant and the rest in
Aggressive customers, on the other hand, demand the bargain basement. They were shocked when the
(and often receive) the highest product quality, the results put about half of the 164 large customers in
best service, and low prices. Procter & Gamble, boast- the passive and aggressive quadrants (see Exhibit 3).
ing an efficient procurement function, has a reputa- We believe this pattern is more common than is
tion among its suppliers for paying the least and generally recognized. Among the various factors in-
getting the most. Aggressive buyers are usually pow- fluencing buying behavior, the most important are
erful; their practice of buying in large quantities gives the customer’s situation and migration patterns.
them leverage with suppliers in seeking price deals
and more service. The national accounts described in
the second example at the beginning of this article Customer’s Situation
drove hard bargains with the capital equipment sup- Four aspects of the customer’s nature and position
plier. affect profitability: customer economics, power, the
Marketing managers often assume a strong corre- nature of the decision-making unit, and the institu-
lation between net price and cost to serve; they rea- tional relationship between the buyer and seller.
son that price-sensitive customers will accept lower As we all know, fundamental economics helps
quality and service, and demanding customers will determine a buyer’s price and service sensitivity.
pay more for better quality and service. Thinking in Customers are more sensitive to price when the
terms of service and quality demands unfortunately product is a big part of their purchases, more sensitive
deflects attention from the critical issue of cost to to service when it has a big impact on their opera-
serve. In addition, weak cost accounting practices tions. Independent of economics, buying power, of
that average costs over products, orders, and custom- course, is a major determinant of the buyer’s ability
ers often support the high-cost, high-price myth. But to extract price concessions and service support from
as we have seen, costs and prices are not closely vendors. The power of big customers shows in their
correlated. ability to handle many aspects of service support

HARVARD BUSINESS REVIEW September–October 1987 5

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in-house—like breaking bulk—for which they de- CAD/CAM equipment), the buyer may pressure the
mand price adjustments. Sometimes small custom- supplier for price reductions even while service re-
ers also wield considerable power. A technological quirements remain high. The migration tends to be
innovator that influences industry standards com- downward from the carriage trade toward the aggres-
mands the eyes and ears of suppliers. Thus the rela- sive quadrant, as in the case of electrical generation
tionship of cost to serve and customer size in this equipment for utilities. In commodities like pipe
industry is not clear without careful measurement. resin, a combination of customer experience, expand-
In respect to the decision-making unit, the pur- ing influence of the purchasing staff, and increasing
chase staff is generally sensitive to price, while engi- competitive imitation often leads customers into the
neering and production personnel are sensitive to bargain basement category.
service. These roles will affect decisions, depending
on who most influences vendor choice and manage-
ment. MANAGEMENT OF CUSTOMERS
Naturally, this element is bound up with any rela-
tionships that have built up between the buyer and The shifts toward the bargain basement and aggres-
seller. Long-standing friendships, long histories of sive quadrants are part of the general tendency of
satisfactory performance, and appreciation for any products to evolve from high-margin specialties to
special help or favors all tend to make customers low-margin commodities. The dispersion of cus-
reluctant to pressure suppliers for price and service tomer profitability we have observed can be managed.
concessions. Procter & Gamble rotates the responsi- We suggest a five-step action program: pinpoint your
bilities of its purchasing department members to costs, know your profitability dispersion, focus your
discourage the development of strong personal rela- strategy, provide support systems, and analyze re-
tionships with vendors. peatedly.
Pinpoint your costs. Manufacturers can usually
Migration Patterns measure their factory costs better than costs incurred
Changes in organizational buying behavior and com- by the sales, applications engineering, logistics, and
petitive activity can produce predictable patterns of service functions. For instance, few companies have
change in customer profitability. Often a relationship a sense of the cost of unscheduled executive effort to
begins in the carriage trade category. Customers need handle the demands of aggressive customers. So it
extensive sales and service support, insist on high seems likely that customer profitability varies more
product quality, and do not worry much about price widely in businesses where a large percentage of the
if the product is new to them. They need the func- total expenditure is incurred outside the factory. This
tionality and will pay for it. would be the case in many high-tech companies that
Over time, however, as the customers gain experi- have low manufacturing costs but spend a great deal
ence with the product, they grow confident in dealing on sales, design engineering, applications engineer-
with the vendor and operating with less sales and ing, and systems integration.
service support or even without any. The cost of Because many specialty products are custom de-
serving them is likely to decline, and they are likely signed and manufactured and carry heavy nonfactory
to become more price sensitive. In addition, the buy- costs, the cost dispersion for these products is greater
ing influence of the customer’s procurement depart- than for commodities. But as we pointed out in our
ment often grows, while the role of engineering and pipe resin example, profit dispersion can be high even
operating personnel diminishes. This shift, of course, in a commodity product.
reinforces the tendency toward price sensitivity and Costs incurred at different times in the order cycle
away from service concerns. Finally, through rival have different effects on the true cost to serve the
product offerings (often at lower prices), customers customer or order. In major sales with long order
gain knowledge that improves their competence with cycles and long lead times, the presale effort may
the product and thus their ability to demand price begin several years ahead, and service under warranty
concessions and lessen their dependence on the ven- may extend several years after installation and bill-
dor’s support efforts. ing. If the cost of capital is 15%, a dollar spent two
If the customer perceives the product as trivial (as years before the billing of the customer is worth
in the case of office supplies) and therefore does not $1.32, and a dollar spent three years after billing is
seek it avidly, price sensitivity will not necessarily worth only 61 cents at the time of delivery. Compa-
increase as service needs abate. In terms of the matrix nies with long lead times and order cycles, such as
in Exhibit 2, migration will be toward the passive and sellers of power generation equipment and commer-
bargain basement areas. If the buyer values the prod- cial airliners, with long-term, substantial service li-
uct and it is complex or service sensitive (like abilities, evidently have cost dispersions much larger

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than average, except where progress payments bal- pricing schemes will find most of their accounts in
ance out cost flows. These companies need particu- the bargain basement or carriage trade quadrants of
larly good control systems and management judg- the matrix. Though this pattern is perfectly reason-
ment to measure costs and act accordingly. able, sales management should try to develop ac-
Companies with poor cost accounting systems counts in the passive quadrant. Many such customers
have no way to determine order, customer, product, will accept higher prices because they like the prod-
or market segment profitability. Consequently, their uct so much. The cost to them of negotiating a lower
cost control and management systems will be weak, price (or better service) outweighs the extra benefits
and the result is likely to be above-average dispersion they would get. The passive quadrant represents a
of costs. The sales manager of a large office equip- region of maximum value for both the seller and the
ment supplier who lacked adequate cost information buyer.
described his situation thus: “It’s management by A dispersion of profits is no bad thing; only not
anecdote. Salespeople regularly make passionate knowing it exists is. The best-managed companies
pleas for price relief on specific orders. When I press know their costs well and set prices on the basis of
them for reasons, they say `threat of competitive product value to customers rather than cost to serve.
entry.’ When I ask them if a cutback in service would So they have some accounts in the passive categories.
be acceptable to make up for the price decrease, they In fact, their profit dispersion will be greater than that
give me a resounding no! What choice do you have in of companies pricing on a cost-plus basis. The worst
the absence of cost data, except to go by your judg- managed companies, ignorant of their costs and set-
ment of the salesperson’s credibility? I’ve wrongly ting prices mainly in response to customer demands,
accepted as many bad price relief requests as I’ve are likely to have a large number of accounts in the
rejected.” aggressive category, with, obviously, pessimistic im-
An effective cost accounting system records data plications for profitability.
by product, order, and account, and records costs Focus your strategy. The next step is to use your
beyond the factory, including selling, transportation, knowledge of cost, price, and profit dispersion to
applications or design engineering, and even unusual, define a strategy for managing your accounts. Here
unprogrammed activities like investments of blocks the company defines its personality. The low-cost,
of corporate management time. Presale, production, low-service, low-price provider is in the lower left of
distribution, and postsale service costs should all be a profitability matrix, while the company that offers
recorded, analyzed, and related to orders and ac- differentiated and augmented products, intensive
counts. service, and customization—and, therefore, more
Of course, there are enormous difficulties in creat- value added—is in the upper right quadrant. Because
ing and maintaining such a system. But even a system any company’s capability is necessarily limited, it
that estimates such costs only approximately can cannot span the entire dimension. If it tries to, the
help a great deal. Twice a year, for example, one poor focus will leave the company vulnerable to
industrial company calculates the cost of serving competition. This will allow rivals to jump into the
three sizes of customers (large, medium, and small) aggressive quadrant with high service and low prices,
and two sizes of orders (truckload and less-than- drawing customers away from both the bargain base-
truckload) for a representative sample of accounts ment and carriage trade quadrants. The result for the
and orders. During the following six months, sales stretched-out company is reduced profitability.
managers use these numbers to guide their decisions The company has two strategy decisions to make.
on price-relief requests. One is to locate the center of gravity or core of the
Know your profitability dispersion. Once costs are company’s business along the axis. The other is to
known, the company can plot them against realized define the range along the axis it will cover.
prices to show the dispersion of account profitability, The fundamental choice to be made is the selection
as in Exhibit 2. Clearly the framework must be of customers, for companies that reside in a given
adapted to the characteristics of the business. Simi- quadrant will generally produce orders in that quad-
larly, the price axis should be defined in a meaningful rant. Customers in each quadrant of the profitability
way. Since list prices are often misleading, use some matrix behave in a distinctive manner. The supplier
sort of net price. However, discounts should not be has to decide which behavior is most consistent with
double-counted under costs as well. The ultimate its strengths. For instance, in an industry with high
objective is a measure of net profit by customer and transport costs, like cement or sand, a customer
order. Tracking cost and price data by order is an located at the maximum practical distance from your
essential first step in building an account profitability plant is likely to be in one of the right-hand quad-
matrix. rants—for you. For a competitor whose plant is lo-
Companies that know their costs and use cost-plus cated near the customer, that account will probably

HARVARD BUSINESS REVIEW September–October 1987 7

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be in a left-hand quadrant. Unless you can form a product and service. Likewise, the more a company
carriage-trade relationship with that customer—real- increases its cost to serve, the more important inter-
izing high prices because of the value of your serv- functional coordination becomes. Low-cost, low-
ices—you would do better to concede the account to price, low-service bargain basement operators don’t
your competitor. need and can’t afford elaborate logistics, field service,
Provide support systems. Unless it wants to follow and other coordinating mechanisms. Carriage trade
a policy of cost-plus pricing, the company needs to customers can’t operate without them.
develop processes and systems that will help it man- Deciding what strategic choices to make requires
age the profitability dispersion. The company’s infor- maintaining market research, pricing analysis, and
mation system should produce reports based on or- cost-accounting functions. While these are high-lev-
der, customer, and segment profitability, not just on erage operations in which small investments can
sales. Management must be oriented toward lateral yield high returns, in hard times companies often
cooperation among functions. A procedure that sim- view them as nonessential overhead expenses. This
ply rewards salespeople for high unit sales and manu- short-sighted attitude can be very damaging.
facturing personnel for low-cost production is un- Repeat analysis regularly. A one-shot profit disper-
likely to lead to the most profitable order mix. sion and strategy analysis is of little use. Buying
Price setting rates special attention. Companies behavior and migration patterns, like markets and
that operate in the bargain basement and aggressive competitors, are dynamic. Migration patterns gradu-
quadrants of the profitability matrix must often set ally dilute a company’s account selection and man-
up centralized offices to price large orders and screen agement policies.
customers’ demands for services. A “special bids” Cumberland Metals (a disguised name) made pol-
group is often the only way to give the quick replies lution control components for the Big Three auto
and careful analyses such orders require. Such a group companies in the mid-1970s. Margins were very good,
can best balance financial implications, production reflecting the high value the auto companies placed
and operating capacity, and customer needs, without on the product, their lack of experience with pollu-
giving away the store. Since carriage trade customers tion control, and the absence of competition. The
value the supplier’s extra services, a cost-plus pricing entry of competitors in the early 1980s and, on the
policy may be appropriate for them. Finally, pricing customers’ part, a shift in influence from engineering
for the trade in the passive quadrant has to be based to procurement staff signaled a fundamental migra-
on the value the customer places on the product. tion in their buying behavior, but Cumberland man-
The analysis, strategy, and customer negotiation agement ignored the warning signs. This inattention
functions must be kept separate. A men’s and boys’ caused long-standing customer relations problems
coat manufacturer we know of is a good example of and a prolonged earnings slump.
what happens when this rule is ignored. The owner’s Cumberland Metals is unusual because it had only
three sons headed divisions serving the department three large accounts. The loss of accounts and orders
store, discount store, and export markets, while the from the carriage trade quadrant is normally a matter
owner himself managed the private-label business. of erosion.
He called on the three big general merchandise chains How often a company should analyze profit disper-
(Sears, Ward, and Penney), one of which gave him sion and strategy depends on the rate of change in the
almost all of his business. The sons’ divisions were market and in technology. In many cases, a once-a-
very profitable, but the private-label unit was a big year analysis integrated with the annual marketing
money loser. plan makes sense. In high technology or other rapidly
Why was this so? Before a son went out to negotiate changing industries, a more frequent review may be
an order, the owner stressed the need to get high better. In any case, the main difficulty lies in setting
prices, keep costs reasonable, and secure orders that up good systems to track costs, prices, and profits;
fit the company’s abilities. The father analyzed large once the supporting information is available, the
orders for profitability. But when the father went to analysis is not difficult to perform.
talk to his biggest customer, no one pressured him to
keep profits up. He consistently caved in to demands
for lower prices, higher service, and better quality. MANAGE THE DISPERSION
His sons felt powerless to analyze his orders for
profitability. The lesson: the same person should not A custom fabricator of industrial equipment, though
set profit goals and negotiate with customers. operating at capacity, was losing money. The obvious
The more services a company provides, the more problem was low price levels for the industry. Inves-
coordination is necessary among the engineers, field- tigation, however, pointed to a mixture of poor pric-
service staff, and other functionaries in delivering the ing, poor cost estimating, and a lack of knowledge of

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profitability dispersion. Some bids were too aggres- ers that fit its production competence and capacity.
sively priced: after winning contracts, the company After a thorough before-and-after review, the finan-
then lost money on them. Executives had structured cial analysis department at headquarters declared
other bids to “make good money,” basing them on that the division had gone from a 5% loss to a 10%
inflated cost estimates. Astute competitors costed profit on sales in a glutted, static commodity market.
these bids better, handled the price negotiations more When meticulous analysis, a sensible strategy, and
skillfully, and won the contracts. So the fabricator effective implementation are combined, a company
was winning only unprofitable bids. can manage its profitability dispersion to generate
The electrical products division of a large corpora- profits, not just sales.
tion, on the other hand, understood the importance
of profitability analysis. It carefully analyzed its 1. See Elliot B. Ross, “Making Money with Proactive Pricing,”
costs, developed a proactive pricing approach, and Harvard Business Review (November–December 1984): 145.
meticulously selected orders, products, and custom-

HARVARD BUSINESS REVIEW September–October 1987 9

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