In prior articles (December 2021 and February 2022), we 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, which often require trade-offs:
- Capture the costs (wages, expenses, capital costs) of your business
- Allow an understanding of the relationship between costs and volume produced and sold.
- Allow calculation of costs (and hence margin) that are reasonably accurate
- Gather the proper input data and update it periodically
We believe it is critical to understand your costs at the most granular level. What 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 answers to these questions: Does a product line make money? Does a geographic region or a certain type of customer make money? 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 re-quires well-judged consideration of the objectives above. A Cost Model lumped at a high level of granularity will be useless for decision-making. It depends on the scope of the decision maker. The CEO of a $5 billion corporation will have little issue deciding to sell off or shut down a perennial money-losing $25 million operation based solely on its income statement. The GM of that business would be best served to be 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 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 (rep commissions, sales wages), royalties and licensing fees, and outbound freight costs for products shipped FOB customer dock can be included. In a custom or semi-custom build environment, there is an engineering cost to fulfill 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 yours. 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 out-bound costs – because 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, which creates challenges within the organization.
An important consideration is understanding if the process costs vary across product/customer segments. If it does, then it’s an important Cost Model candidate. If it is pretty much the same, a simple average can be used or a decision can be made understanding that these costs must be covered by margin. For example, if all products have a salesperson commission of 3%, there is no need to include commission in the margin calculation. 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 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 known 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 and 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 those 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 and typically range 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 sales.
The third level is fixed costs. Fixed costs are costs that do not go up or down with monthly or even six-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 reasonable. When fixed costs are included, the cost is referred to as full cost and the margin as gross margin.
However, there is a gray area in the realm of fixed costs. Manufacturing firms typically include all manufacturing and costs of running their plant in fixed costs, but they exclude any administrative functions and sales. In large construction firms, almost all costs are loaded into fixed costs, 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 they suffer for collecting detail data of bills of material and process costs captured in ERP systems. ERP solutions are sometimes 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.
Author Peter Geise is Area President of FocusCFO.
He may be reached at 330-510-5760 or at firstname.lastname@example.org.
For additional information, visit www.FocusCFO.com.