Conducting a Cost to Serve analysis can help you and your company understand where the biggest influences on your profit margins lie. It can also serve as a basis for understanding which customers are more or less profitable and for identifying ways to do things differently and more to the point, more efficiently
In this short article, I’ll share a case study into one supplier of consumer products, which conducted a Cost to serve analysis, highlighting some of the things the company learned along the way.
Purpose and Scope of the Analysis
The company in question pays a distribution allowance to retailers who undertake their own distribution of the company’s products. Management decided to perform a CTS analysis to see if they and their customers could benefit from a change in the allowance structure.
The company was particularly interested in understanding the Cost to Serve attached to various routes to market since, like many supply chain organisations, it utilizes a number of channels. To that end, the following activities were included in the CTS analysis:
- Transportation from company factory to its own distribution centre
- Transportation from company factory to retailer’s distribution centre
- Transportation from company distribution centre directly to retailer stores
- Transportation from company distribution centre to retailer’s distribution centre
- Activities at the company’s distribution centre, to include product storage, handling and picking
- Order capture, processing and administration activities
Lesson Learned … When it came to understanding the CTS for each product, the company soon identified a serious challenge. With more than 300 line items in its inventory, attempting to understand the cost to serve for each item would be an immense task. As a result, the company chose instead to group products into categories and analyze the CTS per category—a far simpler activity, with just four categories to analyze.
Some Results from the Analysis
The product cost to serve was calculated on a “per case” basis for each of the four categories. When transporting products from its factories to its own distribution centres, the company uses a 3PL partner. The partner charges a fixed cost per kilometer, meaning that the more vehicle-space is utilised, the less each case costs to transport.
Since the company uses the same 3PL to transport products from its factories to retailers’ distribution centres and these centres are located at roughly the same distance from the factories as the company’s own DCs, the transportation cost per case is the same. However, this route to market can only be utilized for single-line-item orders sufficient in size to warrant delivery directly from the factories (generally, this means orders that will fill an entire truck).
Distribution Centre Costs
Most of the company’s customers order pallet quantities that are less than a full truck-load; therefore, the company operates its own distribution centre, where it stores products according to forecast order quantities. Once products hit the distribution centre floor, costs are incurred for intake movements, storage, picking and dispatch.
Lesson Learned … Calculating the costs of DC activity in order to fully understand Cost to Serve, can be complex. The company elected to use the costs allocated to various activities by its ERP system. However, these costs are assigned on a “per pallet” basis. Since the company had chosen to use cost per case as its basis for the Cost to Serve analysis, the costs per pallet had to be broken down. This resulted in different costs per case, dependent on the nature of each product. For example, some products can have more cases on a pallet than others.
Next, the costs of transporting products from the company’s DC to its customers’ stores or distribution centres must be considered. Due to the method of transportation used, another conversion is required. The company uses owner-drivers for this transportation leg and pays them by the weight of goods that they transport.
Therefore, understanding Cost to Serve for this element of the operation requires calculating the price paid per kilogram multiplied by the average weight of a case in each of the four product categories. The cost driver here then, shifts from vehicle utilisation to product weight. Hence it costs more to transport a heavy case of bottled beverages than a case of potato chips.
Meanwhile, transporting products from the company’s DC to retailers’ DCs (in full pallet quantities) takes place on a fixed cost per kilometre basis and is performed by the 3PL partner. To highlight the impact of customer behavior on Cost to Serve, it can be seen here that customers who place larger orders, cost less to serve, since their orders offer better vehicle-space utilisation.
Order Processing Costs
How do you work out what it costs to process a customer order? In this company’s case, with two sales departments, each handling different order types (EDI versus call-centre order capture), the management was fortunately able to utilize the cost allocation functions of their ERP system. Needless to say, without ERP, costing elements of an activity such as order processing can be painstaking.
Outcome of The Analysis
As a result of their analysis, the company’s management team identified that savings made by using customers’ distribution infrastructures were greater than they had originally realized. Subsequently, the company changed the way it payed allowances, offering a greater share of savings with retailers.
Does your organisation know the true cost of serving all its customers? … There are many companies that are simply not aware of their true cost to serve their market. However there is an old adage which says “knowledge is power”. Understanding cost to serve is to have the power to increase profits, share savings with customers and especially to reduce risk when expanding into new markets.
If In Doubt, Seek Some Help
You might find a CTS analysis is less painful with the help of a good management consulting company, for whom such an exercise is all in a day’s work or two. Nothing worth doing is ever easy, but with a professional helping hand, your company can reap the benefits to be had from understanding cost to serve.
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