What is Cost Modelling?

In the previous article, we have discussed how important revenue modeling is and the techniques which are used by companies to ensure that their revenue models are accurate and up to date.

Once the revenue modeling is complete, the next step in the process refers to the modeling of expenses. This process is challenging because there are several different types of costs, and they all behave in different manners.

In this article, we will first have a brief overview of the cost modeling process. Once that is done, we will also have a look at the various important decisions which are undertaken during the development of the cost model.

How is Cost Modeling Done?

The process of cost modeling has been identified, and the important steps are listed below:

1. Segmenting the Expenses: The cost modeling process usually begins by listing down the expenses. Once the expenses are listed down, they are categorized. In financial accounting, expenses are categorized based on the format provided by the regulatory bodies. However, on the other hand, during the cost modeling exercise, expenses are grouped together if they have similar drivers.

   For instance,

   1. Electricity expenses are directly related to the amount of square footage controlled by the company. Other things being equal, the electricity bill will only increase or decrease if the area under the control of the company changes.

   2. Cleaning and facility management expenses are also heavily dependent on square footage.

   Hence, these two can be placed in a similar group. However, advertising expenses are totally different. They have no relation to square footage. Instead, advertising expenses depend upon the sales which the company intends to generate. Hence, advertising expenses must be placed in a separate group.

2. Identifying Cost Drivers: After the costs have been segmented into various groups, the next step is to list down their drivers. These drivers are usually intermediate inputs. Hence, they should also be automatically calculated based on the inputs mentioned in the model.

   For instance, if the company wants to increase its sales, it will also have to increase its production. The production will only be increased by creating new facilities which will lead to an increase in the square footage. Therefore, the model must be capable of converting the company’s goal i.e., a higher sales target into an intermediate input such as increased square footage. The range of these variables must be defined to ensure that the model does not incorrectly extrapolate the data and give the wrong results.

3. Focus on Total Cost of Ownership: Once the relationships between costs and their drivers have been identified, they can be input into the model. However, it is important to ensure that the total cost of any decision is segregated for decision making.

   For instance, if a company plans to expand its manufacturing facilities in order to make more products, then the total cost of this decision needs to be accounted for. The analysis must depict the rent, depreciation, and many other expenses to give the decision maker a sense of the total impact of their decision. In most cases, the total impact will be visible in one place only.

   Most operational decisions related to costs aren’t very complicated. The few which are complicated need to be taken into account while developing the cost model.

4. Allocate Costs to Each Supplier: A good financial model must take into account that the costs do not remain the same for all suppliers. Some suppliers always provide better terms and service as compared to others.

   For instance, some suppliers provide just in time delivery, longer credit duration. The products supplied by many suppliers are found to be faulty less often. Hence, the cost of exchanging the products or getting them repaired under warranty is saved.

   It would not be feasible to allocate the costs exactly for each supplier since large companies deal with thousands of vendors at the same time. However, in order to simplify the process, companies can group their suppliers into different groups. The costs can then be apportioned differently accordingly. This information comes in extremely handy when companies are about to make cost decisions. They can forecast the monetary value of the inefficiencies of the suppliers and make decisions accordingly.

5. Create a Standard Costing System: The final objective of cost modeling is to be able to create a standard costing system. This is where all the costs of the company are collated and expressed in the per unit form. This helps companies keep track of the expected costs.

   The financial model can then be used to keep track of the actual costs as compared to standard costs. The variances can then be brought to the notice of the management. Analysis of these variances allows companies to adjust their standard cost estimates. This process continues until the amount of variance is negligible, and the model has been perfected.

The conclusion is that cost modelling is linked to various different variables. There are some costs which are linked to sales, some are linked to each other whereas some more are linked to a totally different variable. All these complications need to be taken into account while creating a cost model.