Logistics cost analysis

After a century or more of reliance upon traditional cost accounting procedures to provide an often-unreliable
insight into profitability, managers are now starting to question the relevance of these methods. The accounting
frameworks still in use by the majority of companies today rely upon arbitrary methods for the allocation of
shared and indirect costs and hence frequently distort the true profitability of both products and customers.
Indeed, as we shall see, these traditional accounting methods are often quite unsuited for analyzing the
profitability of customers and markets since they were originally devised to measure product costs.

"Because logistics management is a flow-oriented concept with the objective of integrating resources across a
pipeline which extends from suppliers to final customers, it is desirable to have a means whereby costs and
performance of that pipeline flow can be assessed."

Probably one of the main reasons why the adoption of an integrated approach to logistics and distribution
management has proved so difficult for many companies is the lack of appropriate cost information. The need
to manage the total distribution activity as a complete system, having regard for the effects of decisions taken
in one cost area upon other cost areas, has implications for the cost accounting systems of the organization.
Typically, conventional accounting systems group costs into broad, aggregated categories which do not then
allow the more detailed analysis necessary to identify the true costs of servicing customers buying product
mixes. Without this facility to analyze aggregated cost data, it becomes impossible to reveal the potential for
cost trade-offs that may exist within the logistics system.

Generally, the effects of trade-offs are assessed in two ways: from the point of view of their impact on total
costs and their impact on sales revenue. For example, it may be possible to trade off costs in such a way that
total costs increase, yet because of the better service now being offered, sales revenue also increases. If the
difference between revenue and costs is greater than before, the trade-off may be regarded as leading to an
improvement in cost effectiveness. However, without an adequate logistics-oriented cost accounting system it
is extremely difficult to identify the extent to which a particular trade-off is cost-beneficial.

The concept of total cost analysis

Many problems at the operational level in logistics management arise because all the impacts of specific
decisions, both direct and indirect, are not considered throughout the corporate system. Too often decisions
taken in one area can lead to unforeseen results in other areas. Changes in policy on minimum order value, for
example, may influence customer ordering patterns and lead to additional costs. Similarly, changes in
production schedules that aim to improve production efficiency may lead to fluctuations in finished stock
availability and thus affect customer service.

The prpl:)lerns associEtted with id1:1ntifying th~ tQtal system impact of distrit:)ution policies are immense. By its
very nature logistics cuts across traditional company organization functions with cost impacts on most of those
functions. Conventional accounting systems do not usually assist in the identification of these company-wide
impacts, frequently absorbing logistics-related costs in other cost elements. The cost of processing orders, for
example, is an amalgam of specific costs incurred in different functional areas of the business which generally
prove extremely difficult to bring together. Figure 3.6 outlines the various cost elements involved in the
complete order processing cycle, each of these elements having a fixed and variable cost component which
will lead to a different total cost for any one order.
 Figure 3.6

Order placement
and communication

t
Order entry

t
Credit check

t
Documentation

t
Order picking

+
Delivery

+
Invoicing and
collection

Accounting practice for budgeting and standard setting has tended

to result In a compart mentaliz ation of
compan y accounts; thus, budgets tend to be set on a function al
basis. The trouble is that policy costs do not
usually confine themselves within the same watertight boundar
ies. It Is the nature of logistics that, like a stone
thrown into a pond, the effects of specific policies spread beyond
their immedia te area of impact.
A further feature of logistics decisions that contributes to the complex
ity of generating appropriate cost
information is that they are usually taken against a background of
an existing system. The purpose of total cost
analysis in this context is to identify the change in costs brought
about by these decisions. Cost must therefore
be viewed in increme ntal terms -the change in total costs caused
by the change to the system. Thus, the
addition of an extra warehouse to the distribut ion network will bring
about cost changes in transport, inventory
investment and commun ications . It is the increme ntal cost differenc
e between the two options that is the
relevant accounting information for decision making in this case.
Figure 3.7 shows how total logistics costs can
be influenced by the addition, or removal, of a depot from the system.

Figure 3.7

Total
distributi on
costs

.!!] Trunkl"g
costs

Inventory
costs
Outlet costs
Local dellvory
costs
I Order
procoosl ng CO-!lt"S

Number of outlot,a
 cost of holding inventory
As we noted, there are many costs incurred in the total logistics process of converting
customer orders into
cash. However, one of the largest cost elements is also the one that is perhaps
least well accounted for and
that is inventory. It is probably the case that many managers are unaware of what
the true cost of holding
inventory is. If all the costs that arise because of holding inventory are fully accounte
d for, then the real holding
cost of inventory Is probably in the region of 25 percent per annum of the book value
of the inventory.
This figure is as high as it is because there are several costs to be included. The
largest cost element will
normally be the cost of capital. The cost of capital comprises the cost to the company
of debt and the cost of
equity. It is usual to use the weighted cost of capital to reflect this. Hence, even
though the cost of borrowed
money might be low, the expectatio n of sharehold ers as to the return they are looking
for from the equity
investmen t could be high.

The other costs that need to be included in the inventory holding cost are the costs
of storage and handling,
obsolesce nce, deteriorat ion, and pilferage, as well as insurance and all the administra
tive costs associate d
with the managem ent of the inventory (see box).

Cost ol capit.:il
Storage and handling
Obsolescence
Damage and deterioration
Pilferage shrinkage
Insurance
111anagemenl costs

Principles of logistics costing

It will be apparent from the previous comments that the problem of developing an
appropria te logistics-
oriented costing system is primarily one of focus. That is, the ability to focus upon
the output of the distributio n
system, in essence the provision of customer service, and to identify the unique
costs associate d with that
output. Traditional accountin g methods lack this focus, mainly because they were
designed with something
else in mind.

One of the basic principles of logistics costing, it has been argued, is that the system
should mirror the
materials flow, i.e. it should be capable of identifying the costs that result from providing
customer service in
the marketpla ce. A second principle is that it should be capable of enabling separate
cost and revenue
analyses to be made by customer type and by market segment or distributio n channel.
This latter requireme nt
emerges because of the dangers inherent in dealing solely with averages, e.g. the
average cost per delivery,
since they can often conceal substantia l variations either side of the mean.

To operationalize these principles requires an 'output' orientation to costing. In

other words, we must first
define the desired outputs of the logistics system and then seek to identify the costs
associate d with providing
those outputs. A useful concept here is the idea of 'mission', In the conte~ of logistics
and supply chain
managem ent, a mission is a set of customer service goals to be achieved by the
system within a specific
product/m arket context. Missions can be defined in terms of the type of market
served, by which products and
within what constraint s of service and cost. A mission by its very nature cuts across
traditiona l company lines.
Figure 3.8 illustrates the concept and demonstra tes the difference between an
'output' orientatio n based upon
missions and the 'input' orientation based upon functions.
 Figure 3.8

Purchasing Sales Transportation

Production Marketing Etc

Supply chain
mission A

Supply chain
mission B

Supply chain
mission C

The success ful achieve ment of defined mission goals involves

inputs from many function al areas and activity
centers within the firm. Thus, an effective costing system must
seek to determi ne the total systems cost of
meeting desired mission objectives (the 'output' of the system)
and the costs of the various inputs involved in
meeting these outputs .

I \ Figure 3.9 illustrate s how three supply chain mission s may make
a differen tial impact upon activity
center/f unction al area costs and, in so doing, provide a logical
basis for costing within the compan y. As a cost
or budgeting method ,

Figure 3.9

FunctJonal Functional Funcllonal Functional Tola!

a,ea/ areal area/ areal m,ss,on
Acti,,ly cenlre Ac!Mly cenlre Act,v,1y centre AcllVlly centre
cost
1 2 3 4

- - -
Mission A
I 100 90 20 80
> 290

Mission B
I 50 70 200 20 ) 340

I
>
MISSIOn C 70 30 50 70 220
7
' ' 7 7

Activily cenlro 220 190 270 170 850

inputs

mission costing Is the reverse of tradition al techniques: under this

scheme a function al budget is determi ned
now by the demands of the missions it serves. Thus, in Figure 3.9
the cost per mission is identifie d horizont ally
and from this the function al budgets may be determined by summin
g vertically.
Given that the logic of mission costing is sound, how might it be
made to work in practice? This approach
requires firstly that the activity centers associated with a particula
r distribut ion mission be Identified, e.g.
transport, warehousing, Inventory, etc., and secondly that the Increme
ntal costs for each activity center
incurred because of undertaking that mission must be isolated.
Increme ntal costs are used because it is
importa nt not to conside r 'sunk' costs or costs that would still be
incurred even if the mission were abandoned.
We can make use of the Idea of 'attribut able costs'B to operatio
nalize the concept :
"Attributable cost is a cost per unit that could be avoided if a product
or function were discontinued entirely
without changing the supporting organization structure."
,,,/ In determining the costs of an activity center, e.g. transport, attributable to a specific mission, the question
should be asked: 'What costs would we avoid if this customer/ segment/channel were no longer serviced?'
These avoidable costs are the true incremental costs of servicing the customer/segmen t/channel. Often, they
will be substantially lower than the average cost because so many distribution costs are fixed and/or shared.

This approach becomes particularly powerful when combined with a customer revenue analysis, because even
customers with low sales offtake may still be profitable in incremental costs terms if not on an average cost
basis. In other words, the company would be worse off if those customers were abandoned.

Such insights as this can be gained by extending the mission costing concept to produce profitability analyses
for customers, market segments or distribution channels. The term 'customer profitability accounting'
describes any attempt to relate the revenue produced by a customer, market segment or distribution channel
to the costs of servicing that customer/segment/channel.

Customer profitability analysis

One of the basic questions that conventional accounting procedures have difficulty answering is: 'How
profitable is this customer compared to another?' Usually, customer profitability is only calculated at the level
of gross profit - in other words the net sales revenue generated by the customer in a period, less the cost of
goods sold for the actual product mix purchased. However, there are still many other costs to consider before
the real profitability of an individual customer can be exposed. The same is true if we seek to identify the
relative profitability of different market segments or distribution channels.

The significance of these costs that occur because of servicing customers can be profound in terms of how
logistics strategies should be developed. Customer profitability analysis will often reveal a proportion of
customers who make a negative contribution, as in Figure 3.10. The reason for this is very simply that the costs
of servicing a customer can vary considerably- even between two customers who may make equivalent
purchases from us.

Figure 3.10

110
100 - - - - I-_,
90 I I
-;;
I I
80
.2 I I
:i 70 I I
,Q
60 I I
0
u I I
a> 50
.i?
I I
19::i 40
I I
§
(.)
30 I I
20 1-/ 1 I I
10 V I I I
0 I I I I I. 1 : !
0 10 20 30 40 50 60 70 80 90 100
Cumulative customers (%)

Source H G V Log 1s/,c5 T/,e &meground of the 1990s. AT Kearney

 //
ff we think of all the costs that a company incurs from when it captures an order from a customer to when it
_,/
collects the payment, will be apparent that the total figure could be quite high. It will also very likely be the case
that there will be significant differences in these costs' customer by customer. At the same time, different
customers will order a different mix of products so the gross margin that they generate will differ.

As Table 3.1 highlights, there are many costs that need to be identified if customer profitability is to be
accurately measured. The best measure of customer profitability is to ask the question: 'What costs would I
avoid and what revenues would I lose if I lost this customer?' This is the concept of 'avoidable' costs and
incremental revenue. Using this principle helps circumvent the problems that arise when fixed costs are
allocated to individual customers.

Table 3.1
Revenues Net sales value
Less

Costs Cost of sales (actual product mIX)

(attributable costs only) Commissions
Sales calls
Key account management time
Trade bonuses and special discount
Order processing costs
Promo!lonal costs (visible and hidden)
Merchand1s1ng costs
Non-standard packag1ngfunitisation
Dedicated inventory holding costs
Dedicated warehouse space
Materials handling costs
Transport costs
Documentat,on/communicat,ons costs
Returns/refusals
Trade credit (actual payment period)

Figure 3.12 represents a simple categorization of customers according to two dimensions: their total net sales
value during the period and their cost-to-serve. The suggestion is that there could be a benefit in developing
customer-specific solutions depending upon which box of the matrix they fall into. Possible strategies for each
of the quadrants are suggested below.

Figure 3.12

+J
C
::J
0
u
u
n, .c Protect Cost
C)
Q)
I engineer
E
0
+J
(/)
::J
....u0
Q.)
::J
n,
> Build Danger
0
co
...J zone
(/)
+J
a,
z
Low High
Cost of service
 Build

r- These customers are relatively cheap to service, but their net sales value Is low. Can volume be Increased
without a proportionate increase in the costs of service? Can our sales team be directed to seek to Influence
these customers' purchases towards a more profitable sales mix?

Danger zone

These customers should be looked after very carefully. Is there any medium- to long-term prospect ei th er of
improving net sales value or of reducing the costs of service? Is there a strategic reason for keeping th em? Do
we need them for their volume even if their profit contribution is low?

Cost engineer

These customers could be more profitable if the costs of servicing them could be reduced. Is there any scope
for increasing drop sizes? Can deliveries be consolidated? If new accounts in the same geographic area were
developed, would it make delivery more economic? Is there a cheaper way of gathering orders from these
customers, e.g. the Internet?

Protect

The high net sales value customers who are relatively cheap to service are worth their weight in gold. The
strategy for these customers should be to seek relationships which make the customer less likely to want to
look for alternative suppliers. At the same time, we should constantly seek opportunities to develop the volume
of business that we do with them whilst keeping strict control of costs.

Ideally the organization should seek to develop an accounting system that would routinely collect and analyze
data on customer profitability. Unfortunately, most accounting systems are product focused rather than
customer focused. Likewise cost reporting is traditionally on a functional basis rather than a customer basis.
So, for example, we know the costs of the transport function as a whole or the costs of making a particular
product but what we do not know are the costs of delivering a specific mix of products to a particular customer.

There is a pressing need for companies to move towards a system of accounting for customers and market
segments as well as accounting for products. As has often been observed, it is customers who make profits,
not products!

Direct product profitability

An application of logistics cost analysis that has gained widespread acceptance, particularly in the retail
industry, is a technique known as direct product profitability- or more simply 'OPP'. In essence it is somewhat
analogous to customer profitability analysis in that it attempts to identify all the costs that attach to a product
or an order as it moves through the distribution channel.

The idea behind OPP is that in many transactions the customer will incur costs other than the immediate
purchase price of the product. Often this is termed the total cost of ownership. Sometimes these costs will be
hidden and often they can be substantial- certainly big enough to reduce or even eliminate net profit on a
particular item.

For the supplier It ls Important to understand OPP since his/her ability to be a low-cost supplier Is clearly
influenced by the costs that are incurred as that product moves through their logistics system. Similarly, as
distributors and retailers are now very much more conscious of an item's OPP, it is to the advantage of the
supplier equally to understand the cost drivers that impact upon OPP to seek to influence it favorably.
Table 3.3 describes the steps to be followed in moving from a crude gross margin measure to a more precise
OPP.

Table 3.3

The net profit contribution from the sales of a product after allowances
are added and all costs that can be rationally allocated or assigned to an
Individual product are subtracted = direct product profit

Sales

Cosl of goods solcl

Gross m<1rg1n

Allowances and d1scounls

AdIusted gross margin

Warehouse costs
Labour (labour model - case, cube. wc,gtll)
Occupancy (spncc nm.I cube)
Inventory (nvcrngc ,nventoryJ

Transpor1uI1on costs (cube)

Rctntl costs
Stocking labour
Front end labour
Occupnncy
Inventory

Direct product profit

The importance to the supplier of OPP is based on the proposition that a key objective of customer service
strategy is 'to reduce the customer's costs of ownership'. In other words, the supplier should be looking at his
products and asking the question: 'How can I favorably influence the OPP of my customers by changing either
the characteristics of the products I sell, or the way I distribute them?'

From pack design onwards there are several elements that the manufacturer or supplier may be able to vary to
influence OPP/square meter in a positive way, for example, changing the case size, increasing the delivery
frequency, direct store deliveries, etc.

Cost drivers and activity-based costing

As we indicated earlier in this chapter there is a growing dissatisfaction with conventional cost accounting,
particularly as it relates to logistics management. Essentially these problems can be summarized as follows:

• There is a general ignorance of the true costs of servicing different customer types/channels/marke t
segments.
• Costs are captured at too high a level of aggregation.
• Full cost allocation still reigns supreme.
• Conventional accounting systems are functional in their orientation rather than output oriented.
• Companies understand product costs but not customer costs.

The common theme that links these points is that we seem to suffer in business from a lack of visibility of costs
as they are incurred through the logistics pipeline. Ideally what logistics management requires is a means of
capturing costs as products and orders flow towards the customer.

To overcome this problem, it is necessary to change radically the basis of cost accounting away from the notion
that all expenses must be allocated (often on an arbitrary basis) to individual units (such as products) and,
instead, to separate the expenses and match them to the activities that consume the resources. One approach
 th at can help overcome this problem is 'activity-based costing'. The key to activity-based costing (ABC) is to
• · that cause costs because they consume resources. Thus,
• • pipeline
seek out the 'cost drivers' alo ng th e l og1st1cs
r
for example, if we are concerned about assigning the costs of order picking to orders then in the past this may
have been achieved by calculating an average cost per order. In fact, an activity-based approach might suggest
th at it is th e number of lines on an order that consumes the order picking resource and hence should instead
be seen as the cost driver.

The advantage of using activity-based costing is that it enables each customer's unique characteristics in
st
terms of ordering behavior and distribution requirements to be separately accounted for. Once the co
attached to each level of activity is identified (e.g. cost per line item picked, cost per delivery, etc.) then a
clearer picture of the true cost-to-serve will emerge. Whilst ABC is still strictly a cost allocation method it uses
a more logical basis for that allocation than traditional methods.

There are certain parallels between activity-based costing and the idea of mission costing introduced earlier in
this chapter. Essentially mission costing seeks to identify the unique costs that are generated because of
specific logistics/ customer service strategies aimed at targeted market segments. The aim is to establish a
better matching of the service needs of the various markets that the company addresses with the inevitably
limited resources of the company. There is little point in committing incremental costs where the incremental
benefits do not justify the expenditure.

There are four stages in the implementatio n of an effective mission costing process:

1. Define the customer service segment.

To identify the different service needs of different customer types. The basic principle is that because
not all customers share the same service requirements and characteristics they should be treated
differently.
2. Identify the factors that produce variations in the cost of service.
This step involves the determination of the service elements that will directly or indirectly impact upon
the costs of service, e.g. the product mix, the delivery characteristics such as drop size and frequency
or incidence of direct deliveries, merchandising support, special packs and so on.
3. Identify the specific resources used to support customer segments.
This is the point at which the principles of activity-based costing and mission costing coincide. The
basic tenet of ABC is that the activities that generate cost should be defined, and the specific cost
drivers involved identified. These may be the number of lines on an order, the people involved, the
inventory support or the delivery frequency.
4. Attribute activity costs by customer type or segment.
Using the principle of 'avoid ability' the incremental costs incurred through the application of a specific
resource to meeting service needs are attributed to customers. It must be emphasized that this is not
cost allocation but cost attribution. In other words, it is because customers use resources that the
appropriate share of cost is attributed to them.

Clearly to make this work there is a prerequisite that the cost coding system in the business be restructured. In
other words, the coding system must be capable of gathering costs as they are incurred by customers from the
point of order generation through to final delivery, invoicing, and collection.

The basic purpose of logistics cost analysis is to provide managers with reliable information that will enable a
better allocation of resources to be achieved. Given that the purpose of logistics and supply chain
management, as we have observed, ultimately is concerned to meet customer service requirements in the
most cost-effective way, then it is essential that those responsible have the most accurate and meaningful data
possible.