In this article, learn about:
What TCS is and how it works
The key components that make up TCS
How to calculate TCS step-by-step
How understanding TCS improves profitability and decision-making
Understanding the profitability of your business goes beyond calculating the sales revenue over the cost of your products or services. Many additional expenses contribute to delivering a product to a customer, including logistics, order processing, customer support, and operational overhead.
Understanding the true profitability of your business is where total cost to serve (TCS) comes in. TCS can help you calculate the complete cost of fulfilling a product or service. By calculating TCS, you can uncover hidden profit drains and identify opportunities to increase cost efficiency.
In this article, we’ll dig into the TCS framework, how to calculate TCS, and what role it plays in understanding and improving the profitability of your business.
Important Terms to Know
Term | Definition |
Activity-Based Costing (ABC) | A costing method that assigns expenses to activities involved in delivering products or services. |
Cost to Serve (CTS) | The cost associated with specific activities required to fulfill a product or service for a customer. |
Direct Costs | Costs that can be directly tied to producing or delivering a product or service. |
Indirect Costs | Costs that support operations but cannot be tied directly to a single order or customer. |
Total Cost to Serve (TCS) | The full aggregation of all direct and indirect costs involved in delivering a product or service to a customer. |
What is Total Cost to Serve?
TCS is an analytical framework that helps businesses understand the total cost of fulfilling a product or service. The name is self-explanatory, with TCS answering the question:
“How much does it actually cost my business to serve this customer?”
For example, a retailer may discover that a product generating steady sales isn’t actually delivering significant profit once fulfillment, logistics, and service costs are factored in. On the other hand, a supplier may find that selling to a particular retailer is far more profitable than expected due to lower service or operational costs.
Total cost to serve takes things into account like:
Transportation and logistics costs
Warehousing and inventory handling
Order processing and administration
Customer service and support
Returns and reverse logistics
Sales and account management costs
Marketing costs
Operational overhead
By comparing the total cost to serve against what you actually charge the customer, your business can gain a much clearer picture of its true profitability. That’s why the level of granularity in total cost to serve analysis is an important measure for businesses. Looking closely at all associated costs for specific customers, product, channels, etc., can help your business make more informed decisions and optimize your profitability.
Cost to Serve vs. Total Cost to Serve
It’s important to note that while cost to serve and total cost to serve are often used interchangeably, they do represent different levels of analysis. Cost to serve typically refers to the cost associated with specific activities required to fulfill a product or service for a customer. On the other hand, total cost to serve takes a broader view of associated costs. It represents the complete aggregation of all costs required, including direct, indirect, and activity-based costs.
Key Components of TCS
To fully understand the total cost of serving a customer, you must consider a range of costs that contribute to the overall process of getting goods to the customer.
While the exact components may vary by industry, total cost to serve is generally made up of direct costs, indirect costs, and activity-based costs.
Direct Costs
Direct costs are expenses that can be clearly tied to producing or delivering a specific product or service. These costs are more straightforward to identify and measure because they are directly associated with fulfilling a customer order.
Indirect Costs
Indirect costs are expenses that support operations but cannot always be directly linked to a single product, order, or customer. These costs are usually shared across multiple business functions and must often be allocated across customers or products.
Activity Costs
Activity-based costs refer to the specific operational activities required to fulfill and support customer orders. These costs are often identified using activity-based costing (ABC) methods, which track the resources required for different service activities.
Calculating TCS: Step-by-Step Example
While there is no single standard formula for calculating total cost to serve, most organizations develop and follow a structured process to identify and measure the full cost of serving customers, products, or channels.
The steps below provide a practical framework to help you get started.
Step 1: Define the Scope of Your Analysis
Start by deciding what you want to measure. This is a crucial first step because it helps define how costs will be grouped and analyzed.
Some examples of areas to analyze TCS include:
A customer
A product or product category
A fulfillment method
A sales channel (brick-and-mortar, ecommerce, wholesale)
Then, once total cost to serve for a specific product/market/segment is calculated, it can be compared with other TCS calculations to reveal insights like:
The cost of selling product to large national retailers versus regional customers
The cost of fulfilling orders online verses in a retail store
Step 2: Identify Direct Costs
The next step involves identifying direct costs that can be directly tied to producing or delivering the product or service. These costs are typically the easiest to measure because they are already tracked in financial or operational systems.
Examples of direct costs:
Product manufacturing or procurement costs
Packaging materials
Transportation and shipping expenses
Order fulfillment labor
Tariffs and import costs
Step 3: Determine Indirect Costs
As defined above, indirect costs support operations but are not tied to a single transaction.
Examples of indirect costs:
Warehouse facilities and utilities
Administrative support
Customer service teams
IT infrastructure
Operational overhead
Indirect costs can be a little trickier to determine and allocate because these costs are often shared across larger processes. For example, a business may allocate customer service costs based on the number of support interactions per customer. A customer requiring frequent assistance will therefore carry a higher share of indirect costs.
This step is critical because it allows you to connect specific products/services to a subset of larger operating expenses.
Step 4: Add Activity-Based Costs
Activity-based costing, also known as ABC, captures the operational work required to serve customers.
Examples of activity-based costs:
Order processing and invoicing
Inventory handling and picking
Customer support interactions
Returns processing and reverse logistics
Account management and sales support
A useful way to identify activity-based costs is to look for tasks that require additional time, labor, or handling.
Step 5: Calculate Total Cost to Serve
Once all direct, indirect, and activity-based costs have been identified, they can be combined to calculate the total cost to serve. This can then be compared to the revenue of the product/service to determine true profitability.
Improve Your Analysis with SPS Analytics
Understanding TCS can provide valuable insights into your operational efficiency and profitability. However, gathering and analyzing the right data can be challenging.
SPS Analytics provides better visibility into your supply chain, so your business can make smarter decisions that improve efficiency, strengthen customer relationships, and increase profitability.
