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Why You Need Cost-to-Serve Modeling

Bruce Merrifield, President — Merrifield Consulting

• competitive strategy • profit analytics • WayPoint Analytics • distribution management best practices • big data • distribution industry trends • business math for distribution • wholesale distribution basic math • business model

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Does your company have a cost-to-serve model? In this video interview, Bruce Merrifield and Randy MacLean discuss why cost-to-serve modeling is vital to your business's profitability.

As we've discussed in previous videos, looking only at profit margins – rather than also taking cost-to-serve into account – is a surefire recipe for failure. Yet many distributors continue to make this mistake.

"There are quite a few distributors who may have tried a crude attempt at a cost-to-serve model in the past," Bruce explained. "However, this exercise often ends when they get to the bottom of their report and realize that it's telling them that one of their biggest or 'best' accounts is a huge loser. They refuse to believe it and there's inevitable pushback. Rather than recognize a problem with the account, they blame the report."

Basically when a report contradicts their beliefs, the distributor shuts this new information out. There's an inherent problem in modeling where people expect the models to confirm what they already know. When you believe your best customer is really your best customer, any evidence to the contrary is hard to accept.

The flaw with this line of thinking is that reports that tell you what you already know are completely useless. You need reports that point out issues you may be overlooking so you can fix problems and rethink approaches.

When it comes to big customers, distributors are often blinded by volume or the gross profit margin. They tend to overlook that this activity may come with an even higher cost-to-serve. And, without a model, they'll continue to overlook those costs.

"That kind of a reaction isn't uncommon," Bruce added. "Back when I ran some paper companies, we had major profitability issues due to having way too many small orders. This issue formed the basis of a Harvard Business School Paper that I wrote and was followed by several speaking engagements in front of distribution executives, most of whom weren't ready to hear this information."

"However, the crude cost-to-serve model had worked wonders for my business," Bruce explained. "All I did to create the model was take the total cost of running the business which I then divided by the total number of transactions that we had."

"This gave us a very rough cost per transaction," Bruce continued. "If a customer had 100 orders, I multiplied that number by 100 to get his cost-to-serve. The only way to rank at the top of my report was to have huge margin dollars and few transactions."

"Others in the company were worried that there may have been issues, so we tried various iterations of the model and tried to fine-tune it as much as possible," Bruce said. "Each time the big winners were still big winners while the big losers were big losers. It really made no difference."

Our ability to evaluate cost-to-serve has improved dramatically since then, as WayPoint is capable of analyzing that information right down to the individual line thanks to WayPoint Analytics' line item profit analytics (LIPA) software. However, Bruce's approach was brilliant because transactions drive a business's expenses. It was a great starting point.

More importantly, Bruce recognized the importance of working at the profitability extremes since that's where a distributor can drive the most change and achieve the greatest results. After you've grabbed all that low-hanging fruit, you can begin to take a more sophisticated approach to your model and add additional layers of complexity. This allows you to optimize things like delivery and payments so you can find even more effective approaches.

For more information about Bruce Merrifield, visit: www.merrifieldact2.com