To begin, let’s briefly clarify what cost-to-serve is.
Cost-to-serve, widely referred to as CTS, is the sum of all the costs required to provide a product or service to your customer.
The fact that all costs are fully considered is what makes this analysis a high-performance strategy when looking at a customer’s profitability.
We usually associate a good customer with a customer who buys a lot from us – or with the one where we have a significant volume of services and transactions. But this only shows the one where we have had the most sales, not the one where we have made the most money, i.e. the most profitable! A customer with high turnover certainly requires a series of trade-offs and efforts that are often “expensive” to meet.
A study published in the Harvard Business Review showed that on average 20% to 30% of customers are very good from a profitability point of view – bringing between 150% and 300% of the company’s total profitability; on the other hand, between 50% and 60% are neutral (i.e., we do not make or lose money) and approximately 20% are unprofitable.
The big challenge is to understand which ones they are, and in which layer each one is located. Eliminating the clients that we lose money is not enough, as by doing this immediately other clients that are neutral and even those that make some profit start to become unprofitable – after all, our fixed costs don’t disappear, requiring us to make some adjustments in our installed capacity.
Now when we bring into the equation, in addition to the cost of serving each client, the profitability we have with each one and the time we will be serving to this client, we will certainly find situations in which that extremely profitable client will migrate to the competition in the short term; others that are extremely loss-making will continue to drain the organization’s resources. Bad scenario, isn’t it?
The question is, “what should we do?” The first thing to do is to be aware of the need to measure things. As we know, it is impossible to manage what you cannot measure – so measuring and then deciding is key!
“Firing clients”, + the end: those clients who are loss-making often help pay the fixed costs, and if there is no change in the structure of the organization, their “firing” may bring a terrible consequence, which is that clients who are neutral today may start to be unprofitable (and the very profitable ones may become not so profitable). There are companies that have already bankrupted just because of failure in this criterion, and they were excellent “producers”, with well-rounded production lines, equally good product costs, but they neglected this very important detail, which is to understand and act correctly with the costs-to-serve.
During the development phase, it is determined what the cost object is, what the cost of meeting this object will be and how it will be mapped, what the drivers for allocating the aggregate cost will be, and what IT systems will be used to calculate and maintain the analysis of its operation after the development of the customer’s profitability.
On one occasion a large national bank did a project and discovered that it had loss-making clients: What did they do? They eliminated these clients from their portfolio. The result: the clients that were neutral became unprofitable. What did they do then? They eliminated these new unprofitable clients, resulting in a huge loss with this operation. The issue of capacity/idleness must ALWAYS be taken into consideration for cost analysis!
It is also important to know that it is not by firing employees that we reduce costs – at least not indiscriminately. In fact, there are studies that show exactly the opposite: according to the US Conference Board, of the companies that tried to reduce costs, 30% actually had higher costs! Another study by Deloitte showed that 75% of the companies that laid off employees to reduce costs had to rehire others for the same positions within 1 year. And finally, McKinsey showed in a survey that only 10% of cost reduction projects are successful within 3 years of its implementation. Reducing costs is not simple, it demands effort and measurement (measure!) to make the best decisions afterwards.
Check out our content that fully explains the Activity-Based Costing system
The first step is to understand how the organization’s efforts are aimed at serving the various customers and channels; this includes information that must necessarily come from the CRM, but also from interviews with the sales and customer service areas.
Through the metrication of the main activities involved in serving these customers and channels it is possible to understand the effort spent to serve them individually and therefore make specific analyses that allow the understanding of cost and result, customer by customer, channel by channel.
For example: a very common activity of the commercial team is “Meet with Customers”. The cost of this activity is the sum of the commercial area’s efforts (salaries plus salespeople’s benefits and the whole area) including the support areas such as HR (that last month hired 2 new salespeople), the IT area (that this month gave 5 supports related to the new HR system) and also the value of the internal support systems (such as CRM itself); that said, now it’s time to allocate these costs of Meeting with clients – which are not necessarily Product and Service related costs but rather Client related costs (as a periodic maintenance and follow-up activity for these clients); this allocation should be done using the criteria “number of meetings with clients” (assuming that these meetings have an average time approximately equal to each other) or ” meeting hours” if this value varies a lot.
Of course, this allocation must be done taking into consideration the materiality of what is being allocated (that is, many times the effort in collecting and applying this information is not worth it, given the small costs of this activity compared to the other activities of the company) but in many cases it is very well worth it!
This done we have the cost of each customer only with the activity “Meet with Customers” – if we do that with all the activities of the Commercial and Customer Service areas, we will have an interesting suggestion of efforts to be analyzed and surely many surprises will appear, with activities that we never imagined would be so expensive and that would influence so much the costs of each Customer and Channel, and even others that we thought would be expensive, but that in the end turned out to be not very significant.
The set of mapped activities, on one hand their interconnections with the chart of accounts, cost centers, and areas, and on the other hand with the various Products, Services, Clients, and Channels, is called a cost model – and this modeling, if well executed with method and process, allows a vision never before seen in organization!
Access our profitability calculator!
