The real profitability of your customers.
How much does it cost to serve your customers? What changes to product mix, order size and delivery times will increase your profit.How profitable are your customers, or a particular channel or a market segment? It is difficult, if not impossible, to know if the analysis is not done.
But to do the analysis, there must be access to the numbers and the keepers of financial numbers are accountants, using traditional accounting systems. Effective supply chains and logistics are based on understanding and measuring flows – of items, money and information. Traditional accounting however, relies on the grouping of costs into functional categories (e.g. production, sales, transport) and the arbitrary allocation of shared and indirect costs (overheads) to products.
The traditional accounting approach results in the profitability of a customer being calculated at the Gross Margin level. That is by subtracting the costs of goods sold (COGS) for the product mix purchased in a period from the net sales value generated by the customer. To arrive at the Operating Profit, an arbitrary allocation of overheads is subtracted from the Gross Margin.
But this approach hides many costs that are incurred in serving the customer (or a distribution channel or market segment), such that true profitability is not known. This leads to assumptions that customers with a ‘good’ profit margin are the customers to hold and develop. Instead, consider the scenario of two customers A and B. Customer A has an operating profit percentage of 22 percent on sales, while Customer B has 17 percent. Therefore Customer A is ‘better’.
In analysing the business relations with each customer, it is found that Customer A:
- is located in an isolated area and no other customers are nearby
- expects the sales representative to be available on-call
- orders multiple products in small lot sizes at random intervals
- uses a high level of technical assistance
- requires fast delivery
- pays their net 30 day account in an average of 65 days
Customer B has the following profile:
- is located a short distance away
- requires limited technical and sales support
- orders few products in large lot sizes at regular intervals
- accepts reasonable delivery times
- pays their net 30 day account in an average of 42 days
This analysis indicates that the cost to serve Customer A will be higher than for Customer B. It could even be that instead of being profitable, Customer A provides a loss.
Similar situations can occur across your array of customers. There will be different levels of service provided; intensity of account management; predictability of demand for different customer product mix and so on. Therefore, each customer, distribution channel or market sector needs to be analysed for its Cost to Serve (CTS or C2S).
This analysis requires identification of the directly attributable costs for specific customers, which provides the base for identifying the performance measure called Customer Contribution. This is not customer ‘profit’, instead you need to know what a customer contributes to covering the fixed costs and overheads of your business. Once the contribution from customers has been established, the remaining costs of the business could be allocated based on an Activity Based Costing (ABC) analysis.
Due to the quantity of data to be collected for a customer contribution analysis, it is likely that you will initially undertake a distribution channel or market segment contribution analysis. When the process has been established, it can be extended to the Customer Contribution analysis.
Calculate your Customer Contribution
Identify the Gross sales value, less discounts, less cost of goods sold (COGS) = Gross margin
The Cost To Serve (CTS) identifies those customer related costs that would not be incurred if the customer did not exist. The headings of the cost elements for CTS with some examples of attributable costs are:
- Pre-sales costs: sales calls; sales visits; developing and providing quotations etc.
- Sales costs: account management time; order processing costs; special discounts etc.
- Storage and Handling costs: Dedicated warehouse space; dedicated inventory; order size; special order handling and storage e.g. refrigeration; non-standard packaging; special documentation e.g. external quality certification etc.
- Delivery costs: location and access time limitations; delivery time and congestion; express transport etc.
- 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 and ‘cooperative’ promotions; merchandising etc.
The Gross Margin less the CTS = Customer Net Contribution, which should be positive for the business to continue as a customer. If that is not a desired option, then the analysis will identify where changes to serving the customer need to be negotiated for both a reduction in costs and increase in income.
As ERP systems are usually not leaders in applications, your ERP system is unlikely to have facilities that collect CTS data. Undertaking a contribution analysis is therefore likely to be a periodic exercise using worksheets and spreadsheets. To gather allies to your cause, you need the support of marketing and sales; the benefit for them is to allocate resources across customers that really matter and negotiate, based on facts, more profitable arrangements with low contribution customers.
The challenges you may have in wanting to implement CTS as input to the Customer Contribution are:
- Lack of acceptance through the business: This is why logistics professionals must ‘sell’ their proposal, so you must understand the language of accountants to get their support and identify ‘what’s in it for them’. The approach could be that the current functional accounts do not provide the best information for a ‘customer focussed’ business (to use popular jargon). What is therefore needed are the costs to deliver specific orders of products to specific customers. Once you have the senior accountant’s support, others are more likely to accept what you are doing.
- Align your message with the corporate strategy: Supply chains and logistics need to be viewed as strategic and taking the first steps to measuring customer contribution is a part of this approach
- The process is considered too complex: Some people confuse CTS with ABC. The implementations of ABC have a poor reputation for being too complex and not achieving their objectives. CTS is concerned with identifying attributable customer costs, to calculate the Customer Contribution.
- Too difficult to obtain the data: The initial step here is to sell the process to the staff who will be identifying the attributable costs. As this will be an additional task within their regular jobs, where possible, have the people design the data identification and collection method.
- No early success: You must have some ‘wins’ to continue selling the project. Design the process so that ‘low hanging fruit’ is available for you to use in promotion through your business.
Changes to your supply chains and customer markets can affect the CTS for particular customers, so there needs to be an ongoing process to identify when it is preferable for a CTS analysis to be completed. While the current approach to analysing CTS is fairly manual and periodic, hopefully in the near future we will see CTS and Customer Contribution as a part of ERP systems or easy to use plug-ins.