Not all customers are equally profitable. Different customers have different needs, and hence different costs to serve. The overall profitability of a business is a function of the profitability of individual customers and customer groups.
Many businesses measure customer satisfaction but they do not measure customer profitability. A profitable customer is a buyer who yields a revenue stream which exceeds by an acceptable amount the costs incurred to serve that customer. Customer profitability can be measured individually by customer, by market segment, or by channel.
Unfortunately, most businesses are poorly equipped to understand how costs relate to specific customers. Traditional approaches to accounting allocate costs to individual products, but not to customers who are the drivers of these costs. While the average costs in a business may decline as volume increases, there can still be significant leakages of profitability due to the higher costs involved to serve some customers.
In many firms, some costs are assigned to specific products or product groups sold to specific customers or customer groups. All other costs are allocated among all products and customers. For example, all sales and marketing expenses are usually averaged across product and customer groups alike. Because the true costs are rarely classified by customer group, the real costs to serve customers remain hidden from view. This means that some customers are being overcharged while some others are being subsidized.
The general approach for dealing with customers or segments which are less attractive due to lower profitability is to improve their profitability through one of three approaches:
- Reduce the costs to serve. This can be done by focusing Lean techniques and other process improvement methodologies onto the value chain activities that serve the customer group or segment. In addition, products and services may be redesigned to drive out costs.
- Increase the price to increase the total revenue obtained.
- Improve the product mix offered to the customer or segment. Tightening the mix to eliminate unprofitable products can improve the profitability of a customer group or segment.
Where these approaches are not workable or prove ineffective, the firm should consider de-emphasizing the segment or customer group in marketing, or exit the segment or group altogether and focus resources only on the most attractive segments.
Continuous improvement as a concept is a fairly simple idea. Yet, many firms struggle to bring about change. Why?
Over the years, I have noted two common and related failings:
- The failure to take action.
- The failure to keep on taking action.
Continuous improvement is not just about learning new ideas and concepts – it is about taking action to make a difference in something. Taking action is all about bringing about change. If there is no action, there is no change!
Many firms spend a lot of time and resources learning about continuous improvement methods and tools. Yet, they fail to act and apply what they learn. Sometimes even simple behaviours and routines are hard to change – people remain set in their ways, committed to their old routines, and fail to act.
Related to this point is the second failure noted above – the failure to keep on taking action. Continuous improvement is just that – it is continuous, ongoing, never-ending. Taking action once is not enough – you must keep on taking action to address your issues and challenges and raise your firm’s functioning to ever-higher levels of performance.
The inertia imposed by a firm’s current culture is real. Unless that inertia can be overcome by persistent action, real change and improvement is not possible.
Suppose you were stranded alone on a desert island. Because you were alone, you would be responsible for finding your food, building your shelter, making your clothes, etc. In short, you would be responsible for your own production and consumption.
Carrying this little though experiment a little further, it is not hard to see that your standard of living would be directly related to your productivity – how well you use your own labour to produce what you need to survive.
It is little different with a firm (or even an economy, for that matter). A firm’s productivity is a key determinant of its “standard of living”.
When we consider a firm’s productivity, we are really talking about stocks and flows. The firm’s physical capital, human capital, and technological knowledge represent the stock of inputs with which the firm has to work. How efficiently and effectively these stocks are combined, used, and transformed in flows which produce the outputs is what we really mean when we talk about productivity.
Firms which are inefficient have lower productivity. They either do not produce as much output from a given stock of inputs as rivals, or the value of the output they produce is less.
Process improvement seeks to improve a firm’s stock of technological know-how – its production technology, if you like. A firm which has a superior production technology, represented by superior methods, skills, and competencies, will be more productive. Such a firm will enjoy a “higher standard of living” than rivals because it will produce at less cost and greater profit. This fact alone should be enough to motivate firms to continuously innovate and improve their internal processes and systems.
As labour costs in China continue to rise, outsourcing or offshoring manufacturing to that country is looking less and less appealing. In fact, Chinese labour rates have risen to the point where offshoring to China is no longer an attractive proposition for many firms.
Manufacturing labour costs are usually in the range of 15 percent or so of final product costs. While offshoring to low labour rate jurisdictions can save on labour costs, much of the cost saving can be undone by higher freight/inventory costs, the costs of poor quality, and management level costs incurred by having to coordinate production and logistics with offshore suppliers. The labour cost gap is, therefore, not as large as it seems when these additional costs are added.
In addition, in China, wage inflation of about 15 percent annually has been further eroding the cost gap. As this wage inflation increases, China will continue to lose its appeal as an offshoring option.
US firms stand to benefit the most from reshoring their operations due to a weaker US dollar. For Canadian reshoring will not be as attractive due to the appreciating Canadian dollar. The higher Canadian dollar thus hurts manufacturers in two ways: first, by making exports more costly and less attractive to foreign buyers; and, secondly, by helping to preserve China’s attractiveness as a place to offshore production.
If a firm’s output can be defined by a production function, perhaps of the Cobb-Douglas variety, the Lean question becomes a very simple one: in the short run, what is the optimal combination of inputs that yields the desired output? As such, the problem is one of constraint maximization.
In every Lean application, a practitioner needs to be able to show how their Lean interventions are maximizing the constraints imposed by the production function. If they can’t, they are guessing and don’t truly understand the system which they are trying to improve.
A simple example: if a firm’s production function is given by , then a Lean solution should be able to show how total factor productivity (A) is being improved to produce more output (Y) with the same inputs of L (Labour) and K (Capital).
Unless this can be shown, it is unlikely there will be measurable impact on a firm’s bottom line from a Lean effort.
Continuous improvement of a firm’s value chains and processes must necessarily follow strategy. That is, a firm’s continuous improvement activities should be guided and informed by the organization’s overall strategy.
Strategy is about choices. It is about deciding where to focus resources to gain leverage and advantage. It is about deciding which activities to pursue and which not to pursue. Until there is strategic clarity, continuous improvement can use valuable resources wastefully and fail to produce real bottom line impact.
Toyota is a classic example of a firm whose continuous improvement actions are guided and informed by its strategy. The philosophy and practices of the Toyota Production System (TPS) is an operational response to Toyota’s strategy for gaining advantage in the marketplace.
Where can your firm gain leverage to begin building an advantage? Asking and answering this question can begin to suggest to outlines of where actions need to focused and taken. This is the beginning of strategizing which can naturally lead on to continuous improvement of those vital areas of focus.
When firms envisage making leaps in performance, there must be some key strength or capability that they are seeking to leverage. This has to go beyond the mere adoption of “best practices”. Thinking strategically can point the way to where those points of leverage might be within a firm.
A firm exists to supply a product or service to needful customers. Entrepreneurs and mature firms alike are always seeking to identify underserved or unmet needs, against which they can create and deliver a product or service. This is the essence of innovation.
However, innovation alone is not enough. It must be profitable innovation. Firms must be sure that they can make money from supplying a product or service to needful customers. A business model describes the logic of how a firm will make money from serving needful customers with a product or service offering.
A business model takes us beyond the primitive logic of “build it and they will come.” A business model forces the tight reasoning and cause-and-effect logic that minimizes the risk that business ventures will either fail or be unprofitable. With respect to new product development, the business model is a key part of the rationale that justifies allocating scarce and valuable resources to development activities.
Creating and delivering value for customers through offerings is not enough. Firms must know how they will capture their portion of the value provided to the marketplace. This is the source of the firm’s profit.
Unless a firm can describe how it will create, deliver, and capture economic value, it has no business model. Constructing viable business models is a key element of a firm’s competitive strategy. If the key step of business modeling is omitted, a firm’s competitive strategy is incomplete and fraught with risk.