What Is Cost-To-Serve?
In today’s business environment, bottom-line profit makes more difference than top-line sales. Although most companies follow rigorous cost management practices, the primary focus is to generate higher sales. However, revenue growth is not always accompanied by equivalent growth in profit, as associated costs play a major role. Industry analysts believe that more than 20% of a company’s customers are unprofitable – hence the need to identify such customers and analyze their overall impact on business profitability.
Large companies engage in multiple product lines, channels, and SKUs to fuel sales, rather than identifying the unprofitable ones, which can eat into their bottom lines. Identification of these cost leakage points and timely remedial action can increase profitability in the long term and help to improve and sustain a company’s brand.
It is here that cost-to-serve (CTS) analysis helps companies gain visibility into the overall costs associated with each product, customer, channel and SKU to gauge profitability. In B2B marketing, where customers tend to have a high bargaining power, CTS analysis can help assess the value generated by customer relationships.
“Until we began using CTS analysis, we could not estimate the cost of doing business—what would it cost to add a new product line, some new trucks, or a new customer? Should we get rid of certain products or enforce minimum order sizes? We never had a definite answer.” – Kurt Anderson, Director of Operations, J&B Wholesale, February 2013
CTS can help break down costs by product type (material and seasonality), SKU (size and weight), channel (traditional, modern, and direct sales) and customers. In traditional costing, all such entities are estimated to contribute to the overall cost in equal proportion, while CTS takes each activity into account to highlight unprofitable entities.
It helps companies strategize for pricing, promotional spend, and service levels according to the true profitability of products or customers. Additionally, CTS helps gain visibility into hidden costs, such as competitive discounts, volume discounts and sample distribution.
On the flip side, CTS as a stand-alone factor can be misleading. Other factors, such as the revenue-generating capacity, scale of operation, and long-term strategy of a firm should be considered in conjunction to evaluate the long-term value of any entity. Companies have used customer lifetime value (CLTV) along with CTS to overcome this challenge. Moreover, one standard CTS approach cannot be applied across industries owing to the difference in operating models. Also, most CTS solutions do not facilitate benchmarking and forecasting for the long term.
The framework to measure CTS involves activity-based costing (ABC) for customer service. Processes such as assessing marketing costs per product line and structured activity-based models to allocate costs to customers are adopted in the process. Consumption is translated into monetary terms using the cost rate provided by accounting. For example, the time spent by marketing and sales managers to solve customer problems is measured and then converted into a monetary cost by multiplying it with the average hourly cost of marketing and sales personnel.
Various third-party CTS tools and customized reports are available to help companies conduct such an analysis. This helps automate the CTS process, providing timely information for swift decision making, as well as offer ongoing CTS reporting, thereby enabling a firm to review the outcomes of its strategies and reassess them, if necessary.
How Are Industries Adopting CTS?
A Case Study
A multi-national consumer goods company wanted to identify unprofitable customers, product lines, and channels, and assess their impact on revenue. Being a well-diversified company, it found it difficult to identify unprofitable entities.
It adopted the CTS approach internally; however, it faced issues in standardizing the information and allocating costs. Hence, it selected a vendor to help it implement CTS. The company then kick-started the pilot phase of CTS implementation for all product segments in France and the US. Post this, the company’s data from customer service, customer delivery, and finance was evaluated with respect to earnings and ROI. The company then analyzed its operations in other countries and was able to benchmark the difference in CTS in different countries at the same level of customer spend.
This helped it compare profits across geographies. It was also able to assess the impact of factors such as minimum order quantity terms, item distribution network, and network changes. This information was used to empower decision makers to model and analyze profitability by segments.
The Way Ahead
The elimination of non-value-added activities, resulting in instantaneous cost savings, will shift the focus to profitable customers and products. Given the global financial landscape, senior executives, decision makers, and buyers should reflect on the following:
- How can CTS be best used within a given setup?
- Should it be applied across categories or for select troubled categories?
- What will be the different short and long-term benefits of CTS adoption?
- Are there any risks involved in adopting CTS?
- Are your competitors adopting CTS to improve profitability?
- Should you develop internal capability for CTS adoption or outsource it to third-party vendors?