CPG Practice Group White Paper Cost-to-Serve Analysis A Business Imperative for CPG Manufacturers About the Authors Nilesh Joshi Nilesh Joshi has over 18 years of international experience in the US, Europe, and the UK, both in retail (Office Depot, Metro AG, BrandsMart, and McDonald's) and in CPG (Unilever, VF Corp, PepsiCo, and Daymon). He has extensive experience as an SME, Functional Consultant, and Business Analyst for customized applications in Retail and CPG. Nilesh's areas of expertise are Analytics, S&D, SCM, Merchandising, Finance, Strategic Research and Planning, and he has worked for companies such as Siemens, Target Corp, Intentia, and Wipro. He is the author of many white papers, including one for the Grocery Manufacturers Association, USA. Nilesh has a B.E. (Electrical) degree and a PG Certification from SP Jain. Ankit Jain Ankit Jain has over four years of experience as a Business/Finance Analyst in TCS for the Retail and CPG sector. His areas of expertise are Finance, Taxation, and Retail and CPG. Ankit is a Chartered Accountant from the Institute of Chartered Accountants of India. Arunesh Sharma Arunesh Sharma has over three years of experience in the IT industry. His area of expertise is Business Analysis for the Retail and CPG sector. Arunesh has a B.Tech (Electrical Engineering.) degree from the National Institute of Technology, Hamirpur and an MBA (International Business) from the Indian Institute of Foreign Trade, Delhi. Satyajit Mahapatra Satyajit Mahapatra has over three years of experience in the IT industry, and his area of expertise is Business Analysis for the Retail and CPG sector. Satyajit has a B.Tech (Computer Science Engineering.) degree from the Institute of Technical Education and Research, Bhubaneswar and an MBA in Systems from Xavier Institute of Management, Bhubaneswar. It's a VUCA world out there! The primary manifestation of VUCA (Volatility, Uncertainty, Complexity and Ambiguity) for the consumer packaged goods (CPG) industry is its impact on profitability and margins. Dollars need to work harder in today's environment especially for the CPG industry, battered as it is by weak consumer spending and rising competition. To mitigate the impact of VUCA and thrive in such an environment, CPG companies must strengthen their financial monitoring capabilities. This will enable them to reduce costs and improve profit margins. However, this is possible only if an organization has accurate insights into costs and is able to monitor it very closely. Cost-to-Serve (CTS) Analysis offers a comprehensive cost and profitability management solution. It helps understand customer-wise 'cost to serve' for a particular product or product category across various cost dimensions including procurement, manufacturing, distribution, logistics (inbound and outbound), and sales. The analysis can lead to significant improvements in customer management, product management and profitability management—in turn leading to improvements to the bottom line. This paper examines the impact that cost-to-serve analysis can have on an organization's ability to manage costs and improve profitability. Contents Rising Costs and Dwindling Margins in the CPG Industry 5 Figure 2: Key Factors Impacting Costs of CPG Companies 6 Computing Cost-to-Serve: an Imperative 8 Factors that Affect Cost to Serve 8 Significance of Cost-to-Serve Analysis 9 The Current State of Cost-to-Serve Technologies Functionalities in the Ideal Cost-to-Serve solution Conclusion 11 11 12 Rising Costs and Dwindling Margins in the CPG Industry During the boom that lasted from the mid-eighties up to 2002 in the US, the consumer packaged goods (CPG) industry consistently outperformed most other sectors and delivered attractive returns to shareholders. Since 2002, a number of factors have jointly contributed towards a significant reduction in profit margins for the CPG industry. According to analysts, between 2002 and 2007, the reduction in profit margins led to an estimated $70 billion in lost revenues for the industry. Consider the excerpt below from the quarterly results report of Kellogg Company: Operating profit was $485 million in the quarter, a reported decrease of 10.7 percent; internal operating profit declined by five percent, as expected. Higher commodity costs, the timing of investment in Supply Chain, and anticipated weakness in European results all had an impact on operating profit.¹ Figure 1² illustrates the profitability and cost ratios for some bellwether CPG companies operating in the areas of food, home care, and personal care. Operating Profit Margin COGS/Revenue 25.00% 80.00% 20.00% 70.00% 16.00% 60.00% 10.00% 50.00% 5.00% 40.00% 0.00% 30.00% P&G Conagra 2010 2011 Kimberly-Clark 2012 P&G Conagra 2010 2011 Kimberly-Clark 2012 Figure1: Profitability and cost ratios for P&G, ConAgra and Kimberly-Clark from 2010-12 In spite of mounting input costs, CPG companies are unable to increase prices due to increasing competitive pressures, growing retailer clout, and tepid consumer confidence. Figure 2 illustrates the key external factors that adversely affect CPG companies' profitability and growth. ¹ Kellog Company, August 2012, accessed February 2014, http://investor.kelloggs.com/investor-relations/financial-information/earnings-pressrelease/Details/2012/Kellogg-Company-Delivers-Second-Quarter-Results-and-Reaffirms-Full-Year-Guidance/default.aspx ² P&G, Investor / Shareholder Relations, Annual Reports 2010, 2011, 2012, accessed November 2013, http://www.pg.com/en_US/investors/financial_reporting/annual_reports.shtml; ConAgra Foods, Investors, Financial Reports & Filings, Annual Reports 2010, 2011, 2012, accessed November 2013, http://www.conagrafoods.com/investor-relations/financial-reports/annual-reports; Kimberly-Clark, Investors, Investor Resource, Financial Information, Annual Reports 2010, 2011, 2012, accessed November 2013 http://www.kimberlyclark.com/investors/financial_information/annualreports.aspx 6 5 n n Increasing trade promotion costs Power tilt towards retailers Retailers Competitors Private Label & Substitutes CPG n Products from retailers – pricing pressure and increased competition n Suppliers n n n Reducing market share Increased pricing pressure New Entrants Increasing cost of raw material fueled by commodities and crude prices Stringent regulations Heightened awareness amongst consumers Local brands gnawing market share due to Disruptive pricing n Local procurement and effective supply chain n Figure 2: Key Factors Impacting Costs of CPG Companies The main reasons for the decreasing margins of many CPG companies are: n Rising and highly volatile raw material costs n Rising trade promotion spends n Higher distribution and logistics costs Given the importance of these factors, we shall discuss them in detail. n Commodity Costs Agricultural commodities, including corn, wheat, soybean, palm oil, sugar, cocoa, tobacco, beef and pork, are the principal raw materials for the food and beverages segment. Similarly, petroleum derivatives, cotton, wood pulp, and chemicals are the key raw materials for the home and personal care segment. Packaging material such as paperboard, polypropylene (crude derivatives) and wood pulp are the other key inputs used by CPG companies. The cost of such commodities fluctuates widely due to supply and demand issues, changing government policies and regulations, weather conditions, and other unforeseen circumstances. n Trade Promotion Costs For most CPG manufacturers, trade promotion cost is the second highest cost after cost of goods sold (COGS). In the last few years, increasing competition from private labels has forced CPG companies to further increase their trade promotion spending. Also, heightened price-consciousness among consumers since the recession has led to CPG companies offering more price and volume discounts in order to retain market share. 6 n Distribution and Logistics Costs The growing clout of retailers, while negotiating distribution and logistics related terms, has tilted the power balance away from CPG companies. Retailers are constantly pushing for better order cycle times, 'just-in-time' replenishment, and direct store deliveries to reduce their inventory cost. These demands require CPG companies to carry a higher level of inventory in their warehouses and provide more frequent, low volume deliveries. This results in higher inventory carrying costs and transportation costs. In addition, freight rate indices have risen continuously for the last three years, which has further increased both inbound and outbound transportation costs. Figure 4³ shows the freight rate indices for US. The index represents the cost per mile in US dollars and covers all costs related to freight transport by land, such as fuel, wages, equipment, insurance, depreciation, administration, financing and compliance. US Freight Rate Index (Cost per mile in US dollars) 2.70000 2.60000 2.50000 2.40000 2.30000 2.20000 2.10000 2.00000 1.90000 1.80000 1.70000 1.60000 Jul-13 Apr-13 Jan-13 Oct-12 Jul-12 Apr-12 Jan-12 Oct-11 Jul-11 Apr-11 Jan-11 Oct-10 Jul-10 Apr-10 Jan-10 Oct-09 Jul-09 Apr-09 Jan-09 1.50000 Figure 4: Freight rate index for US from 2009 to mid-2013 7 ³ Freight Rate Index, Freight Rate Index Historical Data, accessed February 2014, http://www.freightrateindex.com/index_files/page0015.htm Computing Cost-to-Serve: an Imperative It appears that rising input costs, increasing competition, and supply chain volatility are the new normal. How, then, can companies cope with this new reality? We suggest that CPG companies develop better cost management capabilities to survive and thrive in the new environment. One such capability is the measurement of cost to serve. Cost to serve helps CPG companies arrive at the total cost incurred in all the activities performed in selling a product to a customer. It involves categorizing customers according to various priority or value criteria for better management of costs. A CPG company does not necessarily earn the same profit margin from every customer, even if each customer buys the same product at the same price. Various factors such as distance, method of shipping, trade promotion cost, as well as returns policies and payment terms, must be taken into consideration while calculating the cost to serve a particular customer. Factors that Affect Cost to Serve The cost to serve incurred by a CPG manufacturer to serve its different customers depends on factors such as: n Handling costs: The cost of packaging and shipping varies depending on whether the customer requires standard packaging or customized packaging. For example, it may take one minute to wrap a product with standard packaging, but six minutes for customized packaging. This leads to different costs of packaging for different customers. n Order picking costs: These vary with whether the customer requires full pallet picks or case picks and are measured at the cost per case level, by SKU for a particular customer. n Labor costs: If a customer collects orders beyond regular working hours, the company incurs additional costs for overtime and idle time. n Raw material costs: The ingredients mix required — for example, the use of sugar, fructose, or aspartame as a sweetener — may vary for different customers depending on special requests as well as ingredient cost dynamics. n Transportation costs: This varies based on the type of shipping, shipping address, and distance. The CPG company may supply its products to the distribution center for one client and direct to store for another, resulting in higher costs for the latter due to additional effort and incremental distances. Similarly, the transportation costs of each item in a consignment with full pallet sizes are lower than in a consignment with cases. n Sales costs: This varies with differences in trade promotion costs, ease of account reconciliation, payment terms, and return policies, which may be different for different customers. n Other costs: Complementary activities such as order processing, Electronic Data Interchange (EDI) transactions, credit periods, booking vehicles and timeslots, and handling claims have different procedures and guidelines, which impact the cost to serve. For example, some clients may insist on information sharing via EDI only, requiring the CPG company to incur a cost for each EDI transaction. Other clients, on the other hand, may allow some information sharing via e-mail. 8 Significance of Cost-to-Serve Analysis Cost-to-serve calculations are intended to accurately assess the profitability of a product for each individual customer. The CTS model incorporates all activities necessary to complete the customer delivery and collect product revenue, and takes into consideration how each major supply chain activity affects the complete end-toend cost to serve a customer. Cost-to-serve calculations are derived from activity-based costing methodology. In this methodology, costs are recognized as and when they are incurred during the various activities involved in manufacturing a product and selling it to the customer. To calculate the cost to serve, a portion of the total cost incurred in performing a particular activity, such as purchase order generation, is attributed to the customer based on certain cost allocation criteria. The cost allocation criteria depend upon the key factors that drive the cost for the activity under consideration. This cost allocation to individual customers is done for each activity to arrive at the total cost to serve the customer. CTS customer profitability helps to identify the functional areas and activities that contribute to the costs for a customer. CTS customer profitability looks beyond the traditional measures of revenue and gross margins. It gives a truer picture of profitability by including the hidden costs and the costs that cannot be apportioned by traditional costing methods. Cost to serve and CTS customer profitability may be used by companies to modify the levels of service they provide to each customer. These measures also help identify the areas and activities where companies should focus their cost reduction efforts. 9 Figure 4 illustrates how to calculate cost-to-serve profitability; it also shows how the cost to serve can vary significantly when serving the same product to two different customers. CTS Customer Profitability Individual product (SKU) as well as aggregated product (category, sub-category, customer basket) view Net Sales Customer 1 Manufacturing Cost (both in-house and outsourced) Customer 2 20,000 25,000 Customer 2 Direct Material 5000 6500 Indirect Material 700 1100 Finishing/Packaging 212 320 Quality Inspection 120 (7,500) 37.5% (10,000) 40% 200 Procurement Costs Total CTS Customer 1 Warehousing Costs (Finished goods and Raw Materials) Transportation & Distribution Costs (Third Party Logistics, Direct Store Delivery, Raw Materials Transport) Sales & Promotion Costs Real Profitability Margin (2,700) 13.5% (3,000) 12% (300) 1.5% (700) 2.8% (2,300) 11.5% (2,600) 10.4 % (5,000) 25% (4,000) 16% 2,200 11% 4,700 18.8% Figure 5: CTS Customer Profitability CTS analysis can help address some key challenges frequently faced by CPG companies, such as: n Do we understand what drives cost to serve? Have we taken all relevant costs into account in determining the profitability of different customers? n How do various customers compare with each other? n How will the cost to serve individual customers change with changes in any of the factors that contribute to the cost? n How can we recover increased costs from individual customers? n Where can we reduce cost and improve performance in the overall supply chain? CTS reports and dashboards can be especially useful in management decision making in certain key CPG functions such as: n Sales finance, where more informed pricing decisions can be made based on the insights of actual cost to serve for each product-customer combination. 10 n Supply chain, where executives can identify the need for cost-cutting initiatives at specific levels or activities in the supply chain. Also, based on the knowledge of actual CTS per activity, management can set specific costcutting targets and benchmarks and track the performance of executives. The levels of inventory can also be adjusted based on the cost to serve. n Account management, where managers can better negotiate with customers. CTS can help companies make better decisions on customizing service levels, such as normal delivery versus special delivery (for example, deliveries after working hours or on weekends), high-touch (in person) versus low-touch (online) order management and customer support, regular versus customized labeling, and so on. The granular visibility of costs incurred and insights gained from cost-to-serve analysis can help business managers in their goal of maximizing the profitability of every customer and product combination. The Current State of Cost-to-Serve Technologies While there are several tools available in the market today that calculate cost to serve, these tools analyze gross margins, not end-to-end profitability across the entire lifecycle of each transaction and across the customers. Also, most of these cost-to-serve solutions were originally devised for the banking industry and focus on banking processes, functions, and problem areas. With the need for CTS analysis arising in the CPG space as well, the same solutions have been customized to serve CPG. However, they are yet to be fully attuned to the nuances of the CPG industry or to its pain points. In addition, most existing CTS solutions lack advanced forecasting and benchmarking capabilities. Functionalities in the Ideal Cost-to-Serve solution To adequately address the CPG specific problem areas, a cost-to-serve application must have the following functionalities: n Measurement of individual customer profitability The CTS application should be capable of measuring the individual customer profitability for each product. n Expense allocation on the basis of activity as well as on the basis of customer type: Currently, activity-based costing systems analyze activities taking place at each point in the supply chain, and allocate costs accordingly. Such allocation does not depict the true profitability of a particular customer. The CTS application should be capable of allocating the expense on the basis of both the activity as well as customer behavior and demography (such as a preference for supermarkets over club stores). These should then be mapped to a particular customer. n Analysis of cost at a granular level: Discounts and allowances such as volume discounts, favorable payment terms, rebates, off invoice and bill back usually reduce the profit margins of CPG companies. However, since each of these costs to serve are quite small per transaction, they are often overlooked. The data must be viewed from a transaction perspective, and each individual cost to serve should be accumulated to calculate the total cost to serve for a particular customer. This can be done by identifying and breaking up the entire cost to serve into individual cost elements that cover all the activities that a CPG company undertakes in order to serve its customers. 11 n Forecasting and optimization scenarios: An effective CTS application should predict the future cost to serve for a particular customer based on past data as well as current trends. This is a must-have functionality. Most contracts with retail clients are entered into in advance, are for longer durations (3-6 months), and entail the freezing of the price per unit. This is despite the fact that, in reality, most costs fluctuate on daily or weekly basis. In addition, an ideal CTS application should provide business users with optimization scenarios. These scenarios help reduce the costs incurred on a particular activity by allowing the user to choose from various alternatives and view the impact of different scenarios on the total cost to serve. n Benchmarking: After gaining visibility into the costs incurred for each activity under different functional areas, it is beneficial to know the costs incurred by peers for those activities. This enables the company to identify areas of improvement. It can also help prioritize cost-saving initiatives. A CTS solution that incorporates all these functionalities can provide significant benefits to CPG companies, such as: n Actionable insights about the actual cost to serve across customers n Insights into future cost-to-serve metrics, enabling data-driven pricing negotiations n Identification and reduction of hidden costs through granular capture and analysis of costs incurred n Robust planning for profitability improvement n Customer ranking at all levels of costs n Process improvements due to insights gained from cost data analysis, benchmarking, and best practices Conclusion Historically, cost-to-serve analysis has been a one-off affair, typically conducted as a post-facto analysis related to a troubled product or a category, and carried out by consulting firms. But with the availability of modern applications and the capability of capturing costs at the activity level, cost to serve can be monitored at the product level for every customer. This provides the following benefits: n A single version of truth for all cost-to-serve elements n An enterprise-level governance model for cost approval n Internal benchmarking for various cost heads n Cost reduction by aligning service levels to the margin offered by each customers n Improved profitability and better responsiveness to market changes With all these benefits of cost-to-serve analysis, it has become an imperative for CPG companies. Companies need to either invest in CPG-specific CTS solutions or recalibrate their existing solution to fit the needs of the industry. 12 Contact For more information about TCS’ consulting services, contact global.cpgsolutions@tcs.com Subscribe to TCS White Papers TCS.com RSS: http://www.tcs.com/rss_feeds/Pages/feed.aspx?f=w Feedburner: http://feeds2.feedburner.com/tcswhitepapers About Tata Consultancy Services (TCS) Tata Consultancy Services is an IT services, consulting and business solutions organization that delivers real results to global business, ensuring a level of certainty no other firm can match. TCS offers a consulting-led, integrated portfolio of IT and IT-enabled infrastructure, engineering and assurance services. This is delivered through its unique Global Network Delivery ModelTM, recognized as the benchmark of excellence in software development. A part of the Tata Group, India’s largest industrial conglomerate, TCS has a global footprint and is listed on the National Stock Exchange and Bombay Stock Exchange in India. IT Services Business Solutions Consulting All content / information present here is the exclusive property of Tata Consultancy Services Limited (TCS). The content / information contained here is correct at the time of publishing. No material from here may be copied, modified, reproduced, republished, uploaded, transmitted, posted or distributed in any form without prior written permission from TCS. Unauthorized use of the content / information appearing here may violate copyright, trademark and other applicable laws, and could result in criminal or civil penalties. Copyright © 2014 Tata Consultancy Services Limited TCS Design Services I M I 02 I 14 For more information, visit us at www.tcs.com