Tracking revenue by customer or product comes easily to many businesses but getting at profitability by market segment has been another matter. The ability to measure segment profitability is vital to the attainment of the most important goals and actions. Business executives report that growing/increasing profitability are their top business goals with 27 percent of business executives planning to go after a new customer or market segment.1 Capitalizing on profitable market segments and cutting unprofitable ones is high on the list of priorities.
Simpler-to-use, more intuitive accounting software has become widely available and has improved decision makers' visibility into profitability by segment. It is becoming easier than ever to identify sources of profits and losses. Accounting data used to measure profitability provides the knowledge base to guide where to grow, where to optimize, and where to cut losses. Properly structuring your accounting and financial reporting system can provide standardized reports that answer key business questions:
- What segments or customer groups are most profitable?
- Who are your company's most profitable customers? Least profitable?
- What are your most profitable products and/or services? Do you have a loss leader?
- Which customers, products or services offer the greatest future value?
Using Profitability Data to Drive Smart Growth
Driving smart growth with targeted strategies by market segment starts by defining those segments and gathering profitability data. The following four steps can get you underway.
Step 1 — Create Meaningful Customer Segments
Start by making your accounting system specific and meaningful to your business and drivers of growth. Based on previous accounting data, analyze each customer and sale from the previous year and identify common characteristics. With this history in mind, you can create categories for customer groups. Design enough categories that you can mine your accounting data for opportunities but not so many that the data is difficult to gather and track on an ongoing basis.
Create customer categories and sub-categories using variables such as:
- Ownership (government vs. business vs. consumers)
- Size (revenue, number of employees, income)
- Distribution (online vs. retail vs. wholesale)
- Purchase frequency and customer history
- Demographics (age, gender, ethnicity, lifestyle)
- Source of business (marketing program, referral, etc.)
Helpful Tip: Develop and document consistent definitions for each category for easy understanding by anyone who enters customer information into your system.
You can also look at job proposals to help you think about business you competed for and your success rates in landing different types of customers and jobs. This history can help define the growth strategy as you reach for new product offerings or customer segments.
Step 2 — Create Meaningful Product and/or Service Groupings
Utilize the same methodology as above for your products and/or services. Identify groups of your products and/or services you want to track to gain valuable insight for the future. For example, you may want to create groups around:
- In house-manufactured stock items
- Outsourced production items
- Customized products and tailoring services
- Design and installation
- Shipping and handling
- Ongoing maintenance contracts
- Other professional services
Think about groupings of products and services with comparable production processes, labor inputs, workflow, cost structure and margins.
Step 3 — Assign Direct Costs to Customers and Jobs
Most businesses track basic direct cost information such as labor and materials. Build on this information by having your accountant set up your accounting structure to assign direct costs to specific jobs and customers. Your accountant will be able to assist in auditing and revising your cost data gathering approach to allow it to be tied to individual jobs or customers. You may need to revise or implement timesheets or other record keeping to connect hours to specific jobs and customers or to add job numbers to invoices to track material expenses.
You can then assess profit margins on specific customers, products and services. Share your goals for tracking profitability with employees so they can understand the outcome that you are working towards. Employees sometimes resist the implementation of timekeeping because they misunderstand the objective of the exercise; sharing that you are studying segment profitability can help get them on board with more accurate and/or additional timekeeping requests.
Step 4 — Use Segment Reports to Focus on Pockets of Profitability
With your newly organized database, you will be able to generate profit and loss statements by product, project/job, or customer. Filter these reports based on the groupings you have developed, and you can now quickly and easily generate reports showing profit margins with specific insight to what drives the cost structure for each category. For example, you may find that certain jobs cost more than you thought when you were only looking at expenses in aggregate.
To fully leverage this information, use company forecasts, industry data, and competitive analysis to establish benchmarks like:
- Targeted sales size
- Targeted profit margin by group/segment
- Employee efficiency ratios
Use this information to create strategic customer and product plans to prioritize and allocate resources more effectively. This can help outline segment growth strategies for your business plan. Conversely, you can analyze the pockets of unprofitability to determine the types of projects to avoid or products to cull.
Helpful Tip: Compare your actual profit margins by customer, products and services to forecasts and benchmarks on a periodic basis throughout the year to monitor market changes.