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The Hidden Costs of Providing What Your Customer Wants

Contributor: Scott Atkinson
Posted: 03/10/2011
Scott Atkinson
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Many companies fail to identify - let alone address - the hidden costs associated with providing their customer with the products they want, says Scott Atkinson, Supply Chain Continuous Improvement Manager & Trading Development Manager, at one of the UK's leading discount retailers. In this article, Atkinson looks at how you determine the true profitability of the customer and product/services mix using Cost to Serve (CTS).
Buying a product at an unbelievably low price may sound like a good idea. But if those half a million units you picked up for a bargain will take 2 years to sell through, perhaps it's not such a great idea afterall. Consider the ongoing storage costs, deduct them from the profit margin of the product, and you may find out that you're operating at a loss.
That's where Cost to Serve comes in. Traditional reporting methods aggregate revenues and costs to such an extent that poorly performing sectors of the business can be hidden from view. During this article I will explain the process of Cost to Serve, defining what it is, how it can be leveraged, and what factors within your extended supply chain can affect it, both favorably and adversely.
What is CTS?
Cost to Serve (CTS) enables companies to reduce cost and improve EBIT performance by up to 20%. Evaluating the benefits of CTS, is a ‘must do’ for those companies new to the concept.
Traditional reporting methods aggregate revenues and costs to such an extent that poorly performing sectors of the business can be hidden from view.
How is the approach different?
CTS can best be explained as understanding the total cost of servicing individual customers and individual products, so that the business can match service and cost, to achieve business goals. A CTS approach is more market focused and might segment costs by channel (mass retail, independent, route trade) or by product category (seasonal, continuity, promotional), or even by individual customer and stock-keeping unit (SKU). This segmentation, coupled with the deeper appreciation of product and customer cost drivers, makes CTS reporting so beneficial.
It is a rare business that has such a limited range of products and customers that they can service their whole market with a generic service policy. Conversely, it would be rare for a business to incur similar costs for servicing what can be a complex matrix of customers and products. Unraveling this pot pouri of information, is what CTS is all about.
Steps to Quantifying CTS
The critical steps in undertaking a CTS review are:
Step 1: Identify the characteristics of your customers and products. For example, typical order size, order frequency, geographic location, special handling needs, account management needs, brand support and so on.
Step 2: Identify the cost drivers within the Supply Chain. Processes and functions that will impact CTS will include purchasing, storage, transport, customer service, sales, account management as well as head office
overheads.
Step 3: Determine cost allocation rules for each unique customer and product grouping identified.
Step 4: Conduct a trial data set through the model to test assumptions and results.
Step 5: Implement the CTS discipline and identify the areas of opportunity to a) reduce costs, and b) improve sales.
CTS typically highlights unprofitable products and customers. This enables the company to reduce the CTS by allowing them to adopt alternative approaches to servicing their customers: changing market channels, varying the service level to certain customers, utilizing lower cost transport solutions for certain geographic locations, re-balancing inventory across the business to improve service and reduce costs. The bottom line benefits can be substantial.
What CTS is not
CTS is not just Activity Based Costing (ABC). ABC generally operates at a higher, aggregated level, and fails to identify the impact of different product and customer characteristics and service needs. ABC is often inwardly focused, CTS is market focused.
Leveraging CTS
The knee jerk reaction within many businesses when realizing that certain customers and products have a negative impact on the bottom line, is to try to delete them from the range or customer base. That's a poor answer. The opportunity is to use the knowledge that CTS provides, to turn those customers and products into improved profit.
Some areas of your business that are ripe for the picking...
Focusing on Step 2 in the above list, there are many areas of the extended supply chain that if made to work smarter, more efficiently and with minimal waste they can drastically improve your overall Cost to Serve across multiple channels. These include but are not limited to:
1. Supplier Collaboration (Advanced method known as CPFR – Collaborative Planning, Forecasting and Replenishment)
2. Demand Management
3. Purchase Process
4. Data Management
5. Distribution
6. Accounts Payable
Some of the areas proposed at first thought may not immediately be recognizable as areas for improving your Cost to Serve, but each area if improvements are made and waste reduced can impact your CTS, let us take a look at each in turn.
Supplier Collaboration
This can take many forms from constant contact with your supplier to the more advanced form of CPFR, bear in mind however, placing a person on a seat to chat with your key supplier everyday probably will not drive down your CTS in fact probably the opposite! Supplier collaboration is the process of sharing information; it is a 2 way street with the customer supplying data on anticipated Demand, and the Supplier relaying with data on anticipated supply, the two can be aligned to ensure that optimal supply channels are achieved at the lowest cost with no impact to availability, the anticipated effect of this should remove Peaks and Troughs in the Supply, reduce inventory levels and drive greater efficiency through the Supply Network.
For a period, I worked in the scheduling department of one of the world’s leading Consumer Packaged Goods (CPG) manufacturers. I was responsible for the Global Scheduling of one product type: Demand Data was provided by our key customers - major retailers - including their promotional plans, expected uplifts, and changes of retail positioning. We would translate all this information through SOP media, (Sales and Operation Planning) to determine exactly, based on known constraints and budgets, what we were physically able to supply.
With these known variables we would communicate to each customer our supply plans on how much, and when, both Supplier and Customer were aligned. In cash terms, this meant that as a manufacturer, we knew exactly when and how much of our raw materials to purchase, we knew exactly how many machines to run to achieve the desired volumes, and the labour required to operate these machines. The customer knew when they would receive their goods, allowing them to operate a JiT process (Just in Time) to minimize their stock holding costs, they could better manage their shelves and promotions to suit maximizing their availability and driving their sales. As a result the process end to end worked with minimal waste, which is probably why they are one of the worlds’s leading CPG manufacturers.
Demand Management
This is the Black Art of Knowing what your demand will be before it actually happens...crystal balls at the ready...
Let us straight away dispel with the notion that Demand Management is a scary beast. Standard Deviation and Exponential Smoothing should not be obscure Latin terms known only to learned scholars.
There are now many software companies that can easily offer a solution to this age old problem, and you do not need to be a member of Mensa to understand it. Taking the time and investing the money in developing this area can reap rewards in your ability to lower your Cost to Serve.
When I worked for a Logistics company, for instance, anticipating how many people, Materials Handling Equipment (MHE), and Space they needed to manage their Intake and Out Goings was one of the most difficult tasks to achieve. When they got it wrong, the outcome was expensive: when under-resourced customer orders were delivered late - in some cases driving customers elsewhere - and when over-resourced they had too many people standing around doing nothing. Either way a costly result for the company and which impacted their cash flow.
We introduced a Demand Management tool and we were able to predict to within 5% of the actuals, the Ins and Outs Month, by Week, by Day. This had an almost overnight impact, affording the correct levels of resourcing for Peak periods and Lulls alike. Customer fulfillment increased. Cash Increased. The Cost to Serve was reduced.
Purchase Process
As in the Demand Management area, this is both the art of raising the correct amount to order for your demand, and the physical key punching of the order into an ERP or other transactional management system, it is averaged that the cost of raising a Purchase Order is somewhere between £30 and £50 GBP (approx $50 - $80 USD). It sounds a lot, but consider everything that goes into that key punching exercise: Fixed Overheads like lighting, heating, power, lease, rent, staff - both front line staff and management - and Variable costs, like paper, telephone calls, machine time - actual key punching - and time taken to fax or post [the latter also incurs postage costs]).
Adding all this up, £30 - £50 pounds does not sound that much after all.
Ways to reduce some of these costs and to lower your Cost to Serve is to employ some form of Electronic Trading. EDI (Electronic Data Interchange) was a buzz word 15 years ago, but in the modern working world it is in most cases expected when a company gets to a certain size, EDI can offer the reduction in your Variable costs, these being but not exclusively, having to Fax or Post an order to a Supplier, having to make a telephone call to the Supplier to ensure that they have received and can supply the Purchase Order, with the Supplier on the EDI network, they can send you Acknowledgements’ for each PO received, Advanced Shipment Notifications indicating their intent to ship, all this alleviates the need for somebody making that telephone call. The EDI link between Supplier and Customer is also an excellent media for facilitating your CPFR
initiative. In fact if your EDI is linked to your Demand Management system, you do not even need that person key punching the order... yet another reduction to your Cost to Serve.
Data Management
This does not seem obvious, but Data Integrity can play a part in lowering your Cost to Serve. I worked for a Retail Coffee Company, which was constantly holding too much stock to service their demand. After investigation we discovered that one of their Key suppliers had an incorrect Lead Time for a very high volume consumable product. This lead time formed part of a Days Cover calculation, and it was this calculation that was generating the increased stock holding. But due to the high volume of receipts from the Supplier the problem was not easily visible. Driving excess stock into a business adds bottom line costs, such cost of storage, obsolescence, mark downs, etc. Ensuring that your systems represent the correct and most current data can indeed lower your Cost to Serve.
Distribution
This is directly attributed to your Cost to Serve; if you do not correctly utilize your fleet of vehicles or your third party logistics (3pl) effectively you are adding costs to your company. Consider, for instance, loading a 26 pallet vehicle with products to ship to your customer, all deliveries made and now the vehicle is empty, that vehicle does not magically reappear at your facility ready for the next deliveries, that vehicle has to drive air around on its way back to your company. This costs money, driver, wear and tear, tax, insurance, fuel, so does it really make sense to pay all these out to transport Air along the road.
Ensure that you fully utilize your vehicles, consider the routes that your fleet will take to deliver to your customers, are there Suppliers that you buy from in the general vicinity, if so, why pay them to freight their product to you, your vehicle is already in the locality, go get it, if you have more than one supplier in the area, consider mixing and consolidating loads from these suppliers and saving more money by not having to have minimum order quantities such as vehicle fill constraints. This will also afford a bottom line cost saving as you can often pay Factory Gate prices rather than having to pick up the cost and margin for the suppliers use of their vehicle fleet.
Accounts Payable (AP)
The last part of the jigsaw and this part can be just as costly as all the others and can have a negative impact on your Cost to Serve. As with a Purchase Order there is a cost associated with processing and paying an invoice, the more complex the AP process the more these costs increase. With the introduction of electronic data interchange (EDI), some of these hidden costs can be mitigated by not having to have as many people in your AP department processing invoices.
A word of caution on this: trying to understand the Return On Investment can be challenging in this area. As with Supplier integration with EDI, if you are directly removing a person from a seat, then that is a direct saving, if, however, that person would still need to be on that seat, then a soft saving needs to be identified, perhaps with the added value that this person can now offer. These savings can sometimes be hard to justify.
The Hidden Gems
Throughout this article I have hopefully defined ways of thinking that if time and effort were invested in exploring each would offer your company an avenue to reducing the cost to you of servicing your customers. Ultimately that's money in the bank for you accruing interest rather than throwing your pennies down the drain.

Thank you, for your interest in The Hidden Costs of Providing What Your Customer Wants.
Scott Atkinson
Contributor: Scott Atkinson