What Product Cost Models Are Not — Mythbusting

This weekend, I'd like to welcome Eric Hiller back to Spend Matters. Eric, who is founder and Chief Product Officer at aPriori, will be contributing a series of guest weekend posts on the subject of driving Spend Management upstream. And this is the fourth installment. Please join in welcoming Eric to Spend Matters!

Yesterday, we explicitly defined Product Cost Models and the discipline of Cost Modeling. Today we will define them in the negative and will put some other disciplines to the test. Are they similar or not? As anyone who has ever been part of the launch of a new company, strategy, product, or brand knows, it is equally important to know what you are NOT, in addition to what you are.

Although there may be other adjacent fields of practice, the three of the fields most commonly confused with Product Cost Modeling (and even Enterprise Cost Management) are Accounting, Cost Estimation, and Cost Analytics. Let's talk about how they are different and similar.

Accounting - Yesterdays News
Product Cost Modeling is not Accounting. In college or business school, your kindly Accounting professor taught you that the field of Accounting addresses many concepts including reporting (telling management or investors what happened in the business last quarter), variance analysis (why it is happening), control (keeping people from spending money) and an esoteric, but powerful concept called "Performance Management." Performance Management is about not only identifying What happened and Why it happened, but then figuring out How to improve the situation for the future. For a good reference on this subject see Performance Measurement and Control Systems for Implementing Strategy by Robert Simons (I did not have Professor Simons, but I did use his book). However, the best intentions of the academic field often differ from the reality of practice.

How many accountants do you know that spend time on putting together pro-active plans to reduce product costs, as opposed to doing the necessary, but ex post facto activities of closing out the quarter, making sure variances are understood (a primitive form of Performance Management), and making sure indirect overheads were allocated?

You see, accounting in industry (regardless of what theorists may say) is primarily concerned with historical events -- what HAS HAPPENED (reporting) and how to allocate expenses so that the books all balance (allocating and closing). Product Cost Modeling is concerned with assessing what WILL HAPPEN to costs when a new product is designed, sourced, and manufactured. So, is Product Cost Modeling primarily a combination between "Control" and "Performance Measurement" in the accounting sense? Not exactly, but like Performance Measurement and Control, Product Cost Modeling is active and is about looking forward to actions that will improve profit.

Cost Estimation - Getting this one quote done
Beyond accounting, Product Cost Modeling is also NOT "Cost Estimation." Traditionally, Cost Estimation has referred to costing of specific parts and has more of the "feel" of what goes on in a job shop when the shop is contacted by a customer looking for a quote. Product Cost Models might be useful tools for Cost Estimation activities, but Product Cost Modeling is a re-usable and higher level strategy to costing products, rather than a one-time event like a cost estimate. Product Cost Modeling is not about quoting out the next part; it is about providing forward looking, predictive assessments of product costs that are useful to sourcing, manufacturing, and design early in the New Product Introduction (NPI) cycle. Cost Models give these functions visibility to product costs that they can use to increase profit and/or market share. Furthermore, each traditional cost estimate typically requires a large variable cost in time. Why? Because, every time an Estimator gets a new part to quote, he basically starts from scratch. Conversely, Product Cost Modeling sets up a framework that is reusable with very little variable cost to assess the cost of each new potential product or re-sourcing activity. Furthermore, the Product Cost Models are usable by the whole organization, not just the expert estimator.

Cost Analytics - Arbitraging for Profit
Finally, Product Cost Modeling is not Cost Analytics. Analytics is a general field that can be applied to many problems, including cost. Analytics slices, dices, and combines historical data (most often with statistical techniques) to make sense of the current state of a problem. It assumes that the future will be like the past (forget those mutual fund disclaimers!). Therefore, if, based on historical data, my curve fit says the price or cost should be X, and, in reality, the cost was Y, then I have a market inefficiency on which I can capitalize. The goal of analytics is not really to help the organization develop the right product at the right cost or change old products cost effictively. Its purpose is to point out where there is a little more meat on the bone on which the procurement department can gnaw.

Product Cost Modeling, on the other hand, is focused on providing cost calculations for analysis up front in the product development process so that you don't need to re-source, re-design, or re-route the part over and over later on, after you realize that you have missed your cost targets.

Author: Eric Arno Hiller
Founder & Chief Product Officer of aPriori

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