Most bankers would acknowledge that the profitability among their customers varies significantly. It seems that every bank executive has been approached by some consultant claiming that 80% or more of the bank’s profits come from 20% or less of its customers. Even if you don’t believe in the exact percentages, this perceived imbalance of profit should be addressed. How can we move past theoretical assessments and use customer profitability analysis to truly enhance our profits and not alarm our bankers about running off customers?
It’s not as simple as removing these unprofitable customers and magically improving profit. For example, I was once told by an affiliated service provider that the cost of the service I was purchasing from them had to increase because this company was losing money on it. Knowing that the price I was paying was not too far from market, I responded with, “So, what you are saying is that if we dropped your service you would make more money – right? Maybe I can be a hero and boost your profitability by leaving!”
That was not the response they expected and, of course, it gave them pause. It turns out that there were some fixed costs and capital charges that had been figured into my business’s “unprofitable” label. So, taking my business elsewhere would not instantaneously increase the affiliate’s profitability. Does this ring true in the case of banking customers? You bet it does!
When we dig into the assumptions within most profitability studies, we find that discarding the majority of customers labeled as “unprofitable” would not instantaneously increase the bank’s profitability. So, how should we use these studies?
At the most basic level, every price increase would be profit-enhancing if it weren’t for the ability of customers to choose to take their business elsewhere. To enhance the overall profitability of a bank, we must develop an assessment that enables decisive and measurable action appropriate within each relationship.
Yes, it is highly likely that some customers need to be priced better or respectfully encouraged to find another service provider. Yet, far more often, we are likely to find that improved profitability for the bank does not require the exodus of large portions of its customers. What it does require is a unified profitability awareness within a success culture. The ability to create a culture that enlightens, equips and empowers bankers to take actions that are good for the bank and the customer is something we should all strive for. Our relationship managers can only do that when they have the right information and can accurately and promptly address the likely consequences for all the parties. This means communicating to your staff the anticipated impact to business volumes that the pricing alternatives are aimed at achieving.
Customers with negative gross profit. At the next pricing opportunity for a customer who doesn’t create a positive gross profit (revenue – direct variable costs) it is time to raise prices or lose that business. Nothing less should be considered acceptable. This is the only simple “up-with-price-or-out-with-the-business” scenario. Deliver this message with grace. Remember your customers didn’t design the pricing structure, they simply accepted the bank’s offers. Pricing adjustments are a natural course of business and should be handled as such with this group of customers.
Customers with negative net profit (revenue – direct variable costs + allocated fixed costs). This is part of that basket of accounts labeled “unprofitable” in the fully-allocated cost analysis. However, as in most real life situations, you have to weigh what you can get against what you might be giving up. Simply removing these businesses one-by-one actually diminishes bank profitability.
The important dynamic to recognize here is that a price increase on this bucket of business generally will result in an overall increase of profitable business with little impact on volume. Typically, in this situation, the bank will benefit more from the margin increase on those customers that stick around than suffer from the minor volume decrease that may result from the pricing increases. It is not a sure bet. But, if executed wisely, the net impact of a pricing increase will enhance profit for the bank and move this bucket of customers towards a more optimal balance.
Customers with positive net profit. Business that creates a net profit by covering all variable and fixed costs, but not a fully allocated capital charge, moves us to a new category of pricing dynamic. For this group, the bank should strive to get more volume at these pricing levels as long as the current level of capital is sufficient. Although price increases are typically desirable and often justifiable, the odds of increasing profitability by boosting pricing on this business are less than the previous negative gross profit and negative net profit customer groups. This is because we are operating at a more expensive level of pricing to the customer already and are most likely within market range. It is wise to approach any opportunities for a price increase gently and focus our resources on growing volumes.
Customers with positive economic profit. The ideal goal with every customer would be to create a positive economic profit (defined as revenue – direct variable costs + allocated fixed costs + capital charge). For customers in this group, the goal is not price-enhancement but rather customer satisfaction and increasing the volume of business. What non-price initiatives would strengthen the durability of these relationships? How can we do more with these customers and how can we get more like them?
As can be seen, product and relationship managers need a clear understanding of what they can do and are expected to do with customers in each of these groups. Executive leadership must equip those who control and influence pricing with profitability information for each segment so that bankers can be empowered to interpret each situation and take appropriate action. Building the capability to estimate and the status of your customers with respect to gross, net and economic profit can have a significant and durable impact on the profitability that matters most to those who sign the paychecks.