How to Conduct Cost-to-Serve Analysis for Optimal Supply Chains

How to Conduct Cost-to-Serve Analysis for Optimal Supply Chains

Have you ever wondered why supply chain costs spiral out of control despite your best efforts? It’s not just rising fuel prices or delayed shipments—it’s often hidden inefficiencies you haven’t uncovered yet. That’s where a cost-to-serve analysis becomes a game-changer. By accurately tracking costs across your operations, you can identify waste, optimise performance, and take control of profitability. This guide will show you how to map your costs, leverage advanced analytics, and ensure every penny spent contributes to your bottom line.

Key Takeaways:

• Use Total Cost to Serve (TCS) analysis to identify hidden inefficiencies and improve cost predictability across your supply chain operations.
• Leverage KPIs like Cash Conversion Cycle (CCC) and On Time-In Full (OTIF) to evaluate supply chain efficiency and set clear performance benchmarks.
• Implement Activity-Based Costing (ABC) to allocate costs with precision, ensuring you track expenses accurately to products, customers, and orders.
• Use predictive cost modelling to forecast expenses and proactively address risks like supplier delays or fluctuating demand.
• Perform ABC and XYZ analysis to prioritise high-value stock, optimise inventory levels, and reduce excess holding costs.
• Tailor service levels and pricing strategies by segmenting customers based on their cost-to-serve profiles for maximum profitability.

How to Initiate Cost-to-Serve Analysis

Calculating the Total Cost to Serve

Evaluating the Total Cost to Serve within your organisation offers a fuller understanding of supply chain expenses, ultimately fostering more predictable outcomes. Frequently, companies attribute underperformance and unanticipated costs in their supply chains to external market conditions. Factors such as labour shortages, rising fuel prices, increased freight rates, vendor shipping delays, and erratic consumer behaviour have been highlighted by the US Chamber of Commerce as major contributors to supply chain disruptions. Whilst businesses may grasp how these disruptions arose, there is often a lack of clarity on how to rectify the situation and address ongoing supply chain challenges.

Key Metrics for Calculating Total Cost to Serve

In capturing the Total Cost to Serve, specific supply chain metrics play a vital role. Four key KPIs offer substantial insight into supply chain performance:

• Cash Conversion Cycle (CCC): Calculated as days in receivables plus days in inventory minus days in payables, CCC offers insight into the efficiency of your supply chain. Over time, CCC may increase due to factors such as supplier inefficiency, changes in forecasting models, and irregular customer ordering patterns. This variability can significantly impact expected profits, regardless of whether forecasts are based on actual sales or anticipated demand.
• On Time-In Full (OTIF): A stringent yet crucial KPI, OTIF is indispensable for calculating the Total Cost to Serve. Companies should aim for an OTIF performance exceeding 98%. Understanding variables affecting OTIF, such as the basis of measurement—whether by customer-requested time or an agreed schedule—is essential. Clarity on metrics like “on time” and “in full”, whether pertaining to orders, line items, or cases, is crucial for aligning with customer and supplier priorities.
• Inventory to Sales Ratio: Distinct from days in inventory, this ratio evaluates the productivity of cash utilised versus sales achieved. A well-integrated sales, inventory, and operations planning process utilises reports like Sales and Production to synchronise expenditure with inventory turnover, thereby aiding in forecasting on-time/in-full performance.
• Inventory Management: Metrics such as inventory stated in months-on-hand and inventory velocity serve as early indicators for planning and forecasting departments. These metrics help determine whether to maintain, increase, or reduce vendor orders. Inventory velocity, specifically, assists brands in assessing whether they possess adequate stock to meet demand or face risks of overstock or stockouts.

Guide to Conducting Cost-to-Serve Analysis

Effective cost-to-serve analysis begins with meticulous data collection and allocation, ensuring every cost is precisely attributed to products and customers. By employing Activity-Based Costing (ABC), companies gain a more granular view of their cost structure, enabling targeted improvements. Analysing this data uncovers inefficiencies, providing actionable insights that enhance profitability and operational performance.

Data Collection: The Foundation of Cost Analysis

Begin by systematically collecting data on all costs incurred throughout your supply chain. This includes, but is not limited to, transportation, warehousing, inventory management, order processing, and customer service. Leveraging your internal systems—such as accounting software, ERP systems, and logistics platforms—is essential to gathering accurate and comprehensive data. These systems provide the granularity needed to understand where costs are being generated and how they contribute to your overall expenses.

Cost Allocation: Accurate Assignment for Precision

Once the data is collected, the next step is to allocate these costs to specific customers, products, or orders with precision. This process involves the meticulous assignment of both direct and indirect costs to the appropriate cost centres, based on the activities or resources consumed. Accurate cost allocation is crucial for understanding which aspects of your operations are most cost-intensive and for identifying areas where efficiency improvements can be made.

Activity-Based Costing (ABC): A Detailed Approach

To achieve a more refined view of your cost-to-serve model, consider implementing Activity-Based Costing (ABC) techniques. ABC allocates costs based on the specific activities or processes that drive those costs, offering a more granular and precise analysis. This method enables you to pinpoint exactly where your resources are being consumed and how these activities impact your profitability. By adopting ABC, you can gain deeper insights into the true cost dynamics of your supply chain.

Data Analysis: Identifying Inefficiencies and Opportunities

With your costs accurately allocated, the next step is to analyse the data to identify key cost drivers, emerging trends, and any outliers that may indicate inefficiencies. This analysis should focus on uncovering opportunities to optimise costs by addressing areas of waste, such as high transportation costs, excessive inventory holding costs, or inefficient order processing workflows. Identifying these inefficiencies is the first step towards streamlining your operations and improving your overall cost structure.

Tactical Approaches to Improving Cost-to-Serve Efficiency

Precision in cost attribution, predictive modelling, and customer segmentation are essential tools for optimising cost-to-serve. Leveraging advanced analytics helps companies identify high-cost areas and streamline operations, while tailored service levels ensure profitability is maximised across customer segments. Process optimisation further reduces inefficiencies, making cost-to-serve analysis a cornerstone of strategic decision-making.

Granular Cost Attribution: Precision in Resource Allocation

Through sophisticated analytics, organisations can attribute costs with pinpoint accuracy to specific products, customers, or transactions. This level of granularity is crucial for identifying which products or customers incur the highest costs, thereby enabling more informed decisions regarding pricing strategies and resource allocation. By understanding these cost drivers at a detailed level, businesses can make targeted adjustments that enhance overall financial performance.

Predictive Cost Modelling: Proactive Risk Management

Harnessing historical data alongside machine learning algorithms, organisations can develop predictive cost models that forecast future costs based on various scenarios. These models allow businesses to anticipate changes in cost-to-serve metrics, enabling them to proactively manage costs and mitigate potential risks. Predictive modelling thus serves as a powerful tool for maintaining financial stability in the face of market volatility.

Customer Segmentation: Tailoring Service Levels and Pricing

Analytics also facilitates customer segmentation based on cost-to-serve profiles. By categorising customers according to the costs they generate, organisations can tailor service levels and pricing strategies accordingly. This ensures that high-value customers receive premium service without disproportionately increasing costs, thereby maximising both customer satisfaction and profitability.

Process Optimisation: Eliminating Inefficiencies

Identifying and addressing inefficiencies within supply chain and customer service processes is another area where analytics proves invaluable. By highlighting bottlenecks and suboptimal workflows, analytics enables organisations to streamline their operations, reduce unnecessary costs, and improve overall service quality. Process optimisation, driven by data insights, is a critical factor in maintaining a competitive edge.

Techniques for Cost Allocation in Supply Chains to Identify High-Cost Customers and Products

Total Cost Allocation (TCA) emerges as a pivotal method in calculating costs across batch orders, distinguishing between the main formula item and its associated co-products. This dynamic approach computes costs as a weighted average of quantities reported as finished, both for the formula item and the co-products. The advantage of TCA lies in its ability to streamline processes, eliminating the need to assess cost allocations for every individual batch order. In instances where TCA is not employed, formula calculations must rely on existing, less dynamic functionalities.

Benefits of Effective Cost Allocation

When executed with precision, cost allocation becomes instrumental in shaping a robust financial framework for an organisation. Notable benefits include:

• Informed Decision-making: A nuanced understanding of costs empowers management to make more strategic and operational decisions.
• Enhanced Accountability: When departments or projects bear specific costs, there is a heightened propensity to utilise resources judiciously.
• Accurate Pricing: Recognising true costs enables more precise product or service pricing.
• Improved Budgeting: Realistic and effective budget setting is facilitated when costs are allocated accurately.

Allocation of Corporate Costs

In multi-division companies, corporate headquarters’ costs may need to be apportioned to subsidiaries. Several allocation methods are available, often based on sales, profits, or headcount:

• Sales-Based Allocation: Costs are distributed based on net sales reported by each entity. However, this can unfairly burden low-profit entities with substantial corporate charges, as high sales volume does not inherently equate to high profits.
• Profit-Based Allocation: Costs are assigned based on profits generated by each subsidiary. This method may obscure the inherent profitability of high-profit entities when results are evaluated on a fully-burdened basis.
• Headcount-Based Allocation: This approach is often misleading, as some entities achieve sales and profits with minimal staff, while others may require extensive personnel. Additionally, a large number of low-paid employees can lead to significant cost allocation, whereas a smaller group of higher-paid employees might incur a lesser charge.

Employing “ABC/XYZ” Classification to Optimise Supply Chain Value

ABC classification serves as a robust method for identifying the most valuable goods within an organisation’s market offerings, ensuring that resources are allocated effectively across manufacturing, inventory management, revenue, and sales generation. By categorising products based on their significance, businesses can optimise their supply chains to meet customer demand with precision.

Understanding the ABC Method

The ABC classification framework is crucial for highlighting the items in your warehouse that warrant the most critical attention, management, and control. Typically, the classification is broken down as follows:

• A items: Comprise 10% of total inventory lines but account for 70% of the total annual value.
• B items: Represent 20% of inventory lines and contribute 20% of the total annual value.
• C items: Make up 70% of inventory lines but only account for 10% of the total annual value.

This method ensures that A-class items, which are essential for manufacturing runs and meeting sales demand, are prioritised. Meanwhile, B-class items, which hold moderate value, and C-class items, which contribute less, can be managed accordingly to minimise excess inventory and optimise resource utilisation.

Conducting an Effective ABC Analysis

Conducting a comprehensive ABC analysis involves six critical steps to categorise inventory accurately based on value and turnover rate:

STEP 1: Inventory Identification and Listing

Begin by compiling a detailed list of all inventory items. This comprehensive inventory list serves as the foundation for the ABC analysis.

STEP 2: Annual Usage and Sales Calculation

Calculate the annual usage in quantity and the total cost associated with each item. This provides insight into the financial impact of each product on the company’s operations.

STEP 3: Total Value Calculation

Determine each item’s total value by multiplying its annual usage quantity by the cost per unit. This calculation is essential for categorising items into A, B, or C classes.

STEP 4: Ranking by Total Value

Order the items from highest to lowest based on their total value. This ranking highlights items that contribute significantly to the company’s inventory costs.

STEP 5: Classification into Categories

Utilise the 80/20 rule to classify items into A, B, and C categories. Typically, the top 20% of items by value are classified as A, the next 30% as B, and the remaining 50% as C.

STEP 6: Review and Adjustment

Regularly review and adjust the classifications as sales patterns and costs change to maintain the accuracy of the ABC analysis.

Example Calculation:

Consider a business that stocks 100 different products. For a product with an annual usage of 100 units and a cost per unit of £50, the total value would be calculated as 100 units x £50 = £5,000. Depending on the total value, this product might be classified as an A, B, or C item.

By conducting cost-to-serve analysis alongside an efficient ABC classification, organisations can enhance their strategic decision-making processes, ensuring that their supply chains are both responsive and cost-effective.

Iter, in collaboration with its analytics partner AlignAlytics, applies a unique double Pareto approach to uncover where true profitability lies within your operations. This method begins by segmenting customer/SKU combinations into quadrants, providing a clear view of where genuine value is created. By incorporating proxies for the cost of complexity, the analysis is refined further to highlight where profits are made and where resources might be eroding value. For a deeper exploration of this approach, Iter has hosted a dedicated webinar on this subject.

Tim Richardson
Development Director
Iter Consulting