The word "profitability" is usually associated with a business' financial bottom line, representing the net value generated over a defined period of time. Commercial businesses seek to maximise profitability to generate maximum value for owners, while others such as charities exist to make only as much profit as they need to sustain their reserves. Charities strive to maximise the value they generate for beneficiaries, so any profits over the amount required to sustain reserves represents value not delivered to beneficiaries.
Whatever the type of business, the value its products generate for its customers must be analysed and understood. If a beneficiary segment targeted by a charity does not value its product offerings, then demand will drop and donors will no longer be inclined to contribute. Turnover will fall and the charity could face a threat to its existence. Similarly, if the targeted customers of a commercial business do not value its products, they will either pay a lower price or transfer their custom elsewhere.
Segment-specific strategies
Management accountants therefore must analyse product profitability and devise strategies to maximise product profitability by customer segment.
Since 80% of a product's direct costs are generally locked in at the design stage, not much can be done post-development to reduce its direct costs. However, it is possible to improve profitability by driving or holding down product or customer service costs. To do so, the management accountant must have a deep understanding of the full product cost structure – not just direct costs.
This insight is typically achieved through a product hierarchy that might start at the top level with product category and end with a bill of material. Each product category should be associated with a customer need; variants within the category might be associated with variations of the top-level need. This will help the business understand the unique customer (or segment) value proposition for each product within a hierarchy.
Understanding cost drivers
It costs more to serve some customers than others. In some cases this increased cost might be justified by the importance of the customer segment to volume or profitability. In others, the business may actually be losing money, meaning that a clear understanding of cost drivers is vital to turning loss-making customer segments into profitable ones.
A clear understanding of the cost drivers for existing products and customers should also inform new product and business development.
