There was a very inter­est­ing arti­cle in last Tuesday’s (Novem­ber 10) edi­tion of The Wall Street Jour­nal. It is enti­tled, It Just Isn’t Work­ing? Some File for Cus­tomer Divorce, and it relates how some small busi­nesses are elim­i­nat­ing prob­lem­atic customers.

In the paper edi­tion, the arti­cle appeared under the “Small Busi­ness’ ban­ner, and it now resides under a similarly-​labeled sec­tion of the web site; how­ever, it applies equally well to busi­nesses of all sizes.

We must admit, though, that the topic is espe­cially poignant for small busi­nesses because the decision-​maker and the imple­menter (exe­cu­tioner) are often one-​and-​the-​same per­son, and the cus­tomer may be a friend or acquain­tance. There’s no, “my boss told me that I have to do it” excuse when you are the boss. Note, how­ever, that many seemingly-​independent, entre­pre­neur­ial men still use their wives as rea­sons why some­thing can’t be bought or sold at a given price. We would never admit to such behav­ior, unless our Chair­man, Jill, per­mits us.

The main point of the arti­cle is that despite gen­er­ally tough eco­nomic times, a few small busi­nesses are find­ing that it is not worth­while to deal with cer­tain clients because those clients dis­pro­por­tion­ately con­sume time and resources given the rev­enue that they generate.

Dis­ci­pline! Discipline!

Though we sound like Colonel Hathi from The Jun­gle Book, there are a cou­ple of obvi­ous ways to min­i­mize the prob­a­bil­ity of enabling such problems:

1. Don’t appear too des­per­ate or too needy for the busi­ness. (In that sense, it is a lot like dating.)
2. Eval­u­ate the client, and have a slid­ing scale of prices rang­ing from lower prices for easy clients to higher prices for pains-​in-​the-​butt or annoy­ing ones, and stick to it.

Admit­tedly, such tac­tics may not be fea­si­ble with all prod­ucts and ser­vices. They gen­er­ally work bet­ter for ser­vices than prod­ucts, and for cus­tomized ser­vices, rather than uni­form or generic ones, and for short-​term projects rather than long-​term ones. How­ever, unless there is a sub­stan­tial ben­e­fit that can be derived from either exist­ing or prospec­tive clients because of the rela­tion­ship with a tire­some one, the tire­some one should pay for the irri­ta­tion, aggra­va­tion, dis­com­fort, and effort that they cause. (We’ll qual­ify this a bit below.)

If such cus­tomers are not will­ing to pay, then the sup­plier or ven­dor is, in fact, sub­si­diz­ing the oppor­tunis­tic behav­ior. More­over, if the sup­plier is not will­ing to sever the rela­tion­ship (or take actions that will change the other party’s behav­ior and prof­itabil­ity), then we humbly rec­om­mend that they not com­plain to every­one around them (thereby mak­ing their employ­ees’ and fam­i­lies’ lives more mis­er­able than need be).

That may seem a bit harsh, but it is con­sis­tent with our response when some­one com­plains about a spouse: divorce them, kill them, or shut-​up. Revealed pref­er­ence says that despite the com­plaints, if the ven­dor is unwill­ing to sever the rela­tion­ship, then he or she must find the arrange­ment to be accept­able. Some­times it is nec­es­sary to do unpleas­ant things – not immoral, uneth­i­cal, or ille­gal, just unpleas­ant ones – to get what one wants out of life.

So, be a good stoic, and live with it in silence (or turn it into a blog post).

We pre­fer to main­tain pric­ing dis­ci­pline because at the mar­gin, one’s will­ing­ness to lower the price or fee is often viewed as a sign of weak­ness. So, clients who make that infer­ence then often request more time and/​or resources. That means that a sign of weak­ness harms both rev­enue and resource-​usage, espe­cially for ser­vices that are pro­vided over time. (Note that this prob­lem can be mit­i­gated some­what by offer­ing a lower-​quality or less-​robust sub­sti­tute when­ever some­one wants a lower price, i.e., “we’ll lower the price, but you’re not getting…”)

By the way, another option is to write very, very detailed con­tracts, but those prepa­ra­tion costs only add to the resource con­sumed by such cus­tomers, and cov­er­ing those incre­men­tal, transaction-​related costs increase the nec­es­sary price to make the trans­ac­tion “worth­while.” (You can see why many folks open fran­chises where such devel­op­ment and prepa­ra­tion costs can be shared nation­ally or even globally.)

Two Costs to Consider

Before fir­ing a cus­tomer who is thought to be “unprof­itable” be sure to con­sider a few fac­tors to deter­mine if the cus­tomer is truly unworthy.

Clearly the choice of fir­ing or retain­ing a cus­tomer is a deci­sion, or the selec­tion (and imple­men­ta­tion) of one pos­si­ble alter­na­tive from sev­eral avail­able alter­na­tives. (Note that “do noth­ing” is often an avail­able course of action.) So, rather than be con­cerned with the report­ing of finan­cial results, or account­ing, per se, we are inter­ested in the costs and ben­e­fits that vary across alter­na­tives, the rel­e­vant costs and ben­e­fits.

In par­tic­u­lar, we are inter­ested in

1. Expected Rel­e­vant Ben­e­fits and Costs
2. Expected Oppor­tu­nity Costs

Note that these costs may vary through time as cir­cum­stances and capac­ity uti­liza­tion change. Tech­ni­cally, oppor­tu­nity costs, which we’ll define below, can be cat­e­go­rized as rel­e­vant costs, but we think that they are wor­thy of their own place on the list.

1. Expected Rel­e­vant Costs (& Benefits)

In a deci­sion, which involves the selec­tion of one pos­si­ble course of actions from sev­eral avail­able options, the rel­e­vant costs of an alter­na­tive, like fir­ing a cus­tomer, are the resources sac­ri­ficed by select­ing and imple­ment­ing that course of action. Rel­e­vant rev­enue (and/​or ben­e­fits) is(are) the resources received by tak­ing that course of action.

Gen­er­ally, one thinks of such costs and ben­e­fits as being mea­sured finan­cially and reported in terms of dol­lars or some other cur­rency, but they need not be. That’s true for small busi­nesses where many sac­ri­fices, includ­ing, say, stay­ing awake an extra hour to work on a project, are dif­fi­cult to mea­sure finan­cially.¹

For items that can be mea­sured finan­cially, the dif­fer­ence between rel­e­vant rev­enues and rel­e­vant costs is the con­tri­bu­tion, and the con­tri­bu­tion of an alter­na­tive can be very, very dif­fer­ent than its reported profit. That’s because: (1) cer­tain rel­e­vant items may not appear on an income state­ment the shows reported rev­enue and expenses and (2) cer­tain reported rev­enue and expenses that do appear on an income state­ment may be irrel­e­vant for the deci­sion at hand.

So the total net ben­e­fit of an alter­na­tive is some mea­sure of the dif­fer­ence between rel­e­vant rev­enues (and other non-​financial ben­e­fits) and the rel­e­vant costs (and other non-​financial sac­ri­fices). We are ignor­ing the prob­lem of com­bin­ing dollar-​denominated rev­enues and costs with non-​financial and psy­chic ben­e­fits and costs since it is very sub­jec­tive and goes far beyond the scope of this already-​long essay. We would have to intro­duce a long recita­tion about util­ity func­tions and expected utility.)

Prospec­tive, not Historical

Note that these costs are incurred prospec­tively – i.e., in the future, not in the past, and that means that they are uncer­tain or impre­cisely known. That’s why we titled this sec­tion “Expected Rel­e­vant Costs:” to indi­cate that ran­dom­ness. How­ever for sim­plic­ity we’ll imme­di­ately drop the uncer­tain aspect and assume that we can pre­cisely mea­sure such resource sac­ri­fices.²

Despite our var­i­ous caveats and qual­i­fi­ca­tions, we’ll try to be clear: by “rel­e­vant” we mean the real incre­men­tal costs that are incurred by mak­ing a deci­sion. For exam­ple, if the deci­sion is deliver a good or per­form a ser­vice, then costs of rent, com­put­ers, soft­ware, and most non-​manufacturing-​related util­i­ties usu­ally don’t change whether an addi­tional cus­tomer is served or not. Paper and ink or toner costs might change – if there is a lot of print­ing involved. Monthly health-​care pre­mi­ums won’t unless more employ­ees are added and retained. Trans­porta­tion costs will but only if more travel or trans­porta­tion is required.

Arbi­trari­ness of Reported Costs

By “rel­e­vant” we don’t mean nec­es­sar­ily mean the reported or account­ing costs that are assigned or allo­cated to a cus­tomer or project on some arbi­trary basis. An account­ing sys­tem, regard­less of its cost, serves many pur­poses, e.g., to sat­isfy the IRS, for per­for­mance mea­sure­ment, etc. When there are jointly-​used resources and/​or resources that last more than one account­ing period, then all account­ing sys­tems require many, many assump­tions and con­ven­tions. Those assump­tions and con­ven­tions per­mit sim­pli­fi­ca­tions so that addi­tion, sub­trac­tion, mul­ti­pli­ca­tion and divi­sion can be used to deter­mine reported costs, but such account­ing sys­tems are very par­tic­u­lar mod­els (or abstrac­tions or dis­tor­tions) of his­tory – of the real­ity that has hap­pened, and do not con­sider (much) of the future.

Irrel­e­vant Costs

For exam­ple, by def­i­n­i­tion, the allo­ca­tion of fixed and/​or sunk costs, e.g., depre­ci­a­tion, of shared resources is arbi­trary. For long-​lived assets, the allo­ca­tion of its cost across time is arbi­trary. For shared resources, the allo­ca­tion across objects is arbi­trary. That means that the reported cost depends upon the account­ing meth­ods applied and is an arti­fact of sim­ple arith­metic cal­cu­la­tions and not a reflec­tion of behav­ior. (They’re fixed for Pete’s sake.)

So, while pur­chase costs of such shared resources can often be mea­sured with high degrees of pre­ci­sion, there is no notion of accu­racy when allo­cated to par­tic­u­lar cus­tomers or prod­ucts. There are gen­er­ally an infi­nite num­ber of rea­son­able and jus­ti­fi­able ways to make such assign­ments.

There are good rea­sons – behav­ior, tax, rhetor­i­cal – for select­ing one allo­ca­tion method over another, but none pro­vides more or less infor­ma­tion. Dif­fer­ent meth­ods may pro­vide greater or fewer details and may pro­vide dif­fer­ent assign­ments across objects – dif­fer­ent reported costs. That may or may not be use­ful for those non-​informative pur­poses, e.g., min­i­miz­ing taxes, but by its very nature, the arbi­trari­ness of the method makes it unin­for­ma­tive. In other words, unless there is only one cus­tomer (in one account­ing cycle), then shared-​and-​fixed costs can be assigned to cus­tomers in a vari­ety of rea­son­able and appro­pri­ate ways, and one method isn’t bet­ter than another unless it helps attain a goal. More­over, some allo­ca­tion meth­ods may make a cus­tomer appear to be “prof­itable” or not – despite the fact that there would be no change in resource con­sump­tion if the cus­tomer is dropped or kept.

In the pre­vi­ous para­graph, we cov­ered the equiv­a­lent of five or six ses­sions of a good man­age­r­ial account­ing course – like the kind we used to teach. The les­son for small busi­nesses – and for all for that mat­ter – is sim­ple. Don’t try to be too sophis­ti­cated and believe that the out­put of your account­ing sys­tem, the reported costs accu­mu­lated from past trans­ac­tions or event, describe real­ity for any par­tic­u­lar deci­sion (set of alter­na­tives). If there are shared resources – shared across objects or time – then there is no notion of true profitability.

That means that one shouldn’t imag­ine that there is some type of hid­den account­ing magic that per­mits vast sim­pli­fi­ca­tion via var­i­ous assump­tions and con­ven­tions, yet some­how can­cels out in just the right way to accu­rately inform, regard­less of the deci­sion. Now, if that sen­tence doesn’t make sense to the dear reader, and he or she is in charge of such deci­sions, then the reader should con­sider get­ting help because it is a very impor­tant notion.

Your account­ing sys­tem out­put may be use­ful to help deter­mine rel­e­vant costs of a deci­sion, but when shared resources have fixed costs, know that your sys­tem is one of many equally-​valid and sim­pli­fied rep­re­sen­ta­tions of real­ity – anal­o­gous to Picasso’s cubism or a two-​dimensional car­toon ani­ma­tion of yesterday’s com­mute or the size and color vari­ety of the pix­els of a dig­i­tal photo. With dif­fer­ent assump­tions, the reported costs of var­i­ous objects will change; oth­er­wise, the dif­fer­ent assump­tions would really be dif­fer­ent. How­ever, note that the under­ly­ing real­ity doesn’t change.

Costs reported in account­ing sys­tems can help iden­tify some cat­e­gories of rel­e­vant costs, but account­ing sys­tems cap­ture only past trans­ac­tions and don’t cap­ture future sac­ri­fices (and how those sac­ri­fices change among alter­na­tive (future) courses of action). In addi­tion, cost reports ignore oppor­tu­nity costs, or ben­e­fits fore­gone by tak­ing one action that pre­cludes tak­ing another, mutually-​exclusive one. (But, we won’t ignore, them: see below.)

The con­sid­er­a­tion or inclu­sion of irrel­e­vant costs – par­tic­u­larly the poorly-​reasoned desire – to recover or recoup the allo­cated expenses related to fixed or sunk shared resources often leads to dis­as­ter, e.g., down­ward death spi­rals of demand. In such cases, the elim­i­na­tion of one “unprof­itable” cus­tomer cre­ates addi­tional unprof­itable ones in the future because they the costs may be much more rigid than per­ceived or reported.

Be sure that reported costs behave the way that you think they do – and are, in fact, rel­e­vant – before elim­i­nat­ing seem­ingly unprof­itable clients.

2. Expected Oppor­tu­nity Costs

In a deci­sion, the oppor­tu­nity cost of the selected course of action, is the ben­e­fit for­saken by not tak­ing the next best alter­na­tive. It is non-​negative, and if there is noth­ing bet­ter to do, it might be zero.

Unlike in our dis­cus­sion of rel­e­vant costs, we’ll keep the mod­i­fier “expected,” because the next best alter­na­tive may involve attempt­ing to gain busi­ness and rev­enue from new cus­tomers, and the out­comes of such activ­i­ties are usu­ally uncertain.

Tech­ni­cally, and non-​financially, there is an oppor­tu­nity cost to any course of action, and through time, as con­straints vary, the next best thing to do changes fre­quently. (Often, how­ever, that sac­ri­fice has zero mon­e­tary value.)

Per­haps the reader vis­its this site from their office but never vis­its it from home. Why? As much as it hurts to admit it, per­haps the reader has esti­mated – pos­si­bly erro­neously – that there may be more valu­able or enjoy­able actions to take at home than read­ing our opin­ions and expo­si­tions. That might not be for cer­tain, but there may be a high enough like­li­hood and high enough pay-​off to jus­tify ignor­ing us in the evening.

Aside: given the var­i­ous con­straints that come and go through time, those read­ers with a bit of math­e­mat­i­cal apti­tude should be able to imag­ine the dif­fi­culty of mod­el­ing and quan­ti­fy­ing these var­i­ous opportunities…a seem­ingly infi­nite hori­zon, mul­ti­ple deci­sions that affect resources and oppor­tu­ni­ties, the option to quit… ad infini­tum. It gets ugly very quickly.

Expected to Oper­ate at Capacity

So, if a busi­ness plans to oper­ate at capac­ity and that capac­ity can­not be changed, then the expected oppor­tu­nity cost of accept­ing a new cus­tomer is the finan­cial con­tri­bu­tion (and other ben­e­fits) asso­ci­ated with the next best alter­na­tive, i.e., the lost finan­cial contribution(s) and ben­e­fits asso­ci­ated with get­ting rid of the customer(s) to free-​up suf­fi­cient capac­ity to serve the mar­ginal cus­tomer.³

Expected to Oper­at­ing below Capacity

If a busi­ness plans to oper­ate below capac­ity, then the expected oppor­tu­nity cost is what the firm is likely to for­sake by not purs­ing other cus­tomers. That requires the assess­ment of the like­li­hood of gain­ing new cus­tomers and the “dis­tri­b­u­tion” of con­tri­bu­tions from those new cus­tomers. For our math­e­mat­i­cal and argu­men­ta­tive read­ers, note that we are using “expected” and “dis­tri­b­u­tion” very loosely. More­over, depend­ing upon one’s risk pref­er­ences, the expected oppor­tu­nity cost may be of lit­tle inter­est. (Strictly, the expected oppor­tu­nity cost is inter­est­ing only to risk-​neutral decision-​makers.)

So, when decid­ing to drop a cus­tomer, the decision-​maker should com­pare the finan­cial con­tri­bu­tion of that cus­tomer (and any other non-​financial ben­e­fits) to his or her assess­ment of the prob­a­ble and (the appropriately-​weighted) improb­a­ble ben­e­fits of find­ing new cus­tomers dur­ing the time period of interest.

If there is a strong chance of gain­ing new, prof­itable busi­ness else­where, then drop the client and start your mar­ket­ing drive. Part of that cal­cu­la­tion should include the less-​obvious, indi­rect ben­e­fits of each alter­na­tive. We refer to them as ancil­lary con­cerns, although their mag­ni­tude could be quite large.

Ancil­lary Concerns:

Side Ben­e­fits of Dif­fi­cult Customers

1. Rep­u­ta­tional Effects on Exist­ing or Poten­tial Customers
2. Learn­ing and Exper­i­men­tal Learning

1.Reputational Effects on Exist­ing or Poten­tial Clients

Con­sider how sev­er­ing the rela­tion­ship with one cus­tomer may affect oth­ers. Is the client par­tic­u­larly pres­ti­gious or well-​connected so that an asso­ci­a­tion with them gen­er­ates addi­tional side busi­ness or ben­e­fits? Will sev­er­ing the rela­tion­ship harm that busi­ness or the prospect of gain­ing new clients? Or will it be eas­ier to main­tain higher prices with exist­ing clients if they know of your pric­ing dis­ci­pline and exam­ples of dropped customers?

No action is taken in iso­la­tion; how­ever, not every action gen­er­ates observ­able or mea­sur­able impli­ca­tions. So, spec­ify the var­i­ous indi­rect out­comes of fir­ing a cus­tomer and esti­mate the short– and long-​term con­tri­bu­tions and net ben­e­fits of such actions.

2. Learn­ing

Note that there is an indi­rect advan­tage to deal­ing with and main­tain­ing dif­fi­cult cus­tomers. They pro­vide valu­able infor­ma­tion about how to com­mu­ni­cate with other, exist­ing cus­tomers; how to mar­ket to prospects; and how to pro­tect one’s time, san­ity, and orga­ni­za­tion. They teach what to promise and what not to promise.

Sim­i­lar to the notion that noth­ing is fool­proof because fools are so inge­nious, dif­fi­cult clients expose the weak­nesses in stan­dard oper­at­ing pro­ce­dures and busi­ness meth­ods and practices.

So, there is an infor­ma­tional value to the asso­ci­a­tion, which may be max­i­mized if the sup­plier behaves oppor­tunis­ti­cally, too. By that we mean exper­i­ment with actions and reac­tions to see how the dif­fi­cult cus­tomer responds. Slow deliv­ery, slow the return of tele­phone calls and e-​mail mes­sages, men­tion addi­tional ser­vice charges for any­thing not spec­i­fied by the con­tract, and con­sider the response.

We don’t rec­om­mend such tac­tics to be vin­dic­tive or venge­ful, or passive-​aggressive, or any other anti-​social rea­son. We rec­om­mend it sim­ply to dis­cover new ways to use the rela­tion­ship advan­ta­geously. If there is no finan­cial advan­tage, then seek other advan­tages, and exper­i­ment­ing with a real, live (though unprof­itable) client is one way to get valu­able feed­back that may help man­age the expec­ta­tions and rela­tion­ships (and there­fore the prof­itabil­ity) of other customers.

Alter­na­tively, it may be the case that such cus­tomers are much more pli­able than pre­vi­ously thought and that they are (or were) sim­ply bet­ter negotiators.

In addi­tion, the predica­ments they cause that must be solved and those solu­tions may pro­vide valu­able tech­ni­cal know-​how that can be applied else­where (or sold for profit).

We’ll likely add or edit this post in the near, future. If you would like to know more, please con­tact us.

Copy­right © 2009 Spero Consulting.

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