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Three Core Concepts in Building a Cost Model

Article 3 in a Series of 5

By Todd Peter

In prior articles I have discussed the reasons behind the importance of understanding margins (price minus cost) for the seller of any product or service. Your Cost Model is the framework for calculating costs. A Cost Model has the following objectives that often require trade-offs:

  • Captures the costs (wages, expenses, capital costs) of your business
  • Allows an understanding of the relationship between costs and volume produced and sold.
  • Allows calculation of cost (and hence margin) that are reasonably accurate.
  • Is simple enough you can gather the proper input data, and update it periodically.

I have argued the critical nature of understanding your costs at the most granular level. Now what in the world does that mean? The least granular level of a business is the annual financial statement, particularly the Income statement. This will tell you if the business as a whole made money. Increased granularity could be; does a product line make money? Or a geographic region? Or a certain type of customer? The most granular is a specific product to a specific customer in a specific time period.

Understand What Level of Granularity You Need

Picking the right level of granularity is the first concept in building your Cost Model. This decision requires well judged consideration of the objectives above. A Cost Model lumped at a high level of granularity will be useless for decision making. I will allow it does depend on scope of the decision maker. The CEO of a $5B corporation will have little issue deciding to sell off or shutdown a perennial money losing $25M operation based solely on its income statement. The GM of that business would be best served to be way more granular and figure out why they are losing money product by product.

Understand the Product Process

The second element of a Cost Model is the idea of Process. The cost of a product is really a sum of the cost of all the process involved in getting that product to a customer. In manufacturing it’s very common to define all the manufacturing processes and collect and measure the cost to manufacture. There are however other processes involved in getting the product to the customer. Selling costs can be included (rep commissions, sales wages), royalties and licensing fees, and often very important outbound freight costs for products shipped FOB customer dock. In a custom or semi-custom build environment (think special equipment or even items such as residential doors and windows) there is an engineering cost to fulfilling each order, and often an engineering cost for simply quoting even if the order is not won. In a design services firm, the cost is heavily weighted to professional staff tasks.

Choosing the right processes to include in your cost model is the second concept in building your Cost Model. The familiar issues of granularity and materiality will drive these decisions. Is the process a significant part of cost? Does it vary meaningfully across customer/product types or is an average good enough? Can you identify the costs so that you can provide meaningful inputs to the cost model?

Traditional concepts in financial accounting reporting are often not very helpful once you step outside very direct costs (material and labor in a manufacturing environment, or billed hours in a services environment). GAAP rules often will record costs in lumped categories of overhead that meld specific costs and general overhead. Freight is often one of the most problematic, both on inbound and outbound costs as many ERP costing systems do not give good tools for capturing landed cost, or outbound freight cost. Getting good cost inputs for the important processes may require reconfiguring your financial reporting systems at lower granularity, creating challenges within the organization.

An important consideration is understanding if the process costs vary across product/customer segments. If it does than it’s an important Cost Model candidate. If it is pretty much the same a simple average can be used or decisions need be made understanding that these costs must be covered by margin. As example is helpful. If all products have a sales person commission of 3% there is no need to include commission in the margin calculation. And any product with under 3% margins is a clear loser.

Understand Whether to Include Variable, Semi-variable or Fixed Costs

Choosing the “Level” in the cost structure is the third concept to establishing your Cost Model. You have decided on the granularity level and the processes to include. The last decision is deciding if you want to include only variable costs, or also add semi-variable or fixed costs into your Model.

First capturing the variable costs is mandatory to have any usefulness to your Cost Model. A Cost Model that captures only variable costs results in a margin know as Incremental Margin. If you sell at anything less than Incremental margin you are by definition shipping dollar bills along with the product. In a manufacturing environment variable costs will include materials, labor, supplies, consumable tools. In a service environment they would include the labor for the hours worked on the service, any supplies used, and perhaps costs to drive to the customer location. The costs would NOT include costs that would likely not go away for that specific job or order. These could include supervisors’ salaries, or the cost of the maintenance staff. Incremental margin is useful only for a specific order and selling based on low incremental margins is a quick trip to business failure.

 The second level is semi-variable costs. These costs generally do not go up or down with ONE specific order but over time and multiple orders are related to the number of products produced. These can include supervision, maintenance, software licenses, quality assurance, and support tasks such as purchasing, shipping, or expediting. These costs are variable over a period of time typically ranging from 6 – 18 months. The resulting margin is generally called Contribution Margin. Selling products on an ongoing basis, for no Contribution margin is a recipe for losing money. Contribution margin lets you make decisions about the lowest prices you can possibly accept for some portion of your business sales.

The third level is fixed costs. Fixed costs are costs that do not go up or down with monthly or even 6 month variations in volume. The most common are rent, insurance, and top executive salaries. These can also include depreciation on machinery, or lease costs for machines or equipment used in a business. Fixed costs are spread (allocated is the common technical term) across all products in a manner that is rational and seems reasonable. When fixed costs are included the cost is referred to as Full Cost and the margin, Gross Margin.

HOWEVER, there is a grey area in the realm of Fixed Costs. Manufacturing firms typically include all manufacturing and costs of running their plant in fixed cost but exclude any administrative functions and sales. In large construction firms, almost all costs are loaded into Full cost including administrative, financing, and everything but true bottom-line Profit. Service firms vary considerably in their treatment.

Implementing your Cost Model is often done with tools such as Excel or with the costing module of your ERP system. Excel based solutions give the greatest flexibility and ability to deal with complex shared costs but suffer for collecting detail data of bills of material and process costs captured in ERP systems. ERP solutions often are frustrating for their lack of flexibility and ability to move up and down in granularity. The ideal is often an Excel linkage to the ERP database, using advanced Excel modeling tools coupled to the mass detail in the ERP system.

The next article will look at four practical costing situations.

Todd Peter is a FocusCFO Principal based in Cleveland.

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