Identifying causes of margin erosion

2 things happened this weekend that triggered this post.

First, I watched an interesting webinar with Rob O’Byrne from Logistics Bureau in Sydney Australia and second, I read the Bill Gates Monthly Newsletter. The take home from Bill’s monthly newsletter is that while we may have missed an opportunity first time around, there is always time to start it.

https://bit.ly/34a7JCo

From Rob was the reminder of a tool I haven’t used in a long time, and also the need for everyone to contribute to the revival of the economy by assisting businesses to improve their profitability.

Standard costing, the accounting method most businesses use applies the “Fair share” approach when allocating indirect costs to products at SKU level. The result is that in the day to day operation, products that are shown as profitable on the P&L, could very well be unprofitable, and vice versa. This could and often does lead to the incorrect business decisions. The impact of this will be exacerbated for essential services manufacturing and delivering products to market during the Corona virus lockdown, and by industry in general trying to recover their market share after we get used to the new normal.

Right now, essential operations are absorbing additional costs, expediting supplier deliveries, pushing production, and also increased distribution costs. This obviously erodes contribution margin, pushing profitable lines into the red. Marginal companies may come out of this lock down having to assess the viability of the business and many may close down. Not fair for these folks who have risked their health to keep the rest of us fed and medicated.

This raises red flags for me.

  1. Does a business know what the actual impact is on each of their SKUs?
  2. Prior to the pandemic, were these products really profitable?
    1. Is your answer based on your P&L generated for budgeted purposes, or have you analysed budget vs. actual?
  3. How are we going to return them to profitability as quickly as possible?
  4. How do we try to cap costs in the immediate future?

These 4 questions alone will explode into a myriad of more questions as we start breaking our analysis into those areas that affect the big picture the most. There will also be a knock-on effect internally and externally because of interdependency. (Effect – Causes – Effect).

Cost to Serve analysis comes from Activity-based costing and is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing. In the context of supply chain management, it can be used to analyse how costs are consumed throughout the supply chain.

What are the components of Cost to Serve?

The components can be broken down into these 7 groups,

1. Customer + Customer service overhead.
2. Plan + Business unit and factory planning overhead.
3. Source + + COGS materials.
4. Make + COGS, internal conversion costs or outsourced manufacturing costs.
5. Deliver + Internal warehouse costs (space, equipment, people)
6. Return + Product returns costs.
7. Other Core operations overhead distribution volume based? specific supplier arrangements, testing complexity, complexity of supply, or manufacture?

Indirect costs are applicable to the strategic and tactical ranges when costing products in a business. At the operational level, everything becomes a fixed cost. You can’t hire and fire people at will, or shutdown a section of your boiler, compressor or HVAC services because of a breakdown in your process. We need to look at doing everything smarter and more cost effectively Promote and Protect FLOW.

The answers that come from Cost to Serve analysis gives us a very good indication of where to focus our efforts to generate improvements that will directly impact the business’s bottom line. You can also use this information to compare with your P&L statements for each product and product category. Do our costing models accurately reflect reality, or are we losing money on key brands?

The bottom-line impact comes in one of two forms, Cost reduction or process improvements

  • Cost savings from service reductions and more efficient internal resourcing
  • Operating Expense – freight costs, COGS, SG&A, etc.
  • ROI through reduced working capital and improved Customer Service levels
  • Revenue growth resulting from pricing increases—either as an increase to single sale prices or in line-item surcharges, such as those often associated with rush shipments.

So, if you are concerned about your soaring costs, or you just want to know how to apply the cost to serve model, contact SA Coaching via email at dave@sacoaching.co.za. We are offering 2 30-minute sessions free of charge and will guide you to construct your own model.