Three accounts, one product, and the ranking that inverts when orders, visits and payment terms are charged to the customer who causes them.
Customer profitability is pocket revenue less variable cost and commission, less the cost to serve that account: its orders, its sales visits and the cost of the credit it takes. On three illustrative accounts, the one paying the highest price, 131.00 a unit at a 42.0 per cent contribution margin, loses 3,098 a year once 16,866 of cost to serve is charged to it, while the distributor paying 104.00 earns 814,361. Spread the same cost by revenue and every account looks profitable.
Worked in full in Pricing Strategy by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Most businesses rank customers by price or by gross margin. Both rankings reward the small account that pays list less a little, and both miss what the account costs to serve: forty or fifty small orders a year, each one picked, packed and delivered; a salesperson's visit every fortnight; and invoices paid in seventy-five days. None of that sits in cost of goods. It sits in overheads, and an overhead allocated by revenue is allocated to the customers that cause it least.
| Account | Units a year | Pocket price | Orders a year | Sales visits | Days to pay |
|---|---|---|---|---|---|
| Northgate Distribution | 30,000 | 104.00 | 24 | 6 | 60 |
| Harlow Fabrication | 6,000 | 118.00 | 48 | 12 | 45 |
| Pennant Workshops | 250 | 131.00 | 52 | 24 | 75 |
Variable cost is 72.00 a unit and commission 3 per cent of revenue. The cost-to-serve rates come from an activity analysis of the warehouse, transport and sales budgets: 165.00 per order for handling, picking and delivery, 320.00 per fully loaded sales visit, and 9 per cent a year as the cost of carrying receivables. The pocket price is what the account pays after every discount, rebate and allowance; how to get there from list is in how to calculate pocket price from list price.
Step 1. Contribution after commission
Units × (pocket price − variable cost) − commission. Pennant: 250 × (131.00 − 72.00) − 3% × 32,750 = 13,768, a 42.0 per cent margin.
Step 2. Cost to serve, driver by driver
Orders: 52 × 165.00 = 8,580. Visits: 24 × 320.00 = 7,680. Credit: 32,750 × 75 / 365 × 9% = 606. Total 16,866, 51.5 per cent of the account's revenue.
Step 3. Account profit
13,768 − 16,866 = −3,098, or −12.39 a unit. In Excel: =B2*(C2-VarCost)-B2*C2*Comm-D2*OrderCost-E2*VisitCost-B2*C2*F2/365*CapCost.
| Account | Revenue | Contribution | Margin | Cost to serve | Account profit | Per unit |
|---|---|---|---|---|---|---|
| Northgate | 3,120,000 | 866,400 | 27.8% | 52,039 | 814,361 | 27.15 |
| Harlow | 708,000 | 254,760 | 36.0% | 19,616 | 235,144 | 39.19 |
| Pennant | 32,750 | 13,768 | 42.0% | 16,866 | −3,098 | −12.39 |
| Total | 3,860,750 | 1,134,928 | 88,520 | 1,046,407 |
By margin the order is Pennant, Harlow, Northgate. By profit per unit it is Harlow, Northgate, Pennant, and Pennant is negative. The cause is order size: Northgate takes 1,250 units an order and carries 1.73 of cost to serve per unit; Pennant takes about five units an order and carries 67.46. Harlow, in the middle on price, is the best account per unit in the book, because it buys in economic quantities and still pays well.
The 88,520 of cost to serve is 2.29 per cent of revenue. Allocate it that way, as most management accounts do, and Pennant is charged 751, makes 13,017 and shows a 39.7 per cent margin, the best in the book. Northgate is charged 71,536 instead of the 52,039 it causes. The allocation does not change the total profit, but it moves 19,497 of cost from the two smaller accounts onto the large one and tells the sales team to chase the customers who destroy value. Revenue-based allocation of cost to serve is the reason so many businesses discover their small accounts only when they close a depot.
| Orders a year | 124.00 | 131.00 | 140.00 |
|---|---|---|---|
| 12 | 1,837 | 3,502 | 5,643 |
| 26 | −473 | 1,192 | 3,333 |
| 52 | −4,763 | −3,098 | −957 |
The account can be fixed three ways. Raising the price to break even at today's service needs 144.02, 10 per cent more, which a small buyer with alternatives may refuse. A delivery surcharge of 59.58 per order recovers the same amount and lets the customer choose. Changing the service is usually the best answer: with a minimum order that brings it down to 12 orders a year and four visits, the remainder by phone or online, the account earns 9,902 at its current price. Moving from weekly to monthly ordering is worth more than a 7 per cent price rise.
Cost to serve should include only costs that move with the account's behaviour. Charging a share of head office to each customer turns a decision tool into an allocation argument; leave fixed overheads below the account line.
The free workbook for this case computes account profit with two cost-to-serve rates beside the pocket price band, and the real cost of a retroactive volume rebate shows the other way small accounts are often mispriced.
Costs that move with how an account buys: order handling and delivery per order, sales visits, payment terms, returns and special packaging. On an illustrative small account, 52 orders at 165.00, 24 visits at 320.00 and 75 days of credit at 9 per cent give 16,866, 51.5 per cent of its revenue. Fixed head office overheads stay below the account line.
Because cost to serve is driven by orders and visits, not by revenue. An illustrative account buying 250 units a year in about five-unit orders carries 67.46 of cost to serve per unit, against 1.73 for a distributor ordering 1,250 units at a time. Its 42.0 per cent margin becomes a loss of 3,098.
Change the service before the price. On an illustrative account losing 3,098, a minimum order taking it from 52 to 12 orders a year, with four visits instead of 24, produces 9,902 of profit at the same price. The alternatives are a 10 per cent price rise to 144.02 or a surcharge of 59.58 per order.
This article is one calculation from Pricing Strategy. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: business operations: cost, contracts, pricing and supply chain → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.