How To Understand Your Cost-To-Serve To Maximise Your Margin

By: Jacky Broomhead

This article looks at why it’s essential for today’s online retailers to understand the true costs of serving their omnichannel customers if they are going to increase sales and maintain margin

A recent study published through Harvard Business Review investigated the shopping behaviour of an impressive 46,000 customers over a 14-month period from June 2015 to August 2016. Analysing every aspect of the shopping journey across all channels of a retailer, the study concluded that omnichannel retailing works.

According to the findings, omnichannel customers love using the many touchpoints that now form part of the retail offer. And this love is making itself known in the form of sales, supporting current belief that the more channels customers use, the more valuable they are. In the case of this particular retailer, the study revealed that for every purchase omnichannel customers spent 4% more in store and 10% more online compared to their single channel counterparts.

The cost vs value of being omnichannel

The perceived value of omnichannel shoppers is widely acknowledged and well publicised. According to Google, omnichannel shoppers have a 30% higher lifetime value than single channel customers. Deloitte claim they’re three times more valuable. And Macy’s really raise the stakes by reporting their omnichannel customers are an incredible eight times more valuable.

New digital channels are driving sales growth – because the more channels a customer uses, the more opportunity they have to find what they’re after and convert into a sale. But what is less transparent are the costs associated with serving more routes to market. Although sales are up, for many retailer’s margins are going down – and this is due to the higher cost-to-serve the omnichannel shopper.

What is cost-to-serve?

Cost-to-serve is a financial tool that identifies the operational costs that accumulate as a product moves through the supply chain to get to the customer. Unlike traditional methods of activity based costing, cost-to-serve factors in the customer and product characteristics for each transaction.

With omnichannel, cost-to-serve calculates the total cost of serving a customer a specific SKU, through a set channel and at a designated service level. This enables companies to reflect on the true cost of handling and to build cost profiles to identify the most profitable customers, products and routes to market.

Due to the level of variation in how a product now gets from A to B (and, with returns, potentially back to A again), cost-to-serve is a vital KPI in determining retail success. Because, although omnichannel customers are perceived to have a higher lifetime sales value, research from IBM reports that the cost-to-serve the omnichannel shopper is up to three times more expensive than a store only customer!

Uncovering the costs of being omnichannel

If you compare the traditional store supply chain to a cross channel supply chain it’s easy to identify the processes that appear to drive up costs.  

Analysis from OC&C strategy consultants has calculated the average fulfilment cost per channel and the results are striking. The average cost to pick, pack and deliver a small parcel to a customer is five times higher than the average cost-to-serve a customer in store.

Source: http://www.occstrategy.com/en-us/news-and-media/2016/03/reinventing-the-last-mile

Fulfilment costs for online channels are clearly more expensive than bricks and mortar but does this indicate the source of dwindling margins? When you consider the operating profits of the major UK retailers, recent performance suggests the issue may be more complex. 

Further analysis from OC&C Strategy consultants tracks the operating profits of the top 10 multichannel and pure play retailers over a five-year period. While operating profits for Multichannel retailers have dropped by two thirds, the margins of Pure-play retailers have more than doubled.

Source: http://www.occstrategy.com/en-us/news-and-media/2016/03/reinventing-the-last-mile

Both business models grapple with the same online fulfilment costs, rising wages and utilities. If it was simply a case of online retail channels being more expensive would there be such a noticeable contrast in performance? What it comes down to is the difficulty in understanding and managing cost-to-serve in an omnichannel environment.

Why don’t we understand the omnichannel cost-to-serve?

Working with LCP Consulting and the Cranfield School of Management, GS1 UK completed an industry report on the challenge of managing the omnichannel cost-to-serve.  Interviewing a mix of omnichannel retailers and brands, all the companies in the study struggled to provide a complete view of their operational costs. This was for three main reasons.

1. Network Complexity

Due to globalisation and digital routes to market, the number of touchpoints in the omnichannel world is growing exponentially – as is the intricacy of the networks required to manage them effectively.

Understanding how costs accumulate across a more varied network where key processes are now undertaken by third parties or suppliers makes it challenging for omnichannel businesses to measure their cost-to-serve.

2. Market Volatility

Expanding their networks to include more channels, third parties and customers has opened up sales opportunities for retailers but it has also exposed them to more volatility.

From the “anytime, anywhere” shopping mentality to the peaks of Black Friday, omnichannel retailers face greater variation in product flows, customer demand and competitor activity. This impacts the level of control retailers have over the activities and costs within their supply chain.

3. Lack of visbility

Due to the complexity and scale of the omnichannel network a lot of retailers simply did not have sight of certain supply chain activities and their corresponding costs.

Key activities previously managed by the retailer are now conducted by external suppliers or third parties and lack connectivity to the main retail operations.  And many retailers are still acquiring the systems and processes to support a single view of their customer, inventory and estate across all channels.

What is driving costs in your business?

Although retailers face similar macro challenges in maintaining margins, cost profiles will be unique to each business. To help retailers understand what is driving costs in their business, GS1 UK has built a free cost-to-serve ready reckoner with The Cranfield School of Management. Using the ready reckoner tool, we’ve assessed the breakdown of costs for two different fashion retailers - a volume based value retailer and a vertical brand.

Source: https://www.gs1uk.org/our-industries/retail/apparel/cost-to-serve

Although downstream costs from warehouse outbound account for the majority of expenditure, this doesn’t necessarily indicate the problem area. As we get closer to the customer in the supply chain, higher expectations of service and managing single units versus pallets or cases will increase outlay. Therefore when managing costs it’s important for retailers to consider not only the amount but what is driving each cost. When we investigated the cost drivers within each process we identified two types of cost:

1. Non-value added cost

These are the result of errors or inefficiencies along the supply chain that can delay product moving through the supply chain and create additional work. Examples of non-value add costs included:

• Addressing inbound disputes
• Relabelling/repackaging or pre-retailing product
• Invoice/shipping corrections
• Product recalls

2. Value added costs

The retail service offer is a source of differentiation for many businesses and certain investment may be necessary to maintain customer loyalty. But how a retailer manages or mismanages its offer can determine profitability.

There were three key choices identified that can impact cost:

• Width of product range: a broad range and constant newness can be a source of competitive advantage. However, it can also drive up costs through the management of more suppliers, inventory and logistics – and erode economies of scale
• Last mile promise: More direct to customer shipments are part and parcel of the online offer. And with the retailer increasingly bearing the cost of fulfilment and returns, retailers need to consider how they balance shipping costs while maintaining the necessary investments to encourage sales.  
• Peak management: the rise of Black Friday and other peak sale events places pressure on retailers to compete or miss out on sales. Managing peaks effectively requires the flexibility to quickly scale capacity either internally or through third party partnerships – both of which are costly.

Conclusion

To establish where and when to compete when it comes to value added costs, online retailers need to be in tune with what their customers want and understand the value versus cost to their business. Ultimately, this is vital if retailers are to keep growing sales and prevent the slow erosion of margins.

By Jacky Broomhead - Market Development Manager For Apparel at GS1 UK