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Age old profitability analysis, what’s different? – Cost to Serve

In this three part blog series on what’s different in age old profitability analysis, I will try to explain the following:

Part I – Key needs for profitability analysis, some issues and Cost to Serve

Part II – Evolution of solutions for integrated profitability and cost management

Part III – Deep dive on some of the SAP solutions for profitability analysis

As summarized in the preface to the blog, profitability analysis is the most important activity that happens in an organization. Though it is usually done by finance, every business manager would like to know how good or bad he is from a profitable angle. Often they do not get the right information on profitability.

But isn’t it a very simple and basic thing, as simple as to say Profit = Revenue  – Cost.

Yes it is, but the main issue is not the overall math of profit at a higher level of the business, but its more when you would like to ascertain the profitability at a more granular level – profitability by product group, profitability by customer segment, profitability for a project that is being run etc. Why is this difficult, its difficult because there a big chunk of the cost that is ‘Indirect’ in nature and cannot be attributed to a particular product, customer or project. Often this indirect cost is very high in certain business and its quiet important to allocate the same to the right reporting object, in order to make a good analysis on what is best or worse from a profitable angle.

So the above formula should be broken into

Profit = Revenue – Direct Cost –  Indirect Cost

Or in other words we can name the ‘indirect cost’ as ‘Cost to serve’, analyzing the information in a different approach

Cost to Serve

Cost to serve is an approach that helps a broad view of costs, so that you can track, measure, and model every element of the equation to help improve profits. In other words, cost to serve helps you go more granular and analyze profitability with better confidence. As an example, while talking to a big CPG customer, we find that though the direct cost to produce a product is minor, still they have not made profits. Why? Going a bit granular, you find that you have huge freight costs to transport the product( biscuit) from the factory through the distribution into the homes of the consumer. Also you spend lot of marketing dollars through indirect advertising or events to keep the brand value ,top of mind.  In another example with a banking customer, the cost to serve a certain segment of customers who tend to visit the branch frequently is significantly affecting the profitability. It could be because of the lack of good communication on the banking product or could be just because the target audience is not appropriate for a variant of banking product, so getting insights into cost to serve would help in better structure of products for the right customer segment.

I was following a very good debate in one of the linked forums to the question – ‘As VP of Sales, would you prefer a strong sales team with average product or a very good product with average sales team’. Most of the 400+ respondents preferred Strong Sales team with average product. Now when you  need a strong sales team, you will have to pay the talented sales people high. So if we do a cost to serve analysis, typically we have to consider the cost involved in building and keeping this strong sales team to make the sale happen. Additionally with a weak product, you will have more post sales service cost also. While revenue from the weak product may be impressive, it would definitely affect the cost to serve and the overall profitability, though it may not be reflected due to failure of capturing the true profitability analysis through cost to serve approach.

How does it matter to analyze the cost to serve of the past? Essentially the analysis would help you to optimize the cost to serve, or focus on the right segment of product or customer where there is a chance to have more profitable business. One of the customer that used this approach, could even do better supplier negotiation, by understanding the cost at various phases.

Cost to serve has evolved as an important concept to be incorporated to determine profitability and make useful decisions. We will discuss how solutions can enable this concept as well as little bit of deep into sap’s solutions to handle this concept in the next parts of this blog.

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      Author's profile photo Former Member
      Former Member
      as businesses grow larger, so do their overheads, so most of management accounting boils down to allocating and reallocating overheads which complicates the profit calculation. if you add transfer pricing to optimize tax at the enterprise level and accruals/deferrals to allocate expenses across periods, you end up with a totally artificial profit number which needs to be stripped down (netted) back to where it started, ie. at the gross margin level. most processing and subsequent analysis is done in obtaining the 'true' profit number.
      Author's profile photo Former Member
      Former Member
      Very good point 🙂
      Author's profile photo Former Member
      Former Member
      Blog Post Author
      Greg,  the main issue in the allocation/reallocation of overheads comes when the business managers/product managers to who the cost hits start disputing the allocation claiming they do not own it when the allocation is made on drivers that do not reflect the actual assignment of the cost incurred for them. So its important to have a mechanism to more transparent and accurate form of allocating the overheads based on the actual consumption /cost incurred to serve. Technology is also evolved more, which i am planning to cover in my next blog...