Most dealers precisely know their gross margins on a per-customer basis. If you’re a typical LBM business, you work on about a 25% gross profit margin. Of those 25 points, 20 are usually consumed by overhead, leaving you with a 5% net margin. Some dealers are higher, some lower.
Very few dealers know their net margin on a per customer basis. If you think about what goes into overhead, they are things like delivery expense, sales and marketing, cost of bank borrowing, legal and lien expense, etc. Are these expenses consumed by your customers in direct proportion to their sales volume? I’ll save you the suspense – they’re not. As a result, if you took the effort to allocate those expenses by what each customer actually consumes, you’d find your true net profitability for each customer. What you will realize is that not all customers contribute equally to the bottom line.
To highlight this point and show where perceptions can be wrong, let’s take an example. Ask yourself: Are large customers more profitable than smaller ones?
It’s possible. It also might prove the opposite. Your big customers typically get the best pricing for their large volumes, which means a lower-than-average gross margin to start. Instead of making 25% gross margin, you may be making 19%, before your overhead is paid down.
And the margins for large customers can get even thinner: Big customers often get the attention of your top salesman, they get specialized delivery, and favorable return/restock terms. When a dispute pops up, you are quick to accept responsibility and accommodate without delay. After all, they’re a big customer, right?
Now look at the big customer from the perspective of A/R. Perhaps these customers are also the ones that insist on paying you 60 days late, and politely letting your A/R person know that they won’t pay late fees.
Add all that up, and you may not be making 5% net margins, but shocked to find you are not making any money at all! Trust me, that’s more common than you might expect.
To calculate per customer profitability, attempt to allocate the share of “overhead” expenses each customer is actually driving. Look especially in the following areas: delivery expense, disputes, how quickly or slowly they pay their bills, who pays with credit cards, % late charges collected, restocking and dispute fees, and sales expense. If there are other overhead categories where it’s clear some customers are driving a disproportionate amount of the expense (ex. liens), then allocate those too. Make sure after you’ve attributed the expenses that the sum of the allocations is neither higher nor lower than your actual total.
Next, subtract these expenses from the gross-margin per customer you already have and that’s it. If you are like most dealers, you’re going to find some powerful insights . . . some customers are making you a lot of net margin % that you didn’t realize (usually smaller customers that don’t get special attention) and some customers may be making you less net margin than you thought. Some may even be negative in their profitability!
What to do with those customers? Fortunately, you have lots of ways to improve low or negative net margin customers. Pricing is a great place to start. If that isn’t easily movable, think about collecting late fees from them the next time they are late. Consider how you can reduce expenses that that customer is explicitly driving.
If low or negative net margins can be attributed to issues with A/R and late pays, consider bringing in a credit management provider like BlueTarp, which can pay you upfront for all your sales and protect you from credit risk for a price lower than what you are paying to manage it in-house. Whatever you choose, take heart in knowing that you now have the right insights on true profitability per customer. Knowing that is more than half the battle.
Protect Your Profits
Say your average customer spends $100 and you net $25 in gross profit, or 25%. When you factor in all costs (warehouse, delivery, sales, administrative and financing expenses) the net profit of the average customer is 4%.
Let’s also say you have a line of credit with a 6% interest rate annually, or 0.50% for every month. Someone who regularly pays you 60 days late is costing you 1% more in borrowing costs (2 extra months at 0.50% /month). That also means that customer is occupying more of your credit manager’s time by requiring check-ins and collections calls. You are spending more time internally discussing this customer, and you and your sales reps are reaching out to check in on payment too, taking more valuable time away from growing your business.
The 80/20 rule generally applies here – 20% of your customers are occupying 80% of your time. The time lost isn’t fake money – you are paying yourself, your sales reps, and your credit manager real money, and this is where they will be spending some of it to the exclusion of other work. When you add it up, rather than having administrative and finance costs be 3% for the average customer, they’re more like 9%. Now you stand not to make 4% but actually lose (2%)! (See Figure 1.)
So, to reiterate, when estimating the profitability of your customers, don’t look at them in aggregate. Look at them individually and be sure to allocate all applicable costs before calling them a truly profitable customer.