iSixSigma

Cost Model

Definition of Cost Model:

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A shocking number of entrepreneurs and business leaders can’t answer this one simple question: “How much do you spend to satisfy a customer?”

Even those who can answer the question often only have a guess, not hard data. The truth is that many businesses get by without cost modeling for a while, but eventually, this ignorance catches up to them. If you don’t know what a cost model is or how it applies to your business, now is the time to find out.

Overview: What is a cost model?

A cost model is a method or framework for determining the total value invested to deliver a product or service. The scope and detail of the process can vary depending on the situation, but the goal of all cost modeling is to find an accurate way to assess value input for comparison against value output. This is a necessary step in evaluating the potential of a particular business venture, establishing price points, and estimating overall profitability.

3 benefits of cost models

The benefits of cost modeling are linked to how they inform your business practices, particularly in the area of pricing and streamlining. Knowledge is power, and anyone who is seriously interested in business management should seek it at every opportunity.

1. Set profitable prices

Perhaps the most obvious benefit of cost modeling is ensuring profitability for each product or service your company offers. Tracking total costs can be a tricky proposition, particularly for providers of complex and multifaceted services. A careful assessment of all costs throughout the process allows you to see what kind of return you can expect on the investment.

2. Limit risks of innovation

Cost modeling isn’t just about evaluating existing processes, it’s also a great tool for projections. Businesses can use cost models to estimate the profitability of certain products based on educated guesswork and current market price points. While this method isn’t perfect, it can let you know if an idea has potential or if it’s not worth the time before you start investing in it.

3. Save on supplies

Since cost modeling is all about identifying and quantifying expenses at every stage of the production process, it can also help you target opportunities for saving. Finding “weak links” in the chain, whether it’s the productivity of a particular department or costs for certain materials, can help you slim down your operations to improve value.

Why are cost models important to understand?

The concept of cost modeling is relatively simple, but this simplicity can be deceptive. Be prepared to leverage modern data collection and algorithm design to get the most out of your models.

1. Using the right modeling technique

There are several types of modeling techniques and you need to know when it’s appropriate to use each one. Factor estimating is fast and relatively simple, which makes it good for initial projections or feasibility studies. More detail-oriented modeling that requires a much bigger investment is more appropriate for broader or ongoing operations.

2. Implications on strategic development

Business leaders also need to understand the basics of cost models because of how important they are to long-term strategic development. The importance and frequency of cost models has only increased with the growth of machine learning and the development of data science. Since this trend is only expected to gather steam in the years ahead, it’s fair to expect similar growth in predictive modeling.

3. Answering tough questions

There’s also a more basic and face-saving reason to understand cost models: so you can answer tough questions from your customers. Sometimes clients want to know why a product or service costs what it does. Understanding your cost models means you have a good, accurate and data-driven answer ready to go.

An industry example of a cost model

Consider a website design company that provides various services to clients, including website development, ongoing maintenance, creative design and marketing. Clients typically purchase services as part of a package and these packages are tailored to specific needs, which means there is no standard cost or difficulty per project. To know their real costs, this company needs to know each team member’s total time contribution as well as the group’s material expenses and overhead costs.

This analysis should ultimately include everything from the utility and property costs for the company’s building to purchase of creative rights, cost of domain names and segmented investment in digital outreach. An effective model should show the total cost for each part of the service package, from launching the site to maintaining it each month and conducting marketing efforts.

3 best practices when thinking about cost models

When it comes to leveraging cost models, you should always focus on the end goal. Your purpose is to enhance overall profitability by cutting costs and increasing efficiency as much as possible.

1. Break it down

Even though cost models can cover a lot of ground and include some complicated processes, you should always break it down to bite-sized bits. The entire model should have several layers that are segmented further to make the information digestible and easier to use.

2. Quantify everything

One of the biggest problems of “just going with your gut” instead of hard data is that quantifying different elements isn’t always easy. The key to modeling is quantification of all input, including wear-and-tear or other operating costs that you may not even consider when doing a basic estimate.

3. Consider cost drivers

Cost drivers are the forces behind the costs of individual processes or components. Evaluating drivers into your cost models allows you to start thinking outside of the box and consider “what if” options to forecast optional solutions.

Frequently Asked Questions (FAQ) about cost models

1. What is the best kind of cost model?

Technically, the ideal cost model is one that includes as much information as possible with detailed accuracy. However, the best model for your situation depends on your needs. Developing models can actually be an expensive undertaking, so detailed assessments should only be used when they are worth it.

2. When should I use cost modeling?

In business management, there’s hardly a time when you shouldn’t be using it. Cost models are incredibly important for assessing the viability of a new product or service, identifying reasons for poor profits or simply looking for ways to run a leaner operation.

3. What is a should-cost model?

A should-cost model focuses on the industry as a whole rather than your particular situation. This type of modeling starts by looking at what it should cost to perform certain functions based on the standard costs for the components. This type of model gives you a baseline of comparison to see how you compare to expected standards.

The future of the cost model

Cost models have undoubtedly become more complicated in the last few decades, but they’ve also become a lot more powerful, versatile and detail-driven. Even small businesses with a limited offering should use them to evaluate real cost, improve their supply acquisition and set prices that produce profit. Larger companies should consider investing in more advanced cost engineering and modeling efforts to create a substantial framework to inform major decisions, avoid unnecessary risk and identify efficiency opportunities throughout their organization.

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