Supply Chain Frontiers issue #54
Cost to Serve is a key financial measure that helps companies decide how to segment markets and support customers cost-effectively. However, the way this value is calculated varies from company to company, particularly in terms of how certain costs – including those associated with managing supply chains – are taken into account.
A top-down method for calculating the measure developed by the Center for Latin-American Logistics Innovation (CLI) offers a better way to compute cost to serve, especially for emerging markets.
The method is particularly useful in megacity markets (in cities with populations of at least 10 million people), where many variables such as population density and infrastructure constraints influence supply chain costs. Also, megacities are often served by two types of distribution channel. The modern channel includes outlets that are common in developed economies too, such as supermarkets and convenience stores. There is also the traditional channel based on nanostores; mom-and-pop outlets that serve low-income consumers. This dual structure makes it even more difficult to quantify supply chain costs accurately and to implement tailored strategies to reach the final customer.
There are a number of established ways to calculate Cost to Serve. An example is Activity Based Cost Analysis (ABC). This is a bottom-up method were the starting point is the cost of minor activities that are tallied up until a complete picture of value chain processes and affiliated costs is created. In general, these accepted methods account for supply chain costs by mapping each component activity and separating them into fixed and variable cost types.
However, it can be difficult for companies to apply these established methodologies to real-world operations. For example, the relationship between Cost to Serve and financial statements is often unclear, and how the measure supports decision-making over time is ambiguous.
CLI’s top-down method addresses these issues. The methodology comprises three phases.
Objective definition
In this initial phase critical factors such as the distribution channels involved, customers, geographic regions, and products are clearly defined. These definitions are arrived at by mapping – on both macro and micro levels – relevant processes. CLI recommends that a multi-disciplinary team oversees these activities in critical areas including finance, logistics, sales, IT, and marketing.
Data gathering
The second phase involves a number of steps such as reviewing financial statements and identifying supply chain processes. It is the most valuable step since it forces the team to gain a thorough understanding of the company’s financial statements, as well as its performance and opportunities for improving cost effectiveness.
Measurement and results analysis
Having gathered all relevant information on variable and fixed costs, commercial and logistics activities, these values are added according to which client, product, or channel is involved, to arrive at the Cost to Serve. The results are validated by the multidisciplinary team and/or each discipline involved. The final, and very important step, is to delve into how supply chain costs impact profitability by customer, product, or channel. The team can create strategies for improving supply chain performance as well as customer service, reducing cost to serve according to the life cycle of a client and identifying the type of client (low/high profitability versus low/high cost to serve).
CLI hopes that the new methodology provides a tool that companies can use to translate Cost to Serve into a decision support mechanism for actual and future operations. Of particular importance is enabling companies to create strategies for developing markets profitability in emerging economies, including megacities.
Looking ahead, the methodology can be refined in a numbers of ways. For example, more accurate ways to determine individual costs could be developed, and the future analyses could make use of scenario planning. CLI also aims to look at customer retention in different market segments.
For more information on CLI’s cost to serve research contact Christopher Mejia at cmejia@logyca.org.