Cost to Serve for your customers

If sales are made to customers without knowing the total cost of the business relationship, there are two major risks. The first is selling products to a customer that is thought to be profitable, but is not. The second is to negotiate increased sales or higher levels of service with customers that already incur an unknown high cost to service.

To reduce the level of risk requires that customers are segmented for the required level of service, based on their Gross Margin and ‘Cost to Serve’ (CTS or C2S). The CTS process is to identify customer related activities that only occur due to the needs of a customer – from when a customer order is received to when payment is banked, plus pre and post-sales costs.

Customer profitability

The traditional accounting approach has the profitability of a customer calculated at the Gross Margin level. The table illustrates the profitability of two customers, ‘A’ and ‘B’:

	Customer ‘A’	Customer ‘B’
Sales to customer	$500,000	$520,000
Cost of Goods Sold (COGS)	$250,000	$260,000
Gross Margin	$250,000	$260,000
Overheads @ 30% of sales	$150,000	$166,000
Operating profit	$100,000	$94,000
Profit percentage on sales	20.0%%	18.08%

But this approach of allocating an arbitrary overhead percentage hides the actual overhead costs incurred to serve the customer (or a distribution channel or market segment). This can lead to assumptions that customers with a ‘better’ gross margin are those to hold and develop. Instead, a customer profile is required that identifies the activities required to serve a customer. Consider customers ‘A’ and ‘B’:

Customer ‘A’ service profile	Customer ‘B’ service profile
expects the sales representative to be available on-call	requires limited sales and technical support
requires a high level of technical assistance
orders multiple products in small lot sizes at random intervals	orders a small range of products in large lot sizes at regular intervals
likely to change the order mix, requiring additional work by customer service and distribution	rarely changes the order mix
expects fast delivery from time of order	accepts reasonable delivery times
is located more than 500km from the distribution centre, with no other customers nearby	is located less than 100km from the distribution centre
an average of 65 days to pay their ‘net 30 days’ account	an average of 42 days to pay their ‘net 30 days’ account

Even without a financial analysis, the profiles indicate that the costs to serve Customer ‘A’ are higher than for Customer ‘B’. A more accurate approach is for the overhead costs to be allocated, based on an Activity Based Costing (ABC) analysis. However, at the initial stage, the CTS proposal may be considered only as a requirement of the Supply Chains group, so the effort required to implement and operate the ABC approach is unlikely to gain support from senior management. There are also additional challenges with implementing ABC:

• Acceptance for the proposal: Supply Chain professionals will need to ‘sell’ their proposal.
  • It does not look good for the Supply Chains group to be proposing a process that should be initiated by Marketing and Sales – their support is likely to be low
  • To gain support from accountants, identify ‘what’s in it for them’ in the language of accounting. The benefits for the ABC implementation effort could be difficult to justify
• Align with the Corporate Strategy: The Supply Chains group may not be viewed as a strategic part of the business, therefore the proposal is downgraded
• Difficult to obtain the data: The specific data required for an ABC analysis is held at a low level within the ERP accounting system. Could be difficult to retrieve and re-format.
• No early success: A lot of preliminary work is required to implement the ABC process, therefore early ‘wins’ are more difficult for obtaining support to continue the project.

An alternative approach

This has the initiative kept within the Supply Chains group, with input from Marketing and Accounting on an ‘as required’ basis, not requiring extensive effort. It is a way for the Supply Chains group to gain acceptance of the initiative before expanding its scope. The initial step is to identify the cost elements for CTS. Examples of attributable costs are:

• Pre-sales costs: sales calls and visits; develop and provide quotations
• Sales costs: account management time; order processing costs; price discounts provided
• Storage and Handling costs: Dedicated warehouse space; dedicated inventory; order size and likely product range; special order handling and storage e.g. refrigeration; non-standard packaging; special documentation e.g. external quality certification
• Delivery costs: location and access times – limitations can affect delivery time with traffic congestion; express transport requirement
• After-sales costs: returns due to changed customer requirements; refusal of product e.g. not arrived within the customer allocated time slot; additional customer service time incurred; trade credit – the actual payment period etc. For retail customers, additional after-sales costs are in-store promotions and merchandising

Within each heading, a weighted score is devised so that each customer CTS score is based on the same criteria. Customers are segmented by gross margin with CTS score, which enables improved predictability of demand for different product mix and levels of customer service. In turn, the output information helps to improve Operations Planning and scheduling.

The objective of CTS is not to delete customers or products, but to ensure that all customers are profitable. Therefore, from the analysis process:

• Identify low margin customers resulting from customers spending low amounts, generating small orders, being remote or having special service requirements
• Identify ‘over-serviced’ customers with decisions to reduce services offered or adjust pricing to improve profitability
• Identify high-cost processes such as a high level of returns or packing requirements
• Identify alternative distribution service, to ensure that a customer provides an appropriate contribution to the business
• Justify a price increase when the CTS analysis identifies increased logistics costs for a customer

Gathering the initial data is led by Logistics and the data entry is a spreadsheet based task – a role for vacation students. Changes to your organisation’s supply chains and customer markets can affect the CTS for particular customers, so there needs to be an ongoing update process.

Not all customers want or need the same service level, but most companies do not know the service needs of their customers, although assume they do. A CTS process is an initiative to correct this situation.