The Fundamental Dimensions of a Cost Model

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 fifth installment. Please join in welcoming Eric to Spend Matters!

Last weekend on Spend Matters, we finished introducing Cost Models for Discrete Products. Discrete products are understandable enough, but what about the Cost Models? What is involved in a making or defining a Cost Model? Let’s answer this question by defining the "dimensions" of the Cost Model which we will define as Basis, Applicability, Scope, and Methodology.

Basis (Where does the cost model come from?) -- Is the model based on what happened in the past (historical) or the best knowledge of what may happen in the future (forward)? But, you may ask, aren’t all models focused on giving us knowledge of the future what-if scenarios we wish to analyze? True, but the subtle difference is whether the future can only develop within the bounds of past costs or whether the future costs may be very different from the costs of past products (reminds me of a quote from the head of the patent office).

Applicability (What can I use it on?) -- How useful is a cost model in moving from product to product and providing useful information? What limits the model’s use? The applicability of cost models in discrete manufacturing are defined either by the kind of physical component (is it a wheel or a bracket) for which they provide costs or by the manufacturing processes (forming, casting, molding) for which they provide costs.

Methodology (How does it work?) -- Methodology is how the model is built in a technical sense. Several methods are used including mechanistic modeling, empirical curve fitting, expert opinion, and comparative quoting.

Scope (What costs does it cover?) -- What part of cost is being modeled? Is the cost model covering the Cost of Goods Sold (COGS) of the product? This is typically direct materials, direct factory labor, direct overheads, and amortized tooling. Logistics for shipping would also be considered part of COGS. Scope can expand to also cover the indirect overheads of Sales, General, and Administrative (SG&A) which includes the cost of marketing, the sourcing process (not direct materials), management, and the costs of product development (included making a change to the VP of Engineering). Adding COGS and SG&A is approximately the "as delivered" cost to the customer. Typically, this is where the scope of interest of the company selling the product ends. There is a branch of cost modeling called Life Cycle Cost Analysis that expands the scope to include the costs the customer incurs throughout the time period they purchase, use, service, and dispose of the product.

Summary Comparison of Cost Model Methodologies

Of Arrows and Cost Model Methodology We are going to start off by discussing the different Methodologies for making cost models. Basis, Scope, and Applicability are subjects for future discussion.

But before we jump headfirst into the different methods of creating Cost Models in the next series of posts, let's start by offering a framework within which we can understand different types of Cost Model Methodologies: archery. When I first picked up a bow as a child, I wanted to hit the center of the target. In other words, I wanted to be "accurate." However, I soon was taught by the kind old yeomen at the Peoria archers that accuracy is not the primary concern of an archer: precision is. In other words, the important thing was to group my arrows in a tight cluster over and over. Accuracy is about distance from an arbitrary target, but precision is about consistency (see figure below). Any archer or marksman knows that if you can group your shots consistently, accuracy can be achieved by moving your sight pins or scope. The next challenge is to be able to maintain precision and accuracy at a variety of target distances, elevations, speeds, and environmental conditions.

Accuracy and Precision

"Accuracy" and "Precision" are two of the most misunderstood terms in the fields of Enterprise Cost Management and Cost Modeling. Many times people talk about one of the terms when they are really expressing the thoughts contained in the other. In reality, a good costing methodology must have both accuracy and precision, and automatically re-adjust to new targets (products with new designs, manufacturing plans, and sourcing strategies). With that in mind, stay tuned as we look at the various predictive costing methodologies commonly used today: Expert Opinion, Comparative Quoting, Empirical Curve Fits, and Mechanistic Models.

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

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