Nearly all business leaders will be able to tell you the annual revenue generated by their top customers. Many will also know the gross margins the company achieves for those same customers, as well as the overall profitability of the company.
However, how many can tell you the true profit impact of individual customers on their company’s bottom line?
A cost to serve analysis is a simple, yet important tool for assessing the true value of a company’s customers and providing insights that may otherwise have gone overlooked.
It can help answer questions such as whether your large customers are subsidizing your smaller customers. Or conversely, whether your biggest customers actually cause the company to lose money, when considering the cost of additional services and customized support you provide them that are not reflected in direct costs (and therefore gross margin).
This knowledge will help make better pricing decisions, including review of your prospect bid/no-bid criteria, as well as helping to focus internal operational review of sales, customer service resources, and supply chain management.
Defining cost to serve
A cost to serve analysis identifies the actual expenses associated with providing service to individual customers.
This includes not just directly attributable variable costs such as the cost of goods sold (COGS) to the customer, but identification and, if necessary, allocation of fixed costs that should be assigned to serving that particular customer.
For this reason, determining cost to serve differs from simply knowing customer-specific COGS, as the analysis aims to provide a better understanding of the EBITDA impact of the customer relationship.
Cost to serve analysis – types of costs to consider
Let’s assume you know not just the customer’s annual revenue, but also the gross profit they generate, and at what gross margin. This is where our cost to serve analysis starts.
Conduct a review of the company’s fixed cost base, with the objective of identifying areas of overhead cost for allocation as part of the cost to serve analysis. Common areas to focus on include:
- Customer services
- Account management
- Demand planning
- Warehousing cost
- Distribution channels
- Working capital (typically, inventory hold requirements, and agreed credit terms).
Cost to serve analysis – example
Here’s an example – which is based on a real business, by the way.
This company supplies into the food service industry. It generates $50m of annual revenue, half of which is from contracts with large national chains, of which $6m was from its largest customer – let’s call it Customer H. The other $25m comes from its e-commerce and catalog business, which sells to smaller regional chains and independents.
Customer H is what you might call demanding. Due to the relatively large size of the contract, and the industry status that comes with having them as customer, the company had agreed to pricing that equated to a 10% gross margin, or $600,000. For context, the D2C (Direct to Consumer) customer base averages gross margins of around 65%.
Specific customer demands also drove certain overhead costs, including:
- A dedicated customer service team
- A dedicated account management team
- Custom products requiring dedicated design, warehousing and supply chain management
- Multiple product roll-outs phased throughout the year, requiring inventory build-up and driving up working capital requirements
- More rigorous service levels than standard contract terms
- Longer than average credit terms, impacting the company’s overall cost of credit.
As with any exercise involving the allocation of overhead costs, determining certain costs attributable to the customer is not always straightforward. However, with some consideration and logical assumptions, you can calculate reasonable cost allocations to build the picture.
Understanding the cost of the customer service and account management teams in this instance was relatively straightforward: identify the associated payroll expenses and apply a burden percentage for on-costs.
After reviewing KPIs with the respective design, warehousing and supply chain leads, I worked with them to calculate an estimated cost allocation to the customer for the dedicated time and resources their departments spent serving this customer.
Once quantified, these costs reduced the customer’s contribution to around $100,000, or a $5.9m cost to service $6m in revenue, and that’s before taking into consideration the working capital impact of the inventory roll-out build-ups and generous payment terms.
This company, their largest customer by revenue was, in fact, not contributing much to the bottom line.
This analysis prompted renegotiation of pricing, service levels, and credit terms, together with bringing in a deducated supply chain consultant to conduct an end to end supply chain review to identify cost savings.
Why Understanding the Cost to Serve is Important
Building a clear understanding of the true cost of serving your customers helps you make informed decisions. Even the simplest of cost to serve analysis exercises will help your business leaders to:
- identify low margin and unprofitable customers
- make better pricing decisions
- consider the cost impact of all those ‘added extra’ negotiated special customer contract terms
- transform unprofitable customers
- streamline inefficient and high cost processes.
Therefore, spending some time to understand the cost to serve your customer base in more granularity than gross margin level can be a large step towards improving efficiency and profitability.
If you need help with strategic finance projects for your company, but do not have the internal resources or bandwidth to deliver them, a fractional CFO could be the solution.