After negotiating with a major customer, you successfully close the deal and, initially, you’re satisfied with the new revenue and profit. However, you later discover that margins are diminishing. Despite streamlining operations to reduce costs, the margins remain inadequate. What’s the underlying issue? If your business resembles many others, it’s likely your cost estimate failed to comprehensively account for the cost to serve.
Traditionally, costing focuses on purchasing and manufacturing conversion costs. Cost to serve (CTS) takes that a step further and employs key systems and an activity-based approach to accurately identify the specific costs associated with supporting each customer, thereby providing a deeper understanding of customer profitability. A CTS approach can yield valuable insights to inform repricing strategies and even alter customer behaviors in exchange for lower pricing.
Expenses related to CTS are often overlooked but are essential to quantify. Without a thorough understanding of CTS, you risk setting prices too low, which negatively affects profitability, or too high, which hampers competitiveness. This could lead to loss of sales and market share as well as overinvestment in low-profit customers or channels, while underinvesting in the most profitable ones.
A CPG cost to serve example — and EBITDA impact
Consider, for example, a consumer-packaged goods (CPG) company that was offering unique displays to its customers. Each customer also had distinct labeling and pallet requirements, and some requested the company to maintain ownership of the inventory. Other customers required detailed reporting and extensive rebates. Result: Profit margins were declining. Leadership believed it had negotiated favorable pricing, but the company wasn’t accounting for the full cost of fulfilling individual retailer requirements. “Easy” customers were subsidizing those with more service requirements.
To address this issue, the company implemented a structured approach. First, management created a dashboard that categorized CTS into five areas: material cost, conversion cost, warehouse management, freight and transportation, service/rebates/discounts/fees. This initiative provided the business with a comprehensive and detailed breakdown of its manufacturing, labor, and overhead costs as well as some cost-to-serve metrics for individual customers — all essential data for pricing negotiations and decisions for repricing, product and customer rationalization, and logistics optimization.
The result of this approach was a significant improvement in the company’s profit margins. By accurately identifying and quantifying the cost to serve each customer, the company was able to adjust its pricing strategies, better manage its resources, and negotiate more effectively with its customers. This led to a 12% increase in EBITDA, demonstrating the critical importance of leveraging CTS data to improve competitiveness and profitability.
Pinpointing common CTS expenses and drivers
By comprehensively identifying and quantifying these CTS expenses and related drivers, businesses can gain a clearer picture of their true expenses and adjust their strategies accordingly. Customer support requirements and customer behavior drive many common CTS expenses, such as:
- Promotions, slotting fees, discounts, pay-to-stay fees, premium placement
- Penalties and charge-back fees
- Inventory ownership and management
- Commissions
- Outbound freight (TL, LTL), demurrage
- Storage time and requirements, such as cold, dry, low oxygen
- Unique quality inspection and lot tracing reporting
- Accounts receivable days
- Ordering and forecasts (EDI, fax, email, spreadsheets)
- Sourcing requirements
- Dedicated research and development
- Entertainment and high-touch support needs
- Dedicated equipment
- Overtime
Key steps to implementing a CTS platform
Upon identifying expenses influenced by customer requirements and behavior, the following five steps are essential to establish a CTS platform:
1. Collect cost data
Your business likely is already collecting much of the necessary data for determining CTS (albeit with an important caveat in the next step). Consider the components that contribute to variability but aren’t accounted for in your gross margin. Include both direct and indirect costs, and gather comprehensive data across each customer and channel.
2. Integrate the data
Although you may be collecting the data, it probably doesn’t reside entirely within your ERP or any other single system. Extract the data into a centralized location to enable your business to construct detailed reporting from this point forward.
3. Apply activity-based costing (ABC) methods
Utilize ABC methods to allocate costs to specific activities to ascertain the true cost of serving each customer.
4. Segment costs by channel and calculate total CTS
Disaggregate identified costs by customer and channel — in-store, online, mobile — to pinpoint specific cost drivers. Calculate the total CTS by aggregating direct and indirect costs to determine actual profitability by channel, thereby enhancing decision-making.
5. Monitor and optimize
Continuously review and update CTS calculations to ensure they accurately reflect changes in costs, operations, and customer needs. Leverage CTS data to optimize resource allocation, inform strategic decisions, and drive ongoing improvement.
Use CTS for financial and strategic decision-making — and improved profitability
Now that you’ve developed timely and accurate CTS metrics by customer and channel, it’s time to leverage this data to improve EBITDA. Understanding CTS lets you make more informed business decisions, both financial and strategic — decisions about pricing, manufacturing and distribution, make versus buy, product rationalization, and prioritizing efficiency improvements, among countless others.
CTS also is a critical tool for negotiating price and terms with distributors and retailers. You’ll be able to tell customers precisely why, for example, you’re declining an endcap display or promotion opportunity or why you need new terms from one of your OEMs.
CTS helps you identify which customers to keep working with, channels to invest in, new business to take on — and when to say no. Would you be making operations more complex and driving up costs by working with a particular new customer? On the flip side, is a prospective customer committing to long runs and consistent orders with few changeovers? Do you have longtime customers that routinely take your overruns? Is a customer committing to volume that justifies your investment in a new line, with capacity to take on additional business as you enter this new market?
CTS helps you assess customer- and channel-specific benefits and opportunities and answer questions much more knowledgeably — with facts and data rather than opinion, hope, or gut-feel. In the simplest terms, a CTS approach helps you remain competitive and profitable as you scale and grow your business.
