When it comes to figuring out the value of each customer, United Pipe and Supply knows never to trust conventional wisdom. Not since it realized that one of its "best" customers was actually its worst.

United Pipe is a wholesale distributor of irrigation, pumping, waterworks and air conditioning systems to some 5,000 buyers throughout the Pacific Northwest. Three years ago, it acquired activity-based management (ABM) software from SAS, Cary, N.C. ABM gave the company its first look at the true profitability of all customers, beyond hunches and information scattered among departments.

The SAS model revealed a big surprise. Sales, it turned out, was spending so much time servicing the account of one highly valued customer that United Pipe was actually losing money on the relationship. "It was a stunning revelation," says chief information officer Mike Green. "One of those absolute classic moments."

But there are other kinds of hidden customer costs as well, ones that arise from processes related to the supply chain. And they, too, can be key determinants of whether or not a given customer is profitable. At United Pipe, delivery charges and inventory policies can cut deeply into the bottom line. For example, ABM uncovered the expensive practice of hauling surplus product away from customer sites. The solution? Work with the accounts to curb excessive ordering.

In another case, the employees of one customer were picking up product at United Pipe's warehouses at the rate of twice a day, stifling productivity and driving up transaction costs. United Pipe convinced the buyer to order just once a week, and promised to deliver directly to the job site. The result: a profitable customer, who reaped big labor savings in the bargain.

ABM allowed United Pipe to come up with an optimal cost per unit of activity, based on data from all points along the supply chain. The company's average cost of delivery is $45 per order, a benchmark against which managers can compare costs for each customer. If the number is too high, the system helps to uncover the reason and maps a course of action.

SAS prefers the term ABM for what its product does. But the practice is really just one form of customer segmentation, the process by which companies rank customers according to their actual contribution to the bottom line. And the idea is growing in popularity.

"Business leaders in all kinds of companies want to manage the performance of their customers closer to profitability than in the past," says Don Bean, solution manager of ABM Solutions with SAS. Up until five years ago, when the economy was booming, companies were fixated on revenue growth and market share, Bean says. Now, with business slowing and competition growing fiercer, they are forced to address real issues of profitability. And one way to achieve that is through a clear-eyed view of the customer base.

Starting at the Top
As with most major business strategies, it all begins with enlightened management. Bob Sabath, president of Sabath Supply Chain Consultants Inc., in Racine, Wis., says top executives need to take "a commonsense, intuitive look" at their customers, to identify the characteristics of the best and worst. Location and size are among the factors to be considered. Sabath recommends this relatively "soft" approach to get companies accustomed to the whole idea of segmentation. "It's almost un-American to say that all my customers are not created equal," he says.

Then comes the real work. Logic takes over, as Sabath lays out a four-by-four grid which highlights four categories of customer horizontally (labeled "A" through "D"), and four of product vertically (numbered 1 through 4). The boxes range from best customers and most profitable products in the upper left-hand corner, to worst customers and biggest money-losing items in the lower right. Company response will vary accordingly, from ensuring perfect service for the first group, to "firing" the customer in the last.       
Such a routine is important because it helps companies decide where to focus their limited resources. According to Sabath, the most profitable 20 percent of customers generate between 100 percent and 300 percent of a company's total profits-meaning they pay their own way while making up for losses incurred in serving others. The middle 70 percent tend to break even, while the least profitable 10 percent lose between 50 percent and 200 percent of total profits. Simply culling the biggest losers can result in an instant profit boost of between 3 and 10 percent, Sabath says.

Dumping bad customers isn't the entire answer. One company, a maker of air conditioning equipment (not United Pipe), identified four "C" and six "D" customers that it thought could be made more profitable. By focusing sales efforts and "executing flawlessly against promise," the company could realize a boost in profits of between 20 percent and 35 percent, Sabath says. And that was the result of success with just half of the 10 candidates.

Supply chain considerations became a factor in the case of a commercial food manufacturer and distributor. According to Sabath, it had just one customer in a particular region, forcing that account to absorb all transportation and sales expenses for the area. By seeking out other customers in that region, the company was able to bump the original customer from 77th to 13th in profitability, increasing its total profits by 9 percent.

United Pipe, too, adopted some solutions on the supply chain side. In some cases, it has positioned consigned inventory at the job site or within the customer's warehouse, based on projected needs. Then it replenishes those stocks on a weekly basis. Green says the company had to do a better job of tracking and managing inventory in order to make the system work. In the end, though, it simplified the process of serving customers and actually increased overall inventory turns.

Other supply-chain processes that feed segmentation models including packaging, returns, shipment terms and hours of delivery. Many are assumed to carry standard costs but are really unique to individual customers, Sabath says. For example, the same product might be going to two customers, one of which receives shipments round the clock while the other has narrow windows of acceptance. As a result, the cost of serving those two accounts will differ widely.

Birth of an Idea
Relatively few businesses today are approaching customer segmentation from a supply chain perspective. The idea got its start in the marketing arena, where companies can waste huge amounts of money for lack of intelligence about their customers. Success stories can be found in the financial industry, where banks tailor products to accommodate a wide range of incomes and investor sophistication. Even casinos have boosted profitability, by segmenting their customer base and targeting campaigns at the least profitable segments.

Customer segmentation has been slower to catch on in industries that make physical goods. Here, the effort becomes more complicated, as manufacturers struggle to reconcile and share data among various departments, including sales, marketing, production and logistics. Often these corporate silos can't even agree on what constitutes a profitable customer. Salespeople, driven by commissions or other types of incentives, will push product out the door at any cost. Logistics may balk at the price of serving what sales considers to be a prime account.

The problem is that customer relationship management (CRM), the broad category into which segmentation falls, remains a distinct discipline from supply chain management (SCM). Karen Butner, SCM leader at IBM's Institute for Business Value in Dallas, says 2006 will see "a large push" by companies to marry the two concepts. The key lies in collaborating with customers on multiple processes within the supply chain.

It begins with new product design and development. Customers are increasingly being asked which products should be developed and what they should look like, Butner says. Already common in aerospace and other heavy industries, the practice will gradually filter down to consumer goods makers.

The move toward greater collaboration opens the door to segmentation, as companies seek to know more about their customers' unique requirements. Manufacturers are making greater use of specialized packaging, often in tandem with promotions aimed at particular customers.

As a result, the cost to serve those accounts can vary widely. Point-of-sale data, coupled with demand forecasts, can help companies devise complex pricing strategies that are linked to the profitability of targeted buyers. Prices can even be changed on a daily or weekly basis to reflect actual demand, Butner says.

None of this will work unless companies adopt a cross-functional approach. Demand and supply planning must be linked with marketing and logistics in order to assess customer profitability. Butner says many chief executive officers are waking up to the need for silo busting. According to recent industry surveys by IBM, CEOs and lower managers alike view profitability as their prime objective. However, their second priority, customer responsiveness, could hamper efforts at segmentation without strong direction from the top.

Managers can use supply chain concepts to bolster customer profitability, Butner says. Options include the assembly of larger and less frequent loads, fewer expedited shipments and a greater reliance on cost-efficient intermodal services. Packaging and palletization can be standardized wherever possible, to drive distribution efficiencies.

The Analytical Approach
To build a supply chain geared to demand, managers must incorporate SCM principles into customer analytics, says Lora Cecere, research director of AMR Research Inc. She is working with a number of clients to implement new customer prioritization techniques.

Industry pioneers are starting to build segmentation into their pricing and selling strategies. A report by AMR analysts Kevin Scott and Laura Preslan cites the case of Dow Corning Corp., which operates a Web-based sales channel called Xiameter. It offers low prices for large volumes of commonly used silicone-based products. By targeting some of its biggest customers through an automated, self-service approach, Dow Corning has realized a double-digit reduction in the cost to serve those accounts, AMR says.

According to Cecere, many companies have yet to adopt segmentation tools that can reveal the importance of a given customer to the seller's market share, revenues, profitability and strategic objectives. "Companies are aware, but they're not using the tools," she says. "They don't know how to do it."

What's stopping them is that old roadblock to just about any supply chain initiative: the difficulty of obtaining timely and accurate data. In addition, salespeople have a natural bias against choosing between accounts, Cecere says. They need high-level direction from the executive suite, backed by a mandate to cooperate across departmental borders.

As for the tools, they generally must be built. The biggest need is for a rule-based engine that sits atop existing systems and links segmentation to product allocation, vendor-managed inventory, order management, and manufacturing. Such a system isn't easily found in the form of a packaged application, Cecere says, although it would be similar to traditional enterprise application integration (EAI) software.

In any case, she says, hard logistics costs aren't being figured into most customers' segmentation efforts. Management's first priority on the supply chain side is the creation of "pull"-based systems for order fulfillment, to alleviate shortages and delivery delays. Those elements are more of a constraint to business than everyday logistics expense, Cecere says. Companies need to know what's happening in the field, and how much product is available to meet customer needs.

Still, the lines between CRM and SCM are beginning to blur. Says Cecere: "CRM, SCM, [enterprise resource planning] and [supply chain planning] are all applications, tied to a demand-driven supply chain."

Where It's Happening
The progress of customer segmentation depends on the industry, says Gareth Herschel, research director of CRM analytics with the Gartner consultancy in Atlanta. In general, he says, the most advanced companies can be found in consumer-oriented sectors rather than business-to-business providers. They include financial services, telecommunications, travel and hospitality, and retail.

For the most part, manufacturers' use of segmentation is limited to a customer's size, the amount of business it generates and its geographic location, Herschel says. At the strategic level, segmentation tends to be aimed at large accounts whose fundamentals remain stable and well understood. On the tactical side, things get more complex. Companies might focus on a small portion of customers for a new-product launch and experimental pricing program. And the lines between segments are constantly shifting.

Segmentation got its start on the service side because of a natural emphasis on strong customer relations, says Herschel. By getting closer to the customer, companies obtain critical data about sales and marketing targets. But the main purpose of segmentation-figuring out how to treat customers differently, based on their importance to the organization-is of equal value to manufacturers.

Many companies make the mistake of applying conclusions reached on the marketing side to customer service and support, says Herschel. They give in to pricing pressures in hopes of retaining business that is attractive solely from a marketing or sales standpoint. Yet, as United Pipe learned, that customer could turn out to be seriously unprofitable.

Bickering between departments is a major obstacle to successful segmentation. Different sectors might not agree on who is a customer, let alone how valuable it is. Or they might have different shipping addresses for the same account, frustrating attempts at a rational evaluation. Says Herschel: "It's quite a slow and painful process."

Supply chain based segmentation is an underdeveloped concept, he says. Managers tend to pay attention to logistics only when something goes wrong. They might even be providing better service than the customer wants or deserves, generating unnecessary expense. "In certain industries, logistics and delivery is a huge factor," Herschel says. "But it's still poorly understood in most cases."

Andrew Leigh, director of solution strategy for the CRM products of SAP, agrees that businesses are gradually moving away from an emphasis on economies of scale, in favor of a customer-focused approach. "Even companies dealing with tangible products are realizing that the product itself isn't enough of a differentiation," he says.

Analytical tools have matured sufficiently over the past five years that manufacturers are willing to give them a try. And they're doing more than just singling out the top 20 percent of customers for concierge treatment. Companies are beginning to realize that the real opportunities for growth lie with the remaining customers.

Even assuming that 20 percent of a company's customers will never be profitable, that leaves 60 percent who could be elevated in value through new segmentation strategies, Leigh says. Sellers need to learn the differing needs of those customers while correctly assessing their cost to the organization. SAP, among others, offers a pre-packaged formula which figures overall revenues then subtracts billing and shipping costs, including those generated by returns.

None of this would be possible without harmonized data. SAP's tool takes information from disparate systems and places it into a common platform or data warehouse. Contrary to their original expectations, companies deploying CRM software have come to realize that new systems won't replace all legacy applications for a long time. Instead, they are settling for a common data source that allows for the synchronization of efforts between departments.

The need for segmentation on the supply chain side is greater than ever, says Leigh. As companies shift away from mass production, they increase the risk of overproducing goods for specific customers, even as their margins get slimmer. One solution is sales and operations planning (S&OP), which combines sales and supply forecasts with actual production levels.

Activity-based costing (ABC), which includes the type of ABM tool provided by SAS to United Pipe, can also be of value. It assigns a cost to each category and customer, including those related to logistics. But the concept remains in its infancy. "Companies are just starting to discover how to define all of those cost buckets," Leigh says.

The Big Disconnect
Companies understand the need to integrate CRM with SCM, but those categories are still managed in different parts of the organization, says Andrew Zoldan, vice president and general manager of the consumer sector for San Mateo, Calif.-based Siebel Systems Inc. On the CRM side, he cites a large manufacturer of non-alcoholic beverages, supplying every kind of retailer from the big-box giants to individual kiosks. The supplier must know how to service each customer in a way that's appropriate to its needs, as well as its contribution to profitability. Each decision-how and when to ship product, whether to send sales or merchandise reps, whether to pay stocking fees-must be assessed in this light.

Supply chain costs fall under operations and are generally not well integrated with sales and marketing on one hand and customer service on the other, says Zoldan. Elements such as geographic location are not included in the traditional category of customer segmentation.

Companies are addressing the larger issue of customer profitability, an assessment that requires the management of data from multiple systems. "But that's a huge challenge," Zoldan says. "Very few companies actually build a customer profitability model. Everybody just optimizes their part of the system."

Future versions of CRM and customer segmentation should do a better job of merging with SCM, with the eventual goal of erasing those labels altogether. At United Pipe, Green is preparing to install a business intelligence system along with a customer-data warehouse. The new tools should give the company an even better view of the customer, providing "a deeper dive on what is our marketplace."

Bean says the data gleaned from ABM and other customer segmentation tools will eventually migrate from the financial side to front-line business managers, including those responsible for the supply chain. "We'll see the integration of analytics into the normal way a business runs itself," he says. "That's the next big leap."