Unfortunately, the consolidated financial statement fails to reveal the profound variables of profit within the business. From the transaction-level through vendor/ product family, customer, sales territory, branch, customer group, there are substantial variances and distinctions in net profitability that are obscured by revenue and gross margin statistics that are generally used to assess success or viability.
Each business’s definitive net income results from the tension among three distinct groups of customers and products:
• Profit-makers- products and customers who contribute to peak internal profitability
• Profit-neutrals- products and customers who either maintain or match peak internal profitability
• Profit-takers- products and customers that reduce peak internal profitability to actual net profitability
The dynamics of these three groups and efforts to understand and influence it determines the actual net profit of the business—hence its enterprise value and ability to target and manage profitable growth. The difference between peak internal profit and real net profit is profit opportunity. By remediating profit-takers, improving profit-neutrals and growing its profit-makers, the organization can point its resources toward optimal, profitable growth. Also, because two customers of the same gross margin can consume organizational resources at different rates, a deeper level of analysis is crucial to understanding true profitability.
Regrettably, most managers don’t know where products or customers fall within the categories mentioned above. Thus, they fail to identify and mitigate profit-takers, reducing net income, and enterprise value. Additionally, they often fall short in focusing sales and support teams on those segments that drive profitable growth and market leadership.
Interestingly many executives believe that their largest customers and product categories are their most profitable— however this is frequently not the case. Often sizable customers and categories, when their true cost-to-serve (CTS) is appropriately attributed, can be found across all three profitability groups. Because each product or customer is different, their gross margin contributions do not equally add to the ultimate net income of the business.
Problem: Commonly Used Tools Cannot Identify Individual Product or Customer Profitability
David Bauders, the CEO of SPARXiQ mentions, “We have found revenue and gross margin inadequate to the task of identifying individual product or customer profitability. Today’s macro-income statements do not calculate profitability at this granular level.”
Once the Whale Curve is graphed, it should be shared with the executive and sales teams. Most organizations start on the right side (profit-takers)
In order to analyze the drivers of net income—it’s important to calculate—at the line-item level, the volumes, prices, and cost-of-goods-sold to arrive at the gross margin and then sum to gross profit. To arrive at net income, however, we must attribute to invoice line-items the variable, semi-fixed and fixed cost-to-serve (CTS) of the organization to the products and customers they serve. A methodology known as activity-based costing (ABC) establishes the real cost to attribute to individual invoice transaction for a given time.
The CTS of products and/or customers results from a combination of inherent factors versus behavioral choices and the resulting support costs they incur plus the company’s decisions that determine the efficiency and cost of performing those activities. Product or customer factors such as a product’s sourcing or delivery costs tend to be fixed or stable over time. By contrast-behaviors tend to be a vendor or client’s operational choices. CTS is a function of how your company chooses to perform activities such as automation versus human-labor or online ordering versus call centers. This way, CTS is a function of factors, vendor/customer operations, and internal choices, factors, and efficiencies.
Besides the attribution of operational costs, it is crucial to identify the nature of such costs—whether each cost is fixed, semi-fixed, or variable. Fixed costs do not (over short or medium terms) change proportionally as a function of broad changes in sales volume. Semi-fixed costs vary when specific step-level volume changes are triggered. Finally variable-costs change quickly and proportionally to sales volume. Understanding operating costs at this level allow executives and staff to determine if it is possible to remediate underperforming market segments, how to restructure operations to achieve greater efficiencies and whether or how to serve, expand, shed or restructure market segments, customers or product offerings.
Solution: The Whale Curve—The Tool to Maximize Profitable Growth and Enterprise Value
Most executives are familiar with Pareto’s Law, also known as the 80/20 rule. This law defines the tendency in large, fragmented data sets, for the top 20% of the data points to contribute 80% of value outcomes, with the bottom 80% of data points contributing only 20% of value outcomes. The Pareto Principle is a popular way of understanding opportunities to simplify, prioritize, and exploit advantages.
Nonetheless, when it comes to customer and product profitability, the Pareto principle broadly fails to account for the true underlying economic levers in business. Each business has its own characteristics and within the company—segments, territories will have their divergent properties and ratios.
Once operating costs are attributed to individual customers and products, the results can be illustrated in a graphic depicting, in descending order, the net profit of all customers of products.
“Once the Whale Curve is graphed, it should be shared with the executive and sales teams. Most organizations start on the right side (profit-takers),” informs Bauders. Armed with actionable information, your internal team has several choices to “cut the Whale’s Tale” such as:
• Raise the price of the product.
• Ask for cost support from the vendor.
• Sell more products and services. The increased spend amortizes the margin across the total sale.
• Lower the cost of sale by using the inside sales reps.
• Lower the cost of sale by assigning this account to an inside sales team.
• Lower the cost of sale by having the customer order electronically.
Also, businesses should focus attention on the profit-makers to identify and create plans to grow and replicate them.
As a rule of thumb, as Bauders mentions, “in Whale Curve economics, the top 20% of clients tend to be clear profit-makers, contributing between 150 and 300% of net profits; the middle 60 percent tend to be profit neutrals; and the bottom 20 % tend to be profit-takers, destroying from 50 to 67 percent of your peak internal profit to arrive at the final net profit level.” To ensure you don’t forget this critical insight, call it The 20/300 rule. Or the 20/67 Rule. But don’t fail to remember and act on it!
"In Whale Curve economics, the top 20% of clients tend to be clear profit-makers, contributing between 150 and 300% of net profits; the middle 60 percent tend to be profit-neutrals; and the bottom 20 % tend to be profit-takers, destroying from 50 to 67 percent of your peak internal profit"
For a business with $1.0 million of net profit, it is likely that their peak internal profit – before they took on customer or product profit-takers, who reduced their net profit – was $1.5M to $3.0M. That is, it is likely that their potential net profit could have been 50 to 200% higher than their actual net profit. If they had been able to identify and remediate or discharge their profit-takers, they would have been much wealthier. Most notably, they would be prosperous without adding customers or suppliers; without raising quotas or opening new operations. They would be managing their book of business for profitable growth. And they would set themselves up to become strategic market makers instead of indiscriminate order takers.
For any large, complex business, with hundreds or thousands of products and hundreds or thousands of customers, the overall Whale Ratio, and its distribution and variability across essential management layers such as sales territories, branches, product lines, customer segments, etc. becomes a critical operational set of metrics to identify where and how to remediate the underlying drivers; how to restructure business cost structures and growth targets; and how to align organizational resources to maximize profitable growth.