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Key Account Valuation Strategy

 

Fulfilling corporate strategy
Key customer selection is one of the most important decisions that suppliers face in key account management (KAM). Whether key customers  currently represent 20 per cent or 80 per cent of your business, they should, by definition, be business leaders – leaders in your business, and/ or leaders in their own sectors as well. The key customers to which you give  special attention must be those that will make a substantial contribution  to the fulfilment of your strategic vision, so making the right choices is critical.
If you fail to choose appropriately, your portfolio is likely to contain a mixed bag of big names, old friends and difficult/over-demanding customers which is not going to take your business anywhere, never mind the vision of the future that you have mapped out. Your other customers are typically smaller and more often driven by their markets than leading in them, and it is very unlikely that they can fulfil both their own part in your strategy and make up for what the key accounts fail to deliver. So to achieve corporate objectives, you must select the right key customers.
Although choosing key customers is one of the most important decisions in key account management, and also one of the earliest, some companies believe that their key customer portfolio is a ‘given’, and appear to avoid making the decision at all. In essence, they are saying that their biggest customers now are also their best, and will always be so. This is a very dangerous assumption, and should be challenged and investigated objectively. Look for phrases like ‘We don’t need to do that – our key customers choose themselves’ and ‘It’s obvious – we all know who they are anyway.’

Given the importance of selecting the right key customers, it is something of a puzzle to work out why many suppliers make such a poor job of it.
Although enlightened companies understand the need for rigour and care in making their choices, the selection process is still, in many companies, approached rather casually and intuitively. It is only further down the line, when some of the consequences begin to bite, that suppliers realize their mistake. Numerous companies have had to backtrack with some very large customers when they realized that they could not – or did not want to – deliver on their promises of special treatment.
Real key account management requires suppliers to deliver customized, innovative strategies to individual customers, and that capacity is seriously limited in any company, however large. Obviously, if there are not going to be many key accounts, then choosing all the right ones and none of the wrong ones is crucial to success.

Selecting for superior returns
It quickly becomes clear that key account management and key customers will be a major pull on resources. If they are not, then it will be just a cosmetic programme, soon to be discredited by customers and your own organization alike.
However, when your company is investing in customers, it will be expecting better performance from these customers than it receives from the rest of its customer base, whether in terms of growth, increased margins or some other contribution to profit.
The customers picked out for special treatment should be those who will give a superior yield in the future. Ultimately, that is how your Board will judge whether the approach is successful, and more worthy of their investment than, say, buying more equipment, more staff training or more advertising. Otherwise, why bother?
It follows that including any customers in your selection who do not respond to key account management could bring down the whole initiative, because the overall return on investment will be the poorer because of them . In fact, while you are working hard with the ‘right’ accounts to increase shareholder value, the ‘wrong’ accounts can destroy shareholder value just as fast, by taking all they are given and doing exactly what they would have done anyway. BOC described these customers as the ones that ‘want-it-all-but-don’t-want-to-pay-for-it’ (or can’t).
Even if you did a good job on selection at the outset, unless you have a process for deselecting key customers as well as choosing them, then your company will inevitably have accumulated some poor performers a few years into key account management. The portfolio should be reviewed with relegation and promotion in mind on an annual basis. Obviously, performance will be examined more frequently, but customers should not be selected, deselected and reselected on a quarterly basis. They do not appreciate this kind of fickle behaviour and are inclined to respond negatively.

Sensibly, underperforming customers should be identified at a regular, annual review, and then put ‘on probation’ for the next 12 months. Whether you decide to tell them in advance, or just observe what happens during the year, depends on your relationship with the account. Some companies are quite clear with their customers about what they have to do to become a key account, and therefore what they will have to do to stay as a key account.
Others find this approach uncomfortable, and apply a mix of more subtle hints and negotiations.
Nevertheless, if no response is received, or you see that none is achievable, then restrictions should be placed on the resources accessible to the customer. Of course, you need to remember that these customers probably still give your company substantial business, so resource restriction needs to be accomplished with tact – but nevertheless, it must be done.

 How many key accounts?
Why would key customers spend their time with you if they did not expect significantly special treatment from their key relationships? Genuine key account management reaches deep inside a company to come up with the kind of breadth of offer and innovation that these customers seek. It requires a considerable change from traditional ways of working and, even if that is achieved, the capacity of a supplier to deliver this kind of treatment profitably is not infinitely expandable. There is a ceiling to any supplier’s capacity for intimacy, which needs to be recognized. Hiring an extra bunch of key account managers to go out and be nice to customers does not shift the ceiling – but it may bring the house down!
Big companies with big customer databases often talk about their key customers as the ‘top 100’ or ‘top 200’, or even the ‘top 300’. We can assume these have been badly chosen (usually just on past sales volume) and are inadequately served, certainly below the level expected by a key customer.
As suppliers realize the limitations on their capacity to support key customers properly, they invariably tighten up on the numbers admitted to the portfolio.

Your company should balance the number of key customers it can handle with a number that represents enough business potential to make the initiative and the effort involved worthwhile. Adopt too many key customers, and you risk falling down on internal and external commitments, with a strong chance that the key account management programme will die a messy death. Adopt too few, and key account management will be seen as a marginal activity and not given enough attention and resources to be successful. Alternatively, if this few represents a major part of the business, then while you are reducing the risk by strengthening your relationships with these critical customers, you are also exacerbating the situationby growing your company’s dependency on them. You should increase your portfolio by growing some other customers into key accounts and/or attracting segments of smaller customers to your business.
Nevertheless, it makes sense for novices to err on the side of caution until they have some experience to use as a benchmark. Somewhere between  15 and 35 is often about the right number, but it will finally depend on the particular company and the sector in which it operates.
Curiously, some companies do not seem to know exactly how many customers they count as key. In that situation, it is hard to believe that key account management is a real, living strategy in the organization. If you cannot even name and count your key customers, it is highly unlikely that you are genuinely managing them as key accounts, or that they will know and believe that they are key accounts.

 Identifying customers
Obviously, the potential of customers is fundamental in selecting them to be key accounts and, equally obviously, you cannot assess their potential until you have described the identity of the customer you are considering, which includes defining its boundaries. The identity of the customer is often simply assumed to be self-evident, but that can be dangerous.
In that case, the real identity of the customer was quickly clarified, but often this simple question provokes a lot more debate, either because it has never been clearly defined, or because it challenges the status quo in terms of who ‘owns’ various parts of the customer. Quite often, suppliers cut up the ‘carcass’ of the customer and hand out a limb to everyone in the family, but each separate piece is never going to have as much potential as the whole and, besides, maybe the arms and legs work together! In summary, beware of making artificial divisions of the customer ahead of rating them as a potential key customer; you can do that later, if you must.
In fact, defining a customer in such a way is a figment of the supplier’s organization, and often does not reflect the customer in its own terms. Sometimessuppliers justify the arrangement in terms of the customer’s supposed purchasing history: ‘They only buy from their office in this region, so it fits well with our structure.’ But is that true? Do they buy in this way because you made them? When did you last check?

Choosing selection criteria
Your selection criteria should identify the customer’s attractiveness in terms of its potential for your company, not just what it is delivering today. Best practice companies work with a three-year timeframe, and some with longer. If you overemphasize current size or even current profit, you will put too much resource into those whose life cycle with you is maturing, and you will under-resource those who can grow. This is all too common, but under-resourcing growth is a serious problem when most companies (and their investors) quite rightly judge their performance on growth.

1. Customer outcome-based criteria
These are the criteria that come to mind first. They are generally:
•  ‘Hard’ or quantitative factors, i.e. they can be unambiguously defined and objectively measured
•  Outcomes that represent the business which suppliers like you could do with the customer; like:
– purchases
– margin
– contribution
– profit
•  Factors that reflect the customer, independent of your company:
– customer size/turnover
– growth in customer’s markets
– spend with any supplier on goods and services from the category into which they put your company

2. Customer needs-based criteria
Customer needs-based criteria suggest the likelihood that your company in particular will retain the business, and are therefore:
•  Aligned to your company strategy specifically
•  Representative of the chance of your company securing and retaining the business (because your strategy will be aligned with the customer and you will be differentiated and supportive of their strategy)
•  Qualitative but should be quite specific and are still measurable
•  Factors that reflect your strategy, and are therefore different for each supplier; examples are:
– global presence
– dedication to compatible platforms
– importance of low customer churn in their business

3. Customer attribute-based criteria
Customer attribute-based criteria represent what the relationship might be like and are therefore:
•  Indicators of whether the business will be successful and profitable
•  Perhaps ‘softer’ than either of the other two categories, but can still be quantitatively assessed
•  Factors about how the customer may behave in relationships (which is not necessarily the same as in the relationship you have with them currently), like:
– central decision-making structure
– right attitude to relationships
– prepared to pay for value
– prepared to invest in relationships

Rating and scoring customers in this way allows suppliers to compare customers who may be quite different, through bringing each back to a numerical score that reflects their differences, but still enables valid comparisons to be made. One customer may score well on potential size, but its attractiveness is genuinely reduced by its attitude to relationships, which will have an impact on the business. Another customer may be smaller, but is better to work with, and its overall score may turn out similar to the larger customer. Indeed, the profit each delivers to the supplier in the end may well be similar, which is what the score should represent.

The process of key customer selection should be as objective and informed as possible – that is one of the main reasons for using a clear and criteria-based approach. So, while senior management should certainly be instrumental in determining the selection criteria, they should not rate and choose the customers. They rarely have a sufficiently close involvement to have the extensive, balanced and current knowledge required – but they might think they do!
At the same time, although key account managers should not misrepresent their customers in order to squeeze them into the portfolio, the temptation is there and many fall into it. To combine customer knowledge and objectivity, roll out the task of rating customers against the criteria to several people in each case, not just the key account manager. Other functions that have customer contact, like customer service, logistics and accounts, should be included.

What do customers want?
The kind of customer that is attractive to your company is probably seen as equally attractive to your competitors. They are likely to be the market leaders, the innovative companies who succeed and go on succeeding, year in and year out. Either they already have a very substantial business which is still growing, or they have great potential and are on a steep upward path. Such companies have plenty of choice in suppliers, and if your company is not giving them what they want, they will be welcomed with open arms by your competition. Having said that, most customers do not want the upheaval and cost of changing suppliers unless they have good reason to change.
Obviously, if customers are getting what they want from a relationship, then they will stay with it. However, suppliers often fail to recognize all the potential benefits of the relationship to the customer, so they overestimate the value of a few of elements of support they offer, and oversupply them too, while underestimating the importance of some of the other things they can do.
Some worthwhile initiatives might appear from seeing a broader list of benefits, such as that below, which was collated from the advantages cited by customers in our research:
•  Trust – always behaving appropriately
•  Leverage – something unique, and not always price
•  Unique competitive advantage/customization – or else why bother•
•  Cost reduction – without sacrificing value targets
•  Simplicity – reducing their complexity
•  Continuity – being around in the future as well as the present
•  Supply chain integration – smoother, cheaper
•  Global consistency – the same offer, anywhere
•  Consultancy – calling on the supplier’s expertise
•  Strategic concentration of resources and investment – where  worthwhile.

Above all, customers want suppliers they can trust and with whom they can build open, trusting relationships. Trust may be defined as: ‘The expectation that a company will behave in a predictable and mutually acceptable way.’ That works up to a point, but a customer expects more from a supplier with which it has substantial business and a close relationship than it does from one from which it buys a modest amount of commodity products. Indeed, the customer looks for different minimum levels of trustworthiness at different stages in the relationship.

Profitability  of   key accounts 
First, it is necessary to understand the concept of net free cash flow in relation to key accounts. This is the total sales revenue generated from a customer, less all the costs that are incurred in servicing that account. As already stated, overhead costs include a proportion of overhead costs in relation to their use in servicing the account. Activity-based costing (ABC) can be used to determine how much this should be.
Knowing key account profitability in terms of net free cash flow:
•  assists in deciding whether to keep the customer and on what terms,
•  helps in strategic decisions about the allocation of scarce company resources and
•  enables informed decisions to be taken in negotiations and in pricing.

A basic profitability model  require the following kinds of questions  to be discussed:
•  How much does the customer buy in a year?
•  What is the direct cost of those goods?
•  Are the products standard or bespoke?
•  Is it steady work, or seasonal peaks?
•  How many orders do they place in a year? By what mechanism? How many of these are ‘emergency’ orders? Are they small quantities or large?
•  How many times do sales people have to visit them?
•  Do you have to maintain stock for them, or do you make to order?
•  How many delivery sites are there? Where? What delivery terms?
•  How many invoices do you raise to them? How many credit notes?
•  Do they pay promptly? What are your credit control costs? How much does it cost you to finance their debts?
•  How much after-sales service do they need?
•  What is likely to change in the future?

It is worth remembering that in the early stages of dealing with a major customer, cash flows may be negative whilst a position of strength is established, so it is important to calculate cash flows over a planning period of at least three years.

However, these cash flows need to be reduced using a probability assessment based on the risks associated with particular accounts, such as the risk of:
•  Defection or migration
•  Volatile purchasing patterns
•  Negative word of mouth
•  Default, fraud, or litigation
•  Slow payment.

First,   key accounts can be positioned on a risk/return graph in the same way that companies or markets can. Those below the line are destroying shareholder value; those above are creating shareholder value. The reality, of course, is that there will always be some key accounts that are not creating shareholder value, but as long as these are managed appropriately (i.e. trying to increase revenue and reduce costs) and as long as the aggregate of key accounts are creating shareholders value over the strategic planning period, this is acceptable.

Background/facts:
•  Risk and return are positively correlated, that is, as risk increases, investors expect a higher return.
•  Risk is measured by the volatility in returns, that is, the likelihood of making a very good return or losing money. This can be described as the quality of returns.
•  All assets are defined as having future value to the organization. Hence assets to be valued include not only tangible assets like plant and machinery, but intangible assets, such as key accounts.
•  The present value of future cash flows is one of the most acceptable methods to value assets including key accounts.
•  The present value is increased by:
– increasing the future cash flows,
– making the future cash flows ‘happen’ earlier and
– reducing the risk in these cash flows, that is, improving the certainty of these cash flows, and, hence, reducing the required rate of return.

Suggested approach
•  Identify your key accounts. It is helpful if they can be classified on a vertical axis (a kind of thermometer) according to their attractiveness to your company. ‘Attractiveness’ usually means the potential of each for growth in your profits over a period of between three and five years.

•  Based on your current experience and a planning horizon that you are confident with, make a projection of future net free cash in-flows from your key customers. It is normal to select a period such as three or five years.
•  These calculations will consist of three parts:
– revenue forecasts for each year,
– cost forecasts for each year and
– net free cash flow for each key customer for each year.
•  Identify the key factors that are likely to either increase or decrease these future cash flows. These factors are risks.
•  These risks are likely to be assessed according to the  the relationship risk scorecard
•  Now recalculate the revenues, costs and net free cash flows for each year, having adjusted the figures using the risks (probabilities) from the above.
•  Ask your accountant to provide you with the overall strategic business unit (SBU) cost of capital and capital used in the SBU. This will not consist only of tangible assets.
•  Deduct the proportional cost of capital from the free cash flow for each key customer for each year.
•  An aggregate positive NPV indicates that you are creating shareholder value – that is, achieving overall returns greater than the weighted average cost of capital, having taken into account the risk associated with future cash flows.

Key account portfolio matrix
In the key account portfolio matrix (Supplier business strength with customer vs. Account attractiveness)
Accounts  with the  low potential/high strengths are likely to continue to deliver excellent revenues for some considerable time, even though they may be in static or declining markets. Good relationships are already enjoyed and should be preserved. Retention strategies are therefore advisable, incorporating prudence, vigilance and motivation. More importantly, as the supplying company will be seeking a good return on previous investment, any further financial input here should be of the maintenance kind.  In this way, it should be possible to free up cash and resources for investing in key accounts with greater growth potential.

The key accounts with (high potential/high strengths) represent  accounts with the highest potential for growth in sales and profits. These warrant a quite aggressive investment approach, providing it is justified by returns. Net present value (NPV) calculations may be used as a basis for evaluating these returns, having taken account of the additional risks involved. Any investment here will probably be directed towards developing joint information systems and collaborative relationships.

The key accounts with (high potential/low strength) pose a problem, for few organizations have sufficient resources for investing in building better relationships with all of them. To determine which ones justify investment, net revenue streams should be forecast for each account for, say, three years and discounted to take account of the high risks involved. Having made these calculations and having selected the promising accounts, under no circumstances should financial accounting measures such as NPV be used to control them within the budget year. To do so would be a bit like pulling up a new plant every few weeks to see if it had grown! The achievement of objectives should instead be monitored using measures such as sales volume, value, ‘share of wallet’ and the quality of the relationship, enabling selected accounts to be moved gradually towards partnerships and, in some cases, towards integrated relationships. Only then will it become more appropriate to measure profitability as a control procedure. Accounts which the company cannot afford to invest in should be managed in a similar way to those residing in the bottom right quadrant.

The key accounts with  (low potential/low strength) should not occupy too much of a company’s time. Some of these accounts can be handed over to distributors, while others can be handled by an organization’s sales personnel, providing all transactions are profitable and deliver net free cash flow.
Sometimes, there are very big key accounts in this category – customers who do little other than drive suppliers’ prices down and who do not want to build close relationships with any supplier. Nonetheless, their size ensures that they have to be in the key account programme.
For such companies, net free cash flow must be the prime objective. It makes sense to try to secure such accounts, by lowest prices if necessary in order to secure the high volume of sales, preferably via a two- or threeyear contract. Thereafter, service should be kept to the minimum, orders should, if possible, be made via the Internet or a call centre and personal calls should be kept to a minimum in order to save costs. If such a customer insists on lots of free services, this pressure should be refused, remembering that the objective is to maximize net free cash flow.

All other company functions and activities should be consistent with the goals set for key accounts according to the general categorization . This rule includes the appointment of key account managers to key accounts. For example, some key account managers will be extremely good at managing accounts in the exploratory, basic and cooperative key account management stages where their excellent selling and negotiating skills are essential, whereas others will be better suited to the more complex business and managerial issues surrounding interdependent and integrated relationships.

 

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