By F. Barry Lawrence, Ph.D., Pradip Krishnadevarajan and Senthil Gunasekaran
 
“Customer Stratification,” is written by F. Barry Lawrence, Ph.D., Pradip Krishnadevarajan and Senthil Gunasekaran specifically for wholesaler-distributors. The book offers 20 action steps that distributors can take today.

The following is excerpted from chapter one, Motivation and Trends.

Customer stratification is the process of classifying customers into groups based on various factors, such as profitability, revenue, loyalty and cost-to-serve (CTS). The stratification process helps distributors determine which customers they could grow with and remain profitable. The benefits of customer stratification are multifold, but the key gains from implementing such a process are listed below:

• Better inventory management. Customer stratification helps you maintain or increase service levels for key customers while reducing/redeploying inventory.
• Pricing optimization. The process also helps you price customers based on opportunities and the CTS associated with each customer.
• Improved negotiations. If a salesperson has information about the characteristics of the customer with respect to other customers, he or she will be better positioned to make judicious decisions. Customer stratification reveals this kind of information.
• More accurate sales force deployment. The sales force’s time becomes scarce, given the number of customers sales reps must handle. Customer stratification reveals who the key customers are, allowing sales reps to better focus their time.
• Targeted sales force compensation. Customer stratification helps align sales force objectives with company objectives.
• New growth opportunities. A customer stratification process guides distributors in developing strategies to identify and capture new product and end-market opportunities. The strategies, in turn, provide a roadmap for the marketing department to focus on the new prospects.
• Better marketing communications. Customer stratification aids distributors in allocating their marketing budgets judiciously across customer types by media (that is, direct channels such as field sales and customer service reps, as well as indirect channels, such as catalogs, line cards, and websites) while achieving a higher return-on-investment (ROI).

Customer Stratification And Profitability

Distributors have been wrestling with getting paid for the services they provide for quite some time. Over the past six years, the distribution research team at Texas A&M University has completed many projects on this subject for distributors from various lines of trade. As a result of a Pricing Optimization research consortium, the team identified five key pricing drivers (fundamental to an effective pricing decision) that are critical to managing for improved margins:

1. Customer rank/stratification (profitable and not-so-profitable customers)
2. Item rank or seller’s item visibility (importance of the item from the seller’s perspective based on sales, hits and profitability)
3. Customer’s item visibility or buyer’s item rank (importance of the item from the buyer’s perspective based on the number of orders, recency of transaction and customer spend)
4. Unit cost
5. Gross margin levels

Distributors must manage these five pricing drivers in the process of determining which services to deliver at what cost.
Customer rank, the result of customer stratification analysis, had the highest weight — 55 percent. Although some companies implement a combination of the five key drivers, many firms implement customer stratification (customer rank) only and achieve substantial gross margin improvements or decreases in CTS as a result. Customer stratification has a proven record and has become one of the most important best practices for wholesaler-distributors.

Trends And Best Practices

Many distribution firms are predominantly sales driven (top line) as opposed to cost driven (CTS and net profit). The recent recession was quite challenging for top-line-driven firms, as drops in revenue forced them to reduce prices or substantially increase services to hang on to existing customers.

The problem with this strategy was that distributors extended it across the board rather than target specific customer types who valued price reductions and services more than others. A more selective approach would have been to support customers who have demonstrated a higher degree of loyalty, are likely to become highly profitable in the long run, and can eventually be groomed to become core customers.

Cost-driven firms turned smarter and started to track customer-level profitability — creating profit-and-loss statements at a customer level, but only for select customers. Survival came down to the strategies distributors had for each customer type.

Distributors should, at a minimum, monitor customer profitability, and adjust to changing customer needs to remain profitable and survive business and economic cycles (Eyink, Marn, and Moss, 2008). The key is monitoring customer-level profitability based on different dimensions: revenue, profitability, CTS and life/loyalty. The most complicated application is CTS.

CTS

Cost-to-serve includes the allocation of total costs to each customer beyond the cost of goods sold (COGS). Most wholesaler-distributors find this very difficult to estimate (Narayanan et al., 2007). CTS is influenced by a variety of factors, such as order size, days to pay, transportation costs, inventory costs, and so on. CTS is the only factor that allows companies to charge a different price for the same product across different customers. The service levels various customers require translate to CTS and become a primary determining factor of the profit equation.

To price right and remain profitable, companies track CTS with processes such as activity-based costing (ABC). ABC assigns costs to various distributor services accessed by each customer. The process results in a CTS dollar value for each customer.

For instance, it can cost $23 to process an invoice, $17 to generate a sales order for each customer, and so on. Based on the various services a customer accesses, a total CTS for each customer can be computed to determine each customer’s true profitability. Distributors can also develop alternate methods to ABC approaches using routinely collected information from their enterprise resource planning system (ERP). Regardless of which approach they choose, distributors must understand CTS to perform successful customer stratification (Young, 2008).

Risk Management

The Pareto rule states that 20 percent of customers will generate 80 percent of sales. We have consistently witnessed over the years that 80 percent of profitability and/or revenue comes from less than 10 percent of the customers for a typical distributor. This should give one pause to think, since it demonstrates that the average wholesaler-distributor’s success lies in the hands of only a few customers.

Protecting core customers and continually working on developing the next potential core customer is your sales force’s main objective. This process should increase the number of customers in this category, thereby spreading risk. Your sales force is a valuable resource that must be properly deployed. Salespeople typically understand customers better from a revenue perspective, which often suboptimizes profitability. The solution is having a comprehensive but easy-to-understand customer stratification framework that can guide your sales force in optimizing their time and minimizing business risks.

Resource Allocation

Understanding customers should go far beyond revenue and gross margins to include CTS and loyalty factors. Sales managers, for instance, make critical decisions in training and deploying the sales force and must understand customers from a broader perspective. Customer stratification not only helps sales managers tactically allocate resources, it equally helps salespeople better allocate their time with customers. The stratification provides a common platform for the team to build a sales plan.

Customer stratification also helps marketing managers determine the company’s annual budget by customer type rather than geography or revenue potential. The marketing message (value proposition) may vary substantially between customer types depending on loyalty, CTS and profitability. When asked to describe the business we want to do, salespeople typically fail to reach beyond revenue or gross margin dollars. A better process is profiling core customers (both existing and potential) and developing a value proposition for salespeople around the business we want to do. A comprehensive customer stratification framework helps you create a value proposition, leading to profitable growth in both market penetration and new customer acquisition.

Sales Force Compensation

Sales force compensation is a challenge for many industry sectors, and wholesale distribution is no exception. A comprehensive customer stratification framework gives you insights that can be used to build an effective compensation plan.

When we look at sales reps’ performance (revenue and profitability contributions) through the lens of customer types (resulting from customer stratification analysis), we can better see the degree of alignment between salesperson performance and company objectives. For instance, determining what percent of revenue and gross margin comes from core vs. service drain customers (for each salesperson) helps sales managers measure the sales force’s alignment with the company’s target business we want to do. This, in turn, can be linked to compensation structures.

The key challenge is overcoming sales force resistance to incorporating CTS in compensation models. You must engage your sales force in the customer stratification process to fully understand CTS variables and demonstrate the benefits to profitable growth — for both the firm and the sales force.  

This excerpt is reprinted with permission from the National Association of Wholesaler-Distributors (NAW). To order of copy of “Customer Stratification,” visit www.naw.org/customerstrat





POSTED ON: 9/21/2011