Customer Profitability Analysis and Market Valuation: Differential Pricing and the Comparative Profitability of Major Customer Sales

In this study, I investigate whether inferences drawn from customer profitability analysis (CPA) are associated with the information set used by investors valuing firms’ equity. This research question is motivated by the recent emergence of CPA as the most important aspect of strategic planning for managers (e.g., Foster and Young 1997). To the extent that managers use CPA in developing strategies to devote more (less) effort to more (less) profitable customer segments, information about differential profit margins across segments of customer revenues should be value relevant in efficient capital markets. Given that firms generally do not disclose customer profitability details, I use observed income statement data and SFAS 14/131 disclosures to estimate the differential profitability of firms’ major customer sales and non-major customer sales. Using these estimates, I then test whether the association between share prices and major customer profitability is more (less) positive compared to the pricing of non-major customer profitability when major customer sales yield comparatively higher (lower) profit margins. Based on a sample of 20,527 firm-years disclosing major customer sales during 1980 – 2006, I find evidence consistent with the predictions. This study is the first to systematically examine the value relevance of customer-contributed components of income and adds to the literature bridging management accounting and capital markets research (e.g., Banker and Chen 2006; Hemmer and Labro 2008). Furthermore, my results have implications for i) management accounting research concerned with understanding the valuation consequences of CPA and its potential impact on future management behavior; ii) financial accounting research concerned with the informativeness of disaggregated accounting information used by managers for resource allocation decisions; and 3) research interested in the financial effects of significant seller-buyer relationships.