[Video] Unpacking “cost to serve” for long and short term profitability

Today’s topic is understanding "cost to serve." We have a big focus with our clients about profitability, and if you've been watching these videos, we’ve talked a lot about firing unprofitable customers. Understanding cost to serve is a big part of this equation. Our starting point is: how do we look at “cost to serve” differently than a traditional accounting perspective?

JM: Most people do some version of ABC costing to look at cost to serve. Which makes sense. You have units of measurement, essentially, to look at your large tasks or large activities that a company does, be it process-based or product-based, or whatever it might be. Some traditional things are like tech support, customer service, those types of things right? Which makes perfect sense, and people do really well in measuring those costs to serve. And then there was an article in HBR that talk about time-based elements. Because people have time that they go to the bathroom, or take breaks, or do whatever that need to do, which affects it to make those numbers a little bit more honest. So that's definitely a good look at it. 

JM: What we find with most of our clients when we talk about pricing, when we talk about firing unprofitable customers, or evaluating customer performances within our clients four walls, they try to get into what are their key limited resources? What are those functions? What are those processes that are limited in nature? Is it sales resource, is it tech support? Is it equipment or a process line that's very limited in capacity?

JM: They take those four or five, and really have that measurement to understand who the abusive customers are. The traditional way to look at things is a margin threshold and say, Okay, if there below a margin threshold, of course those customers need to get evaluated. But what about the ones that are at the threshold, or even a little above? But their use of our limited resources are extremely high, because that would drive them into the bucket of us reviewing them as well. And that's the nuance that we need to understand and get to. That’s what we do with our clients is to figure out what are those limited resources that we should be looking at that drives a customer's probability from a long term perspective.

PM: Jeet, another perspective on that is, what you described in the traditional Activity Based Costing (ABC), often it can look at a broad swath of different categories, and might effectively average out what the gross cost to run the business is, allocated across all of the different products and the portfolio. But often what customers can lack is the ability to look at things incrementally, so that when they're making a decision on “Should I take this business or not?” is, is it profitable on the margin? Because it might be that a lot of the fixed costs are already covered, or should not be allocated to some specific volume. And then you have to start thinking about, “How do I narrow that scope from everything, to that limited set of things you mentioned, or even further?” So you really get to that that marginal analysis of what's the benefit? And what does it cost me?

JM: Yeah, that’s a great point. Because the specific nature of that task to understand it by customer is super important. As an example, not all resources are the same. Not all of whatever you're trying to measure are the same. So, using a blanket sort of spread, the peanut butter across everybody in that one organization is probably not doing that.

AA: I've experienced this in a past business another part of where traditionally, you often segment based on the size of the customer account. But to the point that you guys are both making, those smaller customers were taking a disproportionate amount of the cost, and therefore their margins looked quite a bit healthier than they actually were. Once you have that ability, that level of insight, then you can make some more strategic decisions on where you want to focus from a growth and revenue perspective.

JM: That’s right. The other thing that we find from cost to serve that oftentimes it doesn't take into account is opportunity costs. So if I have a tech support organization (I'm going to exaggerate to make this point), but if I have a tech support organization, and ninety percent of that utilization is for a customer base that's not very profitable overall, and you only have ten percent of that capacity going to your loyal customers or your advocate customers, then what does that say about the future potential of that company? 

JM: If we can switch that around where you spend ninety percent of your time with your true advocates. Then, all of a sudden you'll probably have a business that's better in some measurement. Right? So that opportunity cost of how your resources are being utilized, and for whom is extremely important to understand. Because I think you can turn a business around by co-creating with customers, giving time with the right customers that they need to grow with you. 

PM: That’s a great point. Basically, one of the arguments for identifying costs and a lot of different projects… companies say, “Well, I'm not going to fire my customer success team.” No, we don't expect you to. It's not that they're literally costing you this extra money. It’s that you're allocating them to the wrong folks, and if you can put that attention on the places where you're likely to get more upsell and cross sell and loyalty customer lifetime value out of it, that's what you should do.

AA: The other piece of that, bringing transparency into is that point about opportunity cost is the perspective of securing resources in the right areas, right? If you are going down a path where you say, “We are very starved for resources in a particular area, such as tech support, and the costs are disproportionately high,” then that gives you the insight and the ability to fix that problem and perhaps secure additional resources or allocate in a more effective way.

JM: Absolutely. You know the other thing about cost to serve - when it comes to measuring the true profitability of a customer, and to stack-rank them... If we can understand the elements of the costs that are driving the unprofitability, then we can have a corrective action. So it's not always about getting rid of the customers, and drawing a hard line and saying, “The customers are gone.” It's also about understanding where your levers are, so you can pull the right levers to correct the issue that is there. The problem is oftentimes the root causes of the unprofitability is covered up by some promise. We always see, like, “Hey, I like this customer. I know they're not that profitable. But they're going to give us twenty billion dollars in business in the next three years!” Or something like that that that keeps them on the hook, and it's hard to kind of peel back that onion to really get to those root problems to make those correct decisions on some of these customers.

TD: Have you seen a place where you’ve been able to uncover an unprofitable area or dynamic? I guess you could say, and being able to flip it? Because the other part is, you can use it as a prompt to do a price increase. But maybe there's another way. If you can figure out kind of the root cause, and then shift what's not working and fix just what that issue is.

JM: For me, there was a client years ago that really took care of their large contracts, their large customers, and when did a better in-depth understanding of profitability, we found a lot of these large customers were not profitable. And a lot of these large contracts that we had won, we did it through RFPs. Next time around what we decided was, we're going to get those levers out that were driving the unprofitability to course correct. What we found was a lot of these customers left our environment, and they went to competitors, and we found that to be a success, because our profitability increased. Our competitors got these terrible deals, and they were happy for that boost of revenue. The profitability wasn't there, right? And what we also found was, if we ever wanted to get those customers back, we would just lower our prices, and they would come back into our environment and our system. So it wasn't that these strategic clients that somehow we were gaining something else by having them in our environment. These guys were very transactional. Now I get it. It's a very large piece of business, and these are large contracts. I totally understand that, but especially in volatile times, we know this, profitability is king. It's not revenue. It's profitability, and we have to make sure there's long term profitability. It's okay to let some of these larger guys go if they don't adhere to your standards that you're putting out there.

PM: A lot of projects when we look at profitability, it's common that we're uncovering unprofitable customers, and before taking kind of a corrective action, or giving an ultimatum, or deciding to turn the business or letting it expire, you kind of have to look to see: Is this a perennial problem, where this is always the case? Or is it really switching year on year? So if you get rid of an unprofitable customer in one year, maybe they're a whale the following year, and so that it could be cutting off your nose to spite your face. But when you do uncover a perennial pattern, I think then it goes into this sort of a waterfall. It’s not just, “Okay, they're unprofitable, let’s fire them.” It’s, what are the terms of the contract that expire next year? Or can we renegotiate? Maybe one of those levers is that the next one would absolutely be a price increase, and maybe there could be reducing cost to serve for some of the analysis that we've done. Whether that's customer service, time, or any of the other incremental real costs, or whether it's expedited shipping, or anything else. And then, finally, if all of those truly are exhausted, then maybe parting ways is the right answer.

AA: I think it's a great point, being able to go in and understand what those costs are gives you a better leg to stand on over the course of these negotiations. Because to your point, if certain customers are taking a disproportionate amount of customer support, or IT costs, is that something that you could put terms and conditions into play, that aren't necessarily price setting. Then you have a more beneficial relationship on both ends to turn that to a point where it does become more profitable.

JM: Yes. It reminds me of a story, I was negotiating with this one customer and they were fairly large, and they were using our customer service quite a bit, along with our tech support quite a bit. They were heavy, heavy users and their overall product margin was very low. So we knew, even without doing any calculation, we knew this this customer were not very profitable. What we had set up was a good – better – best from a service perspective. We had unlimited customer service calls, on the highest end. We called it a brick, but we would put a margin escalation in the product margins if they chose to be in that high part. 

JM: So the conversation became really easy. We knew the driver of cost, for this one customer was customer service, and we knew they obviously valued it because they were using it a ton. We forced them to say, Hey, you can keep your low price, but you can't call customer service (I'm making this number up) four times a day. But if you want to keep your current rate, you're going to have to take on this extra pricing, and you can keep calling the customer service hotline as much as you want,

JM: And they chose to go into the larger bucket and paid the higher product price because they really truly valued it. So this is another one of those things where it's an opportunity for us like you guys were talking about, to understand what is truly valuable and what is just poor behavior, or a lack of resources. “I’m just going to call this this guy's tech support line.” And you can course correct some of these things.

PM: And some of this could just simply be enforcement. I could imagine you uncover some customers that seem unprofitable. And you're like, hey? We already had business rules that would make this customer profitable, but through whatever exception, they've been grandfathered into these deals.

JM: Yeah, that's a great point, too.

AA: Yeah. I mean, I think typically we would never say that some of this cost analysis delves into these value drivers, but the example that you just gave points to the fact that by simple way of conducting this type of analysis for this particular customer that pointed you in the direction of a value driver, and then kind of fed into your pricing strategy, which I think is really interesting.

TD: I would think, too, it's it could be a really nice prompt to kind of get the integrity of the partnership back on track, like I would imagine for customers that you've worked with over years and things just kind of trend in a direction without resetting or studying those kinds of things, it could keep going a certain way that that's really driving the whole partnership in ways that are kind of like an undercurrent.

JM: Yeah, that's a great point. I think sometimes we forget that us we get trained by our customers, and we also train our customers. And so having this good behavior and making sure you're communicating with your customers, I think it's important. One thing that I know, we used to get a lot of anecdotes like this. If you're talking to a customer about their poor behavior, and you want to turn them around. As an example, they want ninety days to pay you. And industry standard is thirty days, and that's a huge amount of difference, right? And you keep talking to them. Finance keeps talking to them. They don't want to change, they want 90 days. Finally, we go, “Hey, we're not very profitable with you guys. We are going to have to let you go.” 

JM: They go to the competitors. The competitors have a very similar cost structure, typically, right? And they’re going to have the same conversation after six months of putting up with it. And they’re going to realize at some point like, “Wait a minute. Hold on. Maybe we can’t push it to 90. Let’s see if we can negotiate to 60.” Some of those behaviors do get corrected over time, but that transparency of conversation and holding on to our lines that we're setting for ourselves is super important. Because rarely do you have that big of a discrepancy in cost basis where you can go from one competitor to another, and have that flexibility to do some of these things.

AA: And without that level of transparency, it's that much harder to have that negotiation right? Because as a result of having that, it's rooted in truth. Right?

JM: Yeah, that’s right. Tracy. Wrap it up for us!

TD: I think there's a lot of different threads for us to keep unpacking and studying. Different examples and doing round tables like this on it. We'll definitely pick back up on this as we see new things opening up, and we'll pause there for today.