Cost to Serve Analysis

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.
Rising Costs and Dwindling Margins in the CPG Industry
Figure 2: Key Factors Impacting Costs of CPG Companies
Computing Cost-to-Serve: an Imperative
Factors that Affect Cost to Serve
Significance of Cost-to-Serve Analysis
The Current State of Cost-to-Serve Technologies
Functionalities in the Ideal Cost-to-Serve solution
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
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
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,
² P&G, Investor / Shareholder Relations, Annual Reports 2010, 2011, 2012, accessed November 2013,; ConAgra Foods, Investors, Financial Reports & Filings, Annual Reports 2010,
2011, 2012, accessed November 2013,; Kimberly-Clark, Investors, Investor
Resource, Financial Information, Annual Reports 2010, 2011, 2012, accessed November 2013
Increasing trade promotion costs
Power tilt towards retailers
Private Label & Substitutes
Products from retailers –
pricing pressure and increased
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
Figure 2: Key Factors Impacting Costs of CPG Companies
The main reasons for the decreasing margins of many CPG companies are:
Rising and highly volatile raw material costs
Rising trade promotion spends
Higher distribution and logistics costs
Given the importance of these factors, we shall discuss them in detail.
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.
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.
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
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)
Figure 4: Freight rate index for US from 2009 to mid-2013
³ Freight Rate Index, Freight Rate Index Historical Data, accessed February 2014,
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:
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.
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.
Labor costs: If a customer collects orders beyond regular working hours, the company incurs additional costs
for overtime and idle time.
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.
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.
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.
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.
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.
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
Customer 2
Direct Material
Indirect Material
Quality Inspection
(10,000) 40%
Procurement Costs
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
(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:
Do we understand what drives cost to serve? Have we taken all relevant costs into account in determining the
profitability of different customers?
How do various customers compare with each other?
How will the cost to serve individual customers change with changes in any of the factors that contribute to the cost?
How can we recover increased costs from individual customers?
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:
Sales finance, where more informed pricing decisions can be made based on the insights of actual cost to serve
for each product-customer combination.
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.
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
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
Measurement of individual customer profitability
The CTS application should be capable of measuring the individual customer profitability for each product.
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.
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
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.
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:
Actionable insights about the actual cost to serve across customers
Insights into future cost-to-serve metrics, enabling data-driven pricing negotiations
Identification and reduction of hidden costs through granular capture and analysis of costs incurred
Robust planning for profitability improvement
Customer ranking at all levels of costs
Process improvements due to insights gained from cost data analysis, benchmarking, and best practices
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:
A single version of truth for all cost-to-serve elements
An enterprise-level governance model for cost approval
Internal benchmarking for various cost heads
Cost reduction by aligning service levels to the margin offered by each customers
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.
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