GAUSS BLOG
Estimated Cost: the price of lost profit
When you do not have any easy way to track cost you are left with a proxy method, usually a unit cost spreadsheet analysis. This approach is straightforward such as simply calculate the cost per hour per resource. For instance, for each business process, list all the needed resource units, add the cost of the standard materials required and you have the total cost. Then add a markup as a buffer to absorb any possible assumptions and of course a given profit margin.
This situation is shown in Figure 1:
This methodology is expedient but lacks common sense details to gain meaningful insights to improve profit. The resource unit cost is highly dependent on demand, capacity and performance for instance of certain resources over time. Simplified cost allocation models cannot manage these variables.
- Two levels of cost allocation model details such as:
- Resources -> Cost Objects or Cost Centers -> Cost Objects
are very common but insufficient.
- Even 3 level cost allocation models such as:
- Resources -> Cost Centers -> Cost Objects or Resources -> Activities -> Cost Objects
which are used in old Activity Based Costing (ABC), are insufficient to capture meaningful insights.
Working with over 50 customers, we have found that most companies require 5 to 10 cost allocation model levels. Accountancy tools, old ABC Costing tools or simplified models in spreadsheets cannot reflect the real number of cost levels, and because of this they produce unit cost distortions that can range from 10% to 150%. These distortions lead to poor business decisions instead of the insights to effect a profit improvement.
Common sense precise costs
Let say that the common sense cost allocations are larger than the presumed ones as shown in Figure 2:
This situation is all too typical. Our results working with over 60 customers have shown that actually 10% to 50% of the product and services are provided at a loss. With this previously hidden cost information a manager now has a sufficient level of visibility for actions such as adjust the price or reduce discounting.
Although profit is increased, there is a risk of reduced revenue. In practice our experience shows that an increase in prices for a few products does slightly reduce revenue but there is a much bigger impact on profitability.
There are other profit improving options that become apparent with a better allocation of costs, for example, reducing indirect material and labor costs, more efficient processes to reduce waste, and renegotiating with suppliers. For example, being able to consider underutilized capacity to negotiate higher-volume based rates even for non-profitable services can contribute to covering fixed costs and therefore to improved profitability.
The key is having sufficient information to gain meaningful insights that promotes creativity. For example, in one case the solution was to replace a service’s price with 3 service levels and with 3 prices. This particular decision went directly to improving the bottom line.
In contrast there are products or services that can generate more profit through hidden gains as shown in Figure 3.
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| Figure 3 Common cost allocation vs presumed costs showing a hidden gain |
These hidden gains can be harvested through promotions, discounts or bundles. If this hidden gain product or service is fungible then less profitable products or services can be replaced.
Conclusion: what you don’t measure you cannot control
With improved common sense precision, cost allocations comes the opportunity to gain insights that previously were hidden.
CFO’s are very good at improving profits by more than 30% once they have access to this information rather than just estimated costs or worst yet, averages or aggregates.
