Supply chains are complex entities. Even if you simplify your product range and your upstream suppliers, you still have to deal with the ramifications of diverse customers, their expectations, their location and the logistics needed to meet their requirements.
While customer satisfaction is a hugely important criterion by which supply chain success is judged, so is supply chain profitability. The challenge is to measure profitability to the right level of detail in order to see what works and what could be improved.
Too little detail won’t give you the information you need to take action. Too much leads to resources being monopolised on gathering tons of data and a subsequent risk of “paralysis by analysis”.
Cost to Serve (CTS) is an approach that helps you avoid both extremes. It lets you identify specific actions to take for a better bottom line without necessarily sacrificing customer satisfaction.
How Much Does It “Cost to Serve” Your Customer?
By calculating what it truly costs to deliver a good or a service to a customer, and by comparing that cost with what you invoice to the customer, you can see what is finally left for your enterprise in terms of overall profit – or loss.
It comes as a shock to some businesses to see that some major customers are not making them money, but losing it. The reason for this is simple. It costs you a certain amount to make a product.
Unless you are customising your manufacturing for each product, we’ll assume the production cost is the same each time the same product is produced. You then set a sales price for that product. Your sales price minus your production cost is your overall profit or margin; at least, before allowing for further expenses.
So far, so good… but what about those further expenses? Here is a sample list (and certainly not exhaustive), with each item on it potentially chipping away at your overall profit:
- Promotional discounts
- Efficient order terms
- Sales organisation costs
- Marketing costs
- Ordering and cash collection
- Picking and packing
- Outbound transportation
- Customer-specific services
- Returns management
Logistics costs are often a big contributor to overall Cost to Serve. Thus, if you find out that an expensive transport solution (courier for example) is routinely being used to deliver a low margin product to a customer, you’ll understand that much better if the end result for you turns out to be a loss.
The Value of Knowing Your CTS
A knee-jerk reaction to a loss-making sale might be to stop selling that way. A similar reaction to a loss-making customer might be to stop serving the customer. However, while handing a customer over to your competitors is one option, it isn’t the only one—or even the best one.
The real value of knowing your Cost to Serve a given customer is to identify opportunities to increase or recover profit, rather than cut losses. In other words, it often makes sense to see how you can transform unprofitable customers into profitable ones, rather than cutting them off. This is also more consistent with the statistic that it is up to ten times less expensive to sell to an existing customer than to go out and find a new one.
In addition, while you can take the credit for low CTS, it may also be that high CTS is more your fault than the customer’s—and here’s why…
Customers have their own expectations about the service they receive from their suppliers. They may be just as happy with a lower level of service, meaning that you are losing profit by unnecessarily over-serving them. Conversely, they may expect higher levels, but understand that this must also be paid for, over and above standard pricing. In the first instance, you could reduce CTS and increase profit, without upsetting the customer. In the second, CTS would remain the same, but sales pricing could be increased as appropriate.
Knowing your CTS per product and per customer also lets you better control different commercial strategies. You may decide that if you make an overall profit from a customer, then you’ll accept some unprofitable sales as part of the mix.
Knowing your CTS will let you make the initial adjustments so that globally your business relationship with that customer is profitable. If profits start to decline afterwards, your CTS data can offer valuable information about what changed and how to get back on track. It can of course also be used to make an already profitable relationship even more profitable!
Collecting and Using Cost to Serve Data
The Cost-To-Serve approach is a pragmatic one. It aims for a balance between providing useful, actionable information and containing resources and efforts for data collection at a reasonable level. It is inherently more useful than the top-level averaging approach of some enterprises, which fails to identify the real cost drivers and therefore the potential for improvement.
On the other hand, CTS is less complex than the intensely detailed activity-based costing (ABC) approach often used internally to calculate levels of expenditure and departmental budgets. That said, CTS models that include end-to-end supply chain activities can use ABC data in order to calculate the overall profitability of serving a customer with a product.
The tools for determining Cost To Serve include standard spreadsheet applications, such as MS Excel, and network design modeling software. In the first instance, a CTS model allocates costs that are already being tracked by an enterprise: a spreadsheet model can provide a basic yet useful approach.
For categories of costs that are more complicated to manage, purpose-built network modeling applications make it easier to allocate costs and to calculate CTS for different customer/product combinations from transportation, production and warehousing cost data.
The pragmatism of CTS means a piecemeal or partial approach can also yield profit improvements. CTS modeling can be done first on a subset of costs that already make a large contribution to overall profitability, such as logistics costs. As CTS data collection and modeling capabilities develop within your organisation, you can then extend to an end-to-end supply chain model as desired.
The Benefits Derived by Enterprises and Organisations
Cost to Serve data and modeling benefits are sometimes deceptively simple. They may confirm things you already suspected were true. For example, a CTS analysis may show you that customers ordering directly from you at your factory also generate lower costs in transport and inventory costs.
This sounds like common sense. However, what a CTS analysis also then brings to the party is accurate data on how much lower, allowing better cost allocations and pricing decisions for profitability.
Individual customers can be assessed for overall profitability and the results collectively plotted on a graph. This often gives what is called a “whale curve” of accumulated net profits that shows how:
- First, a small percentage of customers (say 20%) is truly profitable for the company, showing a steep climb in accumulated profits
- Then, a relatively large percentage (say 60%) only allow the company to break even, representing a flat line in the graph (no further profit)
- Finally, another percentage (20% in this example) of customers actually loses money for the company, showing a steep dive back downwards in total accumulated profits.
By grouping a particular number of customers together, profitability can also be evaluated for a customer or market segment. A product can be analysed in terms of overall costs to stock and distribute it. CTS models may therefore also lead to SKU rationalisation and simplification. Besides identifying low (or negative) margin customers and products, high-cost processes can also be picked out for improvement and optimisation.
Taking CTS further still, the data and the models built can be used to manage real-time decisions about stocking, transport routing, and order handling.
Orders can be evaluated in terms of their true Cost to Serve, and either accepted, declined, or modified on that basis. Seasonal variations can be taken into account, whether in the costs of production, storage, or transport.
Besides optimising the present or fixing the past, CTS reporting and analysis opens the door to what-if scenarios and projections. Alternative modes of service and distribution can be investigated before trying them out in practice. Similarly, finding out the Cost To Serve customers for another company if you are considering a merger or acquisition can show where additional value can be unlocked if under-pricing or over-serving is happening.
Real Life Cost To Serve Cases
No individual supply chain is the same as another, but the cases below highlight principles or tactics that could find application across a wide range of industry sectors.
A) Hospital group supplies in Thailand, with about 20 hospitals in the group: Supplies were being purchased either individually by each hospital or (about 20% of supplies) via a central purchasing organisation. Up to 7,000 SKUs were being purchased in a process replete with inefficiencies such as multiple handling, redundant stock levels, and duplicated order processing.
At the same time, quality of patient (‘end-customer’) care was of paramount importance. A Cost To Serve analysis highlighted wins for reducing costs that had up till then been undetected by conventional cost reporting. Patient care remained uncompromised and as a bonus, supplier management was streamlined too.
B) Dealing with order-changers: Some order changes in business are inevitable, but they all have a cost. When order changes become the norm instead of the exception, the financial impact can be seen in areas such as logistics, customer service, and returns management.
CTS reporting for one company allowed costs to be broken out and applied per customer. Accounts that repeatedly changed orders, especially orders of high dollar value, were charged correspondingly more to compensate for the negative effect on the company’s profitability. The immediate benefit to the company was estimated at $5 million in additional profit. There was also a longer-term change in customer behaviour that was advantageous for all concerned.
C) Consumer goods distribution in Australia and Thailand: While both in the same business sector, each company benefitted in different ways from Cost to Serve reporting results. CTS showed the Australian company how 30% of its products were already suffering unnecessary margin erosion even before delivery started for customers. CTS then also helped pinpoint simple process changes to improve margin retention significantly.
For the company in Thailand, the issues were linked to poor fleet utilisation with high costs to serve small customers and small orders. After identifying these problems and modeling improvements in the use of distributors and modes of transport, CTS led to annual distribution cost savings of $10 million.
D) Swedish manufacturer of heating systems: Following a cost to serve analysis, this company found itself confronted by a classic ‘whale curve’ of profitable and unprofitable customers. In particular, 20% of customers were generating 225% of total profits, 70% contributed zero profit (break-even) and 10% caused a loss of 125% of total profits. The big surprise however was that its two largest-volume customers were also its least profitable ones. The CTS analysis allowed the manufacturer to adjust pricing and supply volumes to increase profits with the two customers concerned, but without derailing the commercial relationships.
So How Do You Calculate CTS in the Real World?
When first published, this article explained the CTS concept, outlined the benefits of analysing cost-to-serve, and provided some brief examples of successful CTS projects. In the following section, which has been added as an update, I thought I would incorporate some practical value with a brief outline of the steps involved in a cost to serve analysis.
6 Steps to Understanding Cost to Serve
The following systematic approach is not necessarily the only way to go about analysing CTS, but it does represent a logical sequence of activities that will get you and your team to a satisfactory result.
Step 1: Agree on Objectives:
CTS analysis is highly valuable as a general exercise, especially if your company has never completed one before, but certain specific problems can also be solved with help from CTS analyses. Therefore, the first step should be to ensure all stakeholders and project participants understand the objectives of the activity.
Answering the following questions will help your team to determine objectives and hence keep the CTS process on track:
- What is the specific problem to which we are applying the CTS analysis?
- How will we use the outputs from the analysis?
- What will we do differently after arriving at the analysis results?
Step 2: Map out the Activities to be Costed:
Although in this case, you will be creating activity maps specifically for your cost-to-serve model, the process will be an invaluable aid to future projects—and to gaining a better understanding of your supply chain.
Many companies think they know what their operations entail, but activity mapping can often be enlightening.
For the CTS analysis, your activity mapping does not have to drill down to the finite details of your logistics processes. In a warehouse for example, activities might be described and studied as per the following examples:
- Unload pallet from inbound delivery vehicle
- Move pallet to storage location
- Place pallet in storage bay/bin
- Move pallet from storage location to pick face
Step 3: Link the Mapped Activities to Drivers and Cost Elements:
Once your team has mapped all activities within the scope of the analysis, it is time to assign cost elements to each of them. In reality, you might decide to perform steps 2 and 3 together, but I can explain the process more clearly by separating these steps.
Cost elements will typically include services (such as transportation), the cost of inventory, storage, and the use of equipment and labour required to perform the activity in question.
In addition to assigning cost elements, it’s also vital to assign the drivers of each cost, in other words, the factors that influence the costs. For example, time may be a cost driver for many activities, as the longer an activity takes, the more it will cost. If the activity is completed more quickly, the cost will fall.
Step 4: Compute the Actual Costs of Each Activity:
This is the most complex step in what is admittedly a complex process. Your team will need to decide precisely how to calculate costs for each activity and then perform the necessary computations. At the minimum, you will need to create a model using a spreadsheet application such as Microsoft Excel.
For more complex analyses, or if you intend to implement a regular process of dynamic analysis (which is becoming more and more essential in today’s complex multichannel supply chains) you should probably invest in best-of-breed CTS software.
Bear in mind that each activity may generate a requirement to calculate costs for different combinations of cost elements and drivers. For instance, costs for picking an SKU might need to be calculated based on picking single cases, picking pallets, picking at regular pay rates, and picking at overtime rates. That’s four different combinations involved in one simplified example.
Step 5: Plan, Calculate, and Implement Actions Based on Analysis Results:
After completing step 4, you will have the necessary understanding of the costs involved in your current logistics scenarios. The next step is to apply the results to resolving cost pain-points, whether those relate to products or product segments, or customers or customer segments.
Step 6: Post Implementation Evaluation of Changes:
This is the step that many companies overlook, which really is an unforgivable mistake. At some point after implementing changes, you should seek to understand if you have positively impacted your cost to serve in the context of the objectives originally agreed.
Cost to Serve reporting, analysis, and modeling has much to offer organisations of all kinds. Besides allowing a pragmatic approach without the complexity of other accounting approaches, CTS often helps highlight hidden profit potential that does not show up elsewhere.
Some customers on the other hand are aware that their low CTS status can also be used as leverage to gain price discounts. Retailer Wal-Mart is an example of a customer using CTS information to its advantage in this way.
Whether or not CTS analysis leads to price increases for other customers with higher CTS may also depend on other factors such as the strategic sales importance of the customer as a reference for others. However, visibility of relevant Cost to Serve data means organisations can already make informed choices and better control their profitability instead of being forced to struggle with mediocre bottom line performance.
Editor’s Note: This post was originally published in August 2015. It has since been revamped and updated with information that is more comprehensive. The most recent updates were made in October 2018.