Distributors have a harder time creating business and profit if they don’t understand their Cost of Service (CTS) and apply it to pricing decisions. The market has changed dramatically and the standard cost plus margin approach is unlikely to cover their bases at all levels. Competition has intensified, driving down gross margins and raising customer expectations for service. Cost-plus pricing ignores these changes and does not take into account how demands and behaviors vary between customers.
If you are in the industry, you want to raise the bar within your organization by providing additional services to retain customers and be competitive. But you don’t want to waste money on individual sales in the process. To make sure that your efforts will pay off, evaluate your CTS. A clear view of CTS in your customer mix will help you determine the right path to growth and optimal profitability.
Best practices for calculating the cost of service
The calculation and use of the cost of service can be complex. The more complicated it is to use and apply to customers, the more difficult it will be to gain buy-in from your sales force. Plus, a more complex approach means more time and effort. For these reasons, distributors tend to neglect CTS entirely and opt for cost-plus instead.
Some distributors are trying a one-factor approach to CTS. They will use a component, such as sales or transportation costs, to measure CTS. It is good practice, but it is not the best.
There are two best practices that we have discovered in our research and through our experience in the industry:
Cost calculation by activity (ABC)
Activity-Based Costing is a widespread good practice for calculating CTS. However, ABC is complex and labor intensive, and its calculation requires a significant investment of time and resources. It tends to fall flat when it comes to being adopted by sales representatives and other key personnel, although there are some distributors who have successfully applied the ABCs in their pricing decisions and in their relationships with customers. This practice is to use formulas to allocate certain expenses (for example, warehouse costs, shipping costs) to individual orders to arrive at a more precise CTS for each customer. Adding it to gross margin to find net profit (NP) can help you rank your customers. Because it is labor intensive and time consuming, sales forces may not accept it, as happened with a distributor who used ABC to determine per unit loading costs. Calculations showed that the cost in Corpus Christi, Texas was 50 cents per pallet and the cost in Denver, Colorado was $ 5 per pallet. Their sales force dismissed this analysis as false.
The substitution method is a simpler and easier to use model for calculating CTS. With it, you use activity-based methods as well as other criteria such as average order size and returns. And instead of ranking customers based on a more precise CTS, you rank them based on how they compare. It’s as effective as the ABC approach, but it tends to get significantly more buy-in and ROI. The simplicity of the method makes it easier for sales people to adopt it and explain it to customers. It also allows for faster implementation, and distributors already have the data they need to perform these calculations and rankings in their systems.
Critical factors for the calculation of the CTS
Factors relevant to calculating and using CTS typically fall into finance, operations, and sales. In our research, we found 21 potential factors that distributors can use to understand CTS. But not all of them are effective when you compare customers. To identify the best factors within your organization and among your customer mix, each factor must meet the following criteria:
- Has measurable data associated with it.
- Can be quantified at the customer level.
- Is applicable for each customer.
- Can be understood by every sales and price influencer.
The factors that meet these criteria are the ones you can use to determine CTS and segment your customers. We found seven critical factors that apply to customers of most wholesale-distributor organizations:
- Average order size ($): The size of orders affects CTS both from a processing and shipping cost perspective. Small, frequent orders result in higher processing costs than less frequent and larger orders.
- Average number of line items: Small orders with few items can increase your CTS, especially if a customer repeatedly places a large number of small orders. Single item orders have their associated expenses, such as pickup, trucking, and delivery. You get a lower CTS and a more efficient business with more items per order.
- Payment days: Payment days are one of the most important CTS factors, so distributors benefit from careful monitoring and improvement in this area. The more days a customer takes to pay for an order, the higher the opportunity cost (of capital). Minimizing payment days can dramatically improve the cash conversion cycle, resulting in better cash flow. In terms of accounts receivable, the risk increases as customers take time to pay for their orders.
- Call orders (%): It is common for customers to pick up products from distributors’ facilities or warehouses instead of having them delivered, especially in specific trades, such as industry and HVAC / plumbing. These on-call orders affect CTS, reducing freight and delivery costs. This translates to fewer resource commitments for these customers, which significantly reduces their CTS.
- Same day deliveries: Same day deliveries often result in higher freight and inventory costs than other delivery options, such as next day. When customers demand more same-day deliveries, distributors may not have enough time to plan and fulfill orders effectively. It is convenient for customers to get products immediately, but if same day deliveries become a constant, it could indicate poor inventory planning on the part of the customer. Same day delivery is a critical CTS factor as it directly impacts the cost of servicing customers across multiple categories including finance, sales, and operations. For more deliveries, distributors need more inside sales resources, incur higher expenses for transportation, inventory and order processing, and need more time to plan logistics (planning, routing and cubage).
- Elements C and D consulted: Customers who order a product line with a high proportion of C and D items, which generally move slower, tend to have a higher CTS than customers whose product line includes a high proportion of A items. and B, which evolve rapidly.
- Number of returns: Customers who regularly return order items have higher processing costs and potentially back-up costs. Each return order comes with a multitude of red tape and requires resources in the supply chain as it involves suppliers. Managing and tracking this factor requires more discipline from a data entry perspective. For each product return, the distributor must enter the reason. If the cause is not captured accurately, customer stratification and analysis could penalize customers for the wrong reasons.
Putting CTS into Practice
A regional distributor that was growing through acquisition had 22 storage locations while selling in two states. The distributor’s STC was high and it did not have a consistent pricing mechanism for all locations. The management team wanted to roll out a pricing framework across all sites that their sales force would easily adopt. However, they did not have the education and training around CTS, which was critical in positioning the sales force to embrace and adopt the new pricing recommendations. To ensure its adoption, the leadership team needed to help the sales force understand CTS and its impact on pricing.
First, they brought together stakeholders from all departments, including sales, operations, finance, and purchasing, to determine which CTS factors were most relevant. The CFO preferred a full set of 11 metrics, but the VP of Sales preferred a simpler approach with only the most powerful metrics. A simpler approach was more likely to gain buy-in. Together, they selected: the average order size, the number of line items and the days overdue.
Selecting these CTS factors made it easier to put sales and other roles in contact with customers on the same page. In the table below, we compare two customers with similarities side by side. Their sales and gross margin are similar, and it doesn’t seem like prices need to be adjusted for either. But when you factor in CTS, it’s clear that price adjustments need to be made to minimize CTS.
The customer margin percentages are similar although it is clear that Customer 1 places more than twice as many orders as Customer 2. Customer 1 orders only one item per order and pays an average of 12 days late. Customer 1 costs more to serve and has a similar margin to Customer 2. Seeing this, the sales team can see the rationale for the new pricing mechanism and accept it. They just needed a framework and training around the CTS.
Pradip Krishnadevarajan is co-founder of ActVantage, which helps retailers drive profitable growth through analytics. He has over 15 years of experience helping hundreds of distributors while co-authoring seven books for the National Association of Wholesaler-Distributors. He recently published a margin recovery guide that distributors can use to manage the coronavirus pandemic. Prior to joining ActVantage, he co-founded the Wholesale Distribution Focused Research Lab of the Industrial Distribution Program at Texas A&M University. Contact Krishnadevarajan at [email protected] or visit actvantage.com.