Traditional Cost Modeling is Failing. Here's What You Can Do.

Businesses, non-profits, and even government organizations need cost models to support decision making. Without cost and profitability models, financial planning — much less financial optimization — would be almost impossible.

Traditional Cost Modeling

The traditional method of cost modeling is very simple. The organization creates a group tasked with calculating costs and profitability. This group calculates key indicators such as unit/consumer costs and profitability and then evaluates the variations in cost-per-order (for retailers) and cost-per-patient (in hospitals). Typically, fixed costs are separated from variable costs and thereafter total revenue determined which is then used to calculate gross and net prices per unit. Historically, fixed costs were derived through allocation/activity based costing while variable costs were derived through volume/throughput analyses.

Why Traditional Cost Modeling Falls Short

While these traditional cost modeling methods have been invaluable in the past (and are the main reason we are where we are today), there are several reasons why they are no longer effective enough enough. Let’s consider a few scenarios;

Reason 1: Miscalculation of forward thinking product costs

In a Consumer Products Company, the management uses unit costs calculated by the Financial Planning and Analysis (FP&A) team to make decisions on how much promotional activity is needed. However, the team isn’t informed that by running promotions there is bound to be manufacturing overtime. Moreover, such promotions require an expanded inventory and expedition of shipping by the supply chain team. Unless these factors are taken into account during cost modeling, the company might never realize meaningful ROI on the promotional campaigns.

Reason 2: Misinterpretation of fixed and variable costs

With the emergency department (ED) getting overwhelmed, a government-funded healthcare facility decides to take out a mix of outpatient and inpatient specialist physicians with the aim of accommodating more PODs in the ED. Their assumption is that inpatient ward costs would remain fixed. But then things don't turn out as planned; the ED remains clogged up and in addition to that, floor occupancy is increasing, effectively driving up costs.

What happens is that patients now have to show up at the healthcare facility’s ED if they want to see their specialists. Admissions at the hospital increase at a very high rate and regular wards are quickly filled. Before long, overflow patients are moved to costlier ICU care units.

4 Keys to Profitability Analysis

So how should a business or enterprise go about addressing these problem? Below are four foundational capabilities that businesses today need in order to make smarter tactical, strategic or operational decisions. With these in mind, businesses and enterprises no longer need to worry about traditional cost modeling short-comings.

Costs should be tied to decisions at hand

Unit costs tend to change when volume, product/service mix, and contexts change. When modeling costs, all the three factors must be taken into account, alongside the impacts of changes in input prices.

You must NOT always treat costs as completely “fixed” or “variable”

Even costs that are considered “fixed” at one stage may change at a different stage. For instance, in scenario 2, ward costs were variable but the team assumed that the costs were fixed. Rather than mark costs as outright “fixed” or “variable,” organizations should define costs as they are incurred.

Revenue shouldn’t simply be calculated as number of units times the average cost

When marginal prices decline, for example, return cost of capital may be seriously affected. In such a case, you cannot just use “profit-per-unit” to calculate revenue.

Each decision scenario must be considered on its own

Each decision usually includes thousands of assumptions; which is why each decision should be handled on its own. This would allow the business to reflect on the best thing to do at that particular point in time.

Closing Remarks

Don’t just stop at these four tips. Instead, dig deeper and conduct your own research. Sooner or later, you may find even more effective cost modeling tricks. And when that happens, you’ll be able to save your organization even more.

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