segmentation as a tool to see profitability differently
Segmentation is one of the most successful ways consultants actually add value to their clients. The typical situation goes as follows: the company has been relatively profitable over the last few years, but the recent financial turmoil created serious concerns, customer numbers have been reducing and margins plummeted. What to do? Usually the first decision is looking at revenue (and cost) at an aggregate level. From them you can derive the typical cost saving measures like e.g. improve procurement or marginally reduce workforce. However this is not the core of the problem. The key is understanding how much each business line or product line contributes to profitability. Segmentation can be extremely revealing and disclose the only solution that can be really effective. Let’s see it with this case:
A travel agency makes a 10% commission on all of its travel bookings. Their current profit before taxes is $3MM, while the industry average ranges from $4MM to $6MM. Why are they making less than the industry average?
CRACKING THE CASE
After few questions about the business model, you understand that the Travel Agent’s job is pretty simple: sell hotels and get a fixed commission out of that. Competitors are doing exactly the same. Industry looks pretty commoditized, so in principle it would be hard to understand big differences in profitability.
Laying down the structure
Pretty straightforward profitability case, main focus is:
- Understanding why we make less then our competitors
- Identifying the cost structure (fixed vs. variable). Figures per se are not that important, what matters is really how costs grow with volume
Profit should be broken in revenues and cost, as usual. Profit is the product of:
- Total booking value
- Average Commission
Total booking value can be further broken down in:
- Number of bookings
- Average booking value
Costs are grouped into fixed and variable, as usual.
Solving the problem
Asking questions, you find out that our commission is the same as that of our competitors and our total booking value is higher. Hence our revenues are higher than those of our competitors.
If you broke down total booking value in average booking value and number of bookings, you’ll find out that we have more bookings than our competitors, but our average booking value is lower.
Fixed costs are the same across us and our competitors, so we can easily ignore them for the purpose of this exercise. Variable costs per booking are also constant (9$), but obviously higher due to a higher number of bookings.
REVENUE AND COST TOGETHER
At first sight the key takeaway seems to be that our problem is the average booking value, also considering the fact that increasing commissions beyond competition in a commoditized market is likely going to be counter-productive. It looks like the best solution to our problems is simply convincing our current customers to spend. At this point you may come up with a list of potential initiatives incentivizing our customers to spend more and the case looks complete. Unfortunately, this is a partial (and misleading) solution.
THE POWER OF SEGMENTATION
When the cause of lower profitability is unclear at an aggregate level, segmentation enables us to assess how profitable each customer is. We can reasonably expect different customers to bring different levels of profitability, but it could also be that some customers are actually draining profit.
If you dig deeper you’ll find out that there are two types of customers: leisure and business travellers. The average booking value of 120$ is an average of
- 66$ spent by the leisure travellers
- ~200$ spent by business travellers
At this point it is not necessary to compute total profit for each category, but it is enough to evaluate the profit per booking: for every leisure traveller we get 6.6$ in commission, but spend 9$ in variable costs. This is equivalent to say that for every leisure traveller we lose 2.40$. If we only served business customers our total profit would almost increase by 50% overnight, just by turning down leisure customers.
see the problems differently
The most intuitive way of looking at a basic problem like profitability is considering the sheer difference between total revenue and total costs:
profit = revenue - cost
However, if you think carefully, you could also look at total profit as the sum of individual profits generated by each customer. Each specific customer will be generating some revenue and cause some costs. At an aggregate level:
profit = (average revenue per customer - average cost per customer) x number of customers
The fact that average revenue per customer is higher than the average cost per customer means that average profit per customer is positive. However this does not provide any information on the breakdown by different customers: there might be customers (or segments of customers) generating a negative average profit and other segments generating a positive average profit. All we know is that the latter more than compensate for the former. You can perform the same segmentation by product or segment of products. The idea is the same: leveraging this kind of segmentation helps you disclose customers or products which might be contributing less to profitability or even generating losses.
A COMMON PROBLEM
The solution to this case reveals an extremely common problem for companies today: some products, business lines or customers are actually generating losses. This means companies incur extra costs just by keeping them afloat and that their profitability can be boosted by a significant amount just by axing loss-making business lines. The key to solving this problem is evaluating the profit contribution of one additional product or customer in each segment. . Doing so will enable us to understand whether it is actually creating or draining value for the company.