This guide sets out to explain where the benefits arise fromunderstanding the Cost-to-Serve for a trading relationship. It then describes who canapply the techniques, why they have become necessary and what is involved in building asystem.

Measurement of the Cost-to-Serve is an essential step inthe calculation of Customer Account Profitability, equal to the difference between therevenue generated from a particular customer or market segment and the costs arising fromserving that segment. This information can then be used in the following ways:

  • Strategic
  • - guiding the direction of the marketing strategy and the formation of new trading relationships with customers
  • Tactical
  • - allocating limited resource to activities that serve the strategic goals and eliminating waste; optimising the trading interface with customers and calculating trading costs to assist in the design of price structures
  • Operational
  • - tracking actual performance against budgeted and assisting price negotiations with customers through the provision of better information

Renewed interest
Interest in Cost-to-Serve (CTS) first began several years ago, largely because it wasthere. Activity-Based Costing (ABC) had rewritten the principals of product costing, andit soon became apparent that it had wider application, including CTS. However interestabated for a while; many companies registered that the technique existed but felt nourgency to adopt it. This has now changed. Instead of a technology being pushed ontocompanies, there is now a pull from those companies for better information. This is due tothe changed trading environment which is discussed in more detail later.

Measurement of Trading Relationship Profitability
CTS systems are a means to an end, namely to understand the profitability of tradingrelationships. This measurement of profitability has traditionally been undertaken withCustomer Account Profitability (CAP) systems. However in most cases these systems do notattempt to take account of the individual cost behaviour of different trading patterns.Instead customer- specific costs have been apportioned between customers on an arbitrarybasis.

Activity Based Costing has provided the tools to allow thecosts involved in serving a particular customer and allow the profitability of thataccount to be calculated properly. To distinguish these systems from traditional CAPapproaches that employ arbitrary cost apportionment, we describe these activity-basedapproaches to the measurement of the profitability of trading relationships as CTSsystems. We first discuss where within a company the benefits from CTS arise.

Strategic Benefits Tactical Benefits Operational Benefits
Marketing Strategy Resource allocation Tracking actual performance against budget
New trading relationships Elimination of waste Supporting negotiations
  Optimising the trading interface  
Price structures

Strategic benefits of CTS

Marketing strategy
There have always been two dimensions to marketing: brand management and accountmanagement. For fast moving consumer goods companies the former dominated, but for manycompanies now the balance is shifting. In the past, brands have served as an excellentvehicle for transmitting reassurance to consumers over the heads of intermediaries in thedistribution chain, especially retailers; but the exclusivity of brands is now decliningwhile the strength of the intermediaries is increasing. In these circumstances, marketingstrategies are evolving to consider narrower and narrower market segments(hyper-segmentation) and to give trade-marketing, i.e. marketing to the distributionsector, due prominence.

A company's information systems have to evolve toreflect this. Any marketing strategy will of course seek to increase volume in profitablesegments and with profitable accounts, but this cannot be done if there is nounderstanding of segment or customer account profitability. Many manufacturers do not havethis information because very significant market-specific or account-specific costs arenot traced back to their cause; instead, they are apportioned across accounts in anarbitrary way.

To illustrate by example, the management of a manufacturingcompany who were just installing CTS were painfully aware of the ability of largecustomers to extract large discounts. The company therefore chose to develop an exportstrategy on the basis of marketing to small customers. Unfortunately the management wereless aware of the costs of supporting the small customer base (which were high in unitterms because of the small volume per customer). When the CTS exercise was carried out themanagement received a rude shock: large customers were often more profitable than smallcustomers (despite the intuition of the management) and the export market, based on smallcustomers only, was the least profitable market of all. Without a CTS system, the companyis flying blind.

New trading relationships

The commercial logic involved in the supply of goods andservices used to be simple. A company tried to make as much money as possible from thesale while ensuring the minimum price was paid for bought-in goods and services; meanwhileits suppliers and customers behaved in the same way.

The wisdom of this approach is being questioned. Companieswhich sought to develop their supplier base and viewed their suppliers as part of anextended company seemed to gain a competitive advantage, especially in the areas ofproduct development and the synchronisation of the supply chain (the oft-quoted examplebeing the Japanese vehicle manufacturers). The concept of partnerships has spread but theresponse has been very mixed. There have been some genuine successes but wherepartnerships were formed between unequal parties the changes were often superficial. Someregard the very term partnership as misleading and believe that the term co-operation orcollaboration is far more accurate.

One thing is certain, however. If a powerful customerinvites a company to form a partnership then that company requires a CTS system; without ameans of measuring the costs and benefits involved in the partnership there will be no wayfor it to bargain for a share of the mutual gains.

Tactical benefits of CTS

Resource allocation
One of the well justified claims of ABC systems was that by analysing what activities wereactually taking place and the costs being spent on them, then it would be possible toallocate resources more rationally. In particular, it would be possible to avoid ignoringthe longer-term priorities in favour of the short-term priorities. Furthermore, betterknowledge of the scale of value-adding activities can be used in negotiations to justifyprice rises or avoid price decreases. Since CTS systems are based on ABC principles thesame advantages apply.

Elimination of waste
A further use of ABC systems is to identify non-value-added activities and eliminate them.In practice many such activities (e.g. returns and dealing with customer complaints) occurbecause of inefficiencies in dealing with customers.

Therefore one of the ways of avoiding waste, other thaneliminating internal non-value-added activities, is to improve the trading interface.

Optimising the trading interface
The benefits of optimising the trading interface are detailed later in the section IntegratedSupply Chain. Here we will remark simply on how CTS can assist.4

The systems within trading partners will have evolvedindependently. The activities will not be synchronised and the communication between theparties will be inefficient. However, once the activities on each side of the interfacehave been identified it becomes possible to cost them and map them into processes. Thereis then a common language for mutual cost reduction and enhancement of effectiveness.

In practice the areas where this can occur are numerous andinclude:

  • the use of Electronic Data Interchange for ordering goods and making payment
  • the adoption of Continuous Replenishment (essentially the application of just-in-time principles to the supply chain) to lower inventory levels even to the point of synchronising manufacturers' production to consumer demand
  • co-ordination of special packaging and labelling
  • organising pallets to allow cross-docking of goods, i.e. the transfer of manufacturers' pallets straight to transportation to retailers' premises without intermediate storage
  • direct to store deliveries, by-passing customers' own regional distribution centres
  • mutual co-operation in category management, the joint planning of categories of products by manufacturer and retailer

All of these initiatives cost money but generate benefits.A CTS system is required to keep the score.

Price structures
Pricing structures need to provide signals to customers to encourage them to purchase inways that enable efficient production and distribution. This requires an understanding ofcost behaviour. There are two important aspects. First, the real cost of processing asales order; in practice, this is often large and there has to be a sizeable order for itscontribution to cover the associated administration: thesolution is to set a realistic minimum order size. Second, the cost of specials can farexceed the apparent effort needed to make minor modifications. The solution is to pricespecial orders in a way that ensures that the hidden cost (e.g. the cost of engineeringchange orders and special work instructions) is recovered.

Operational Benefits of CTS

Tracking actual performance against budget
Once a CTS system has provided a clearer idea of where expenditure ought to be made thenit remains to track progress, and Activity Based Budgeting principles can now be applied.

During the ABC exercise needed to create the CTS systems,not only will the activities have been defined but so will the volume drivers, the costdrivers (the influences on cost) and relevant performance measures. Taking the singleactivity receive orders as an example:

Activity Volume Drivers Cost Drivers Performance Measures
Receive Order No. Orders Electronic/Paper Time to Process
  No. Order Lines No. Special Orders No. Errors
No. Change Orders    

It is simple to see that if a similar analysis isundertaken for all activities then the company will be in a much better position tomonitor performance and explain deviations from the plan.

Supporting negotiations
This is obviously an important use of customer profitability information. Key customerswill often demand special conditions, relating to either the price, the lead-time or thespecification and quality of the goods. In the absence of information on the profitabilityof key customers there will be uncertainty over the line to take during negotiations.

Application of CTS

Many of the applications of CTS can be deduced from theprevious discussion of benefits. However, for completeness the range of applications istabled below, to indicate who may benefit.

Function Issue CTS Information
Chief Executive Marketing strategy Partnership formation Sector/account profitability
Marketing Distribution channels Marketing expenditure Channel cost
Sector/account promotional cost
Design Quality of range
Design for after-sales support
Discounts 'to clear' and cost of returns (no sale)
After-sales costs
Account Management Sales strategy
Discount structure
Staff allocation
Product mix
Overrider discounts
Total discounts
Changes in account profitability
Sales Price Projected margin on sale
Production Cost of complexity Customer-specific manufacturing costs
Quality Cost of quality Cost of returns (defective)
Distribution Continuous replenishment Sector/account-specific distribution costs
Finance General cost reduction
Financing costs
Financing control
Non-value-added costs
Trade terms by sector/account
Activity based budgets

The need for CTS

Changing trading environment
The underlying reason why CTS systems are becoming a necessity is a fundamental shift inthe trading environment in which manufacturers and retailers operate. We describe the rootcauses below but for a manufacturer the most visible effect has been a change in emphasisfrom general product and brand promotion in broad markets to the development ofsignificant individual accounts or very tightly defined sub-segments. When companies makesuch a change then the information systems must also change.

Growth in consumer power
In the long-run supply and demand must balance but in the short-term imbalances can occur.For the first half of this century there has been a shortage of consumer and durablegoods. In this situation, the emphasis was on production. Companies were organised so asto maximise production efficiency and, to survive, a company had to have an efficientproduction facility, relative to the competitors in its market. In this environment thevoice of the customer (or the retailer) was not generally heard. It is perhaps epitomisedby Henry Ford's comment 'Any colour, so long as it's black'. This is aview that is ridiculed today, but at the time it was a sound summary of the marketconditions: consumers hungry for goods and grateful (usually) for what they got. It was atime when the view was that those involved in the design and manufacture of productsneeded to be insulated (buffered was the term often used) from the customers'demands. Today this is heresy, but at the time it made sense: customers change prioritiesand this lowers production efficiency.

The imbalance has now reversed. Consumers are offered avast supply of alternative goods but there is a limit to the amount that can be consumed.As a result there are three effects:

  • power is shifting along the supply chain from the manufacturer to the consumer
  • consumers no longer view a product as a commodity. They seek differentiation of the product from similar products
  • consumers seek good service, i.e. manufacturers of products have to acknowledge that they do operate, to some extent, in a similar way to a service industry

For a manufacturer the message is clear. They require goodsystems at their interface with the customer, both to assist in negotiations and tomeasure the growing costs of customer service.

Retailer strength
Retailers and manufacturers have always vied for power within the supply chain. Theretailers have usually reaped the benefits of controlling the route to market whendistribution chains were long (e.g. the early spice traders); manufacturers have held swaywhen they could control supply, e.g. through learning curves or patents.

Manufacturers are finding that supply is no longer easilycontrolled, e.g. process technologies are rapidly diffused and there is a difficulty ofprotecting many consumer goods through patent.

In this situation retailers have developed significantpower and reinforced this through heavy capital investment. The implications for thestrategy and marketing of goods are of course profound and so are the implications for thedecision support systems needed to support this activity. Account profitability is ascrucial as brand profitability.