Strong CFOs recognize that part of a thriving (and profitable) corporate culture includes creating awareness and understanding of the role that costs play in every decision. By enabling collaborative and transparent cost management processes, you can improve cost and profit performance while giving you a leg up against the competition.
Building a successful cost culture includes establishing a robust understanding of costs in every phase of the product life cycle—from quoting and development through manufacturing, steady-state operations, and ultimately end-of-life. A cost culture encourages informed decision-making, and there are a few focus areas that can drive success. Below are five strategies that lead to a strong cost culture:
- Embrace an Evolved Costing Philosophy:
Gone are the days of relying on artificially inflated costs as a basis for setting prices. Forward-thinking finance leaders are now championing accurate cost information as inputs to the process. By providing reliable data that reflects the true cost of products or services, you can develop pricing strategies that are competitive and fair. This shift fosters trust between the organization and its customers, paving the way for long-term success.
- Foster Consistency in Costing Methodologies:
Consistency is key when it comes to costing methodologies. As a finance leader, you must establish clear business rules and logic to ensure cost calculations are consistent across the organization. By involving the commercial team in the costing implementation process, it’s possible to proactively address questions and assumptions, leading to improved decision-making and better cost control.
- Establish a Cost-Conscious Decision-Making Framework:
A strong cost culture drives decision-making at all levels of an organization. Facilitate a framework that encourages employees to consider cost implications when making decisions. By ensuring that cost data is readily available and understandable, you can empower your teams to make informed choices that drive profitability. (Here’s our Cost and Profitability Framework that defines all the areas cost can impact an organization.)
- Leverage Accurate Cost Information for Competitiveness:
Cost information directly impacts your company’s competitiveness and you need to harness accurate cost data to set pricing strategies and secure profitable deals. With a responsive costing system in place, it’s possible to swiftly adapt to market changes such as tariffs or material price fluctuations, offering a competitive edge in dynamic business environments.
- Reap the Benefits of Enhanced Cost Information:
Enhanced cost information provides numerous benefits. By having a detailed breakdown of costs associated with customer requests, you can engage in informed conversations and negotiate profitability effectively. Additionally, analyzing cost details by customer, order, and production location enables your team to make data-driven decisions that optimize operations and boost profitability.
You hold the key to building a thriving cost culture. By embracing an advanced cost philosophy, ensuring consistent methods, using cost data for competitiveness, and capitalizing on enhanced information, you can position your organization for success in today’s competitive market. These strategies will not only lead to improved financial performance but also drive overall business growth. Remember, building a cost culture takes time and dedication, but the rewards are substantial. With a strong cost culture in place, your organization will become more competitive, agile, and profitable.
About ImpactECS by 3C Software
ImpactECS is a powerful enterprise cost and profitability analytics platform, offering everything you need to build, run, and maintain cost and profit models tailored to your requirements. With over 700 global installations and 10,000+ users, ImpactECS delivers a highly configurable, secure, and scalable technology platform that connects data across the enterprise and enables organizations to improve their strategic and operational decisions. Learn more at www.3csoftware.com.
In the realm of business, the ultimate goal is to generate profit, and one of the simplest ways to achieve this is by selling products at a price that exceeds the costs of production and delivery. While the concept might be straightforward, the execution is far from simple. Achieving profitability requires a deep understanding of costs, a strategic approach to pricing, and the ability to align these crucial elements seamlessly. In this article, we explore the critical connection between costing, quoting, and pricing and how technology can streamline these processes to optimize profitability.
At its core, profitability hinges on a straightforward principle: make sure that the price at which you sell your products exceeds the cost of sourcing, making, and delivering them. Sounds simple, right? However, the reality is that determining these costs accurately and setting appropriate prices involves complexities that are far from easy to navigate.
Diverse Pricing Approaches: Finding the Right Fit
When considering pricing strategies, businesses are presented with a range of approaches that are tailored to suit specific circumstances and goals. These diverse pricing methods encompass three primary strategies, each offering a distinct perspective on how to determine the right price point for products and services.
The first approach is the Market/Regulatory-Based strategy. This method places less emphasis on direct cost considerations and instead draws heavily from the fluctuations and dynamics of the market itself. It is particularly valuable for analyzing post-sales profitability and understanding how market conditions impact pricing decisions. By aligning pricing with market trends, businesses can make informed choices that reflect the current demands and competitive landscape.
The second commonly used approach is Cost Plus Pricing. In this method, meticulous calculations of costs associated with production, sourcing, and delivery are performed. These costs are then augmented by adding a predefined margin to determine the final price. While this approach is often perceived as fair due to its transparency in accounting for costs, it’s essential to recognize that it might not always maximize overall profitability. Careful consideration is required to strike the right balance between fair pricing and optimal financial outcomes.
Lastly, the Value-Based Pricing approach offers a different perspective. This strategy is tailored to cater to specific customer segments by aligning pricing with the perceived value that the product or service provides to customers. In essence, the price is set based on what customers are willing to pay for the unique benefits and value they receive. This approach is especially relevant for products that offer distinct advantages over competitors or cater to a niche market.
In choosing between these strategies, businesses need to weigh their unique context, goals, and the expectations of their target audience. The decision ultimately hinges on understanding the interplay of costs, market dynamics, and perceived value in order to arrive at a pricing strategy that not only ensures profitability but also resonates with the market and drives sustained business success.
Understanding the Costing Challenge
Costs go beyond the tangible expenses of production. In addition to direct costs like materials and labor, there are customer-driven costs, behavior-related costs, competitive market costs, and market condition costs. Understanding and calculating these multifaceted costs is crucial for an accurate pricing strategy.
The journey of calculating costs from sourcing raw materials to delivering the final product might appear straightforward, but there are several challenges that hinder precision:
- Communication and Data Silos: Different teams in an organization often operate in isolation, leading to fragmented information and misaligned expectations.
- Misaligned Expectations: Decision-makers’ expectations might not align with established business processes, leading to inaccurate cost projections.
- Effort vs. Time vs. Accuracy: Balancing the effort invested in calculating costs with the time available and the need for accuracy can be complex.
The Nexus of Costing, Quoting, and Pricing
To unravel this complexity, organizations need to embrace a comprehensive approach that integrates costing with your quoting and pricing processes. By doing so, they can create a strategic framework that not only calculates costs accurately but also leverages this data for informed pricing decisions. A robust system should enable the analysis of various pricing models and even the creation of custom models tailored to the organization’s goals.
A critical component of this approach is the Cost and Profit Framework, which encompasses four essential areas: Cost to Source, Cost to Make, Cost to Deliver, and Cost of Terms and Incentives. Innovative solutions like ImpactECS provide the means to calculate costs within each of these areas while maintaining multiple cost versions for comparison and simulation.
You can leverage the Cost and Profitability Framework to enable key processes are critical to understand and optimize quote performance. The first, Cost-Based Quoting, involves integrating a comprehensive end-to-end costing process within the quoting function. This approach ensures precise calculation of all costs, from raw materials to overhead, resulting in pricing that accurately reflects your anticipated operational expenses.
The second, Quote to Actual, involves comparing initially quoted costs with actual expenditures during production and delivery. This analysis reveals the accuracy of quoting practices, enabling your company to determine the true profitability of every quote you win.
How is Cost-Based Quoting different from CPQ
The Cost-Based Quoting (CBQ) process is a game-changer for organizations where a traditional CPQ process falls short. The traditional CPQ approach entails assembling a predetermined set of product options or attributes (Configure), aggregating the associated prices for each selected element (Price), and subsequently furnishing the finalized pricing to the customer (Quote).
However, the foundation of traditional CPQ applications rests on the assumption that all conceivable options and features for novel products are already developed, cost-assessed, and assigned prices. This presumption becomes untenable within the context of engineer-to-order scenarios. Effectively generating quotes for new projects necessitates the preliminary tasks of conceptualizing, evaluating costs, and determining pricing for the product before presenting a quote to the customer.
CBQ involves three primary phases, each influenced by stakeholders, data requirements, and evaluation activities. This process covers:
- Inventing the Product: Customer-presented product concepts are turned into structured Bills of Materials (BOMs) and process routings.
- Calculating Costs and Prices: Detailed costs, including material, labor, overheads, dedicated equipment, and non-recurring costs, are computed. Strategic elements like SG&A, freight, logistics, and profit margins are incorporated to determine the final price.
- Sharing Quotes and Analyzing Results: The quote is presented to the customer, and the data is shared across systems. Ongoing monitoring and simulations are used to identify potential risks.
Designing your CBQ process
To establish a state-of-the-art Cost-Based Quoting (CBQ) process, keep these key attributes in mind. First, make sure your process helps you manage the process of creating quotes and managing the quoting process. Next is the ability to perform dynamic cost calculations leveraging detailed bill-of-materials (BOM) and routing configurations to perform accurate and timely cost and price version analyses. Third, the process should support what-if simulations, giving you the tools to assess various scenarios and their potential impact on costs and pricing, enhancing the ability to make informed decisions. Data integration and the consolidation of tribal knowledge into systems can ensure cost calculations and pricing strategies are based on a holistic understanding of all relevant factors. Lastly, decision-making views driven by data provide insights and analytics to allow for agile adaptability to external changes and your business can respond swiftly to market fluctuations, customer demands, and other variables. Overall, a well-rounded CBQ platform equips businesses with the tools needed to navigate the intricacies of cost-based quoting with efficiency and precision.
The alignment of costing, quoting, and pricing is a strategic move that holds the key to sustained profitability. As businesses navigate competitive markets, customer requirements, and fluctuating market conditions, the ability to accurately calculate costs and strategically set prices becomes paramount. By leveraging technology and embracing comprehensive platforms like ImpactECS, organizations can master this intricate interplay and position themselves for a future of informed decisions and enhanced profitability.
Most manufacturing organizations use standard costing as the default mechanism to cost their products, inventory and estimate the cost of manufacturing activities at each step of completion.
This isn’t news or a surprise to anyone. Organizations began using standard costing in the 1920s – and not much has changed since then. Because most companies already use standard costing, new competitors must also use it to help analysts make apples-to-apples comparisons.
However, what this means and how this costing method impacts an organization’s overall profitability and optimization should be considered.
Let’s break that down a little further:
- Using standard costs, the organization spends several months gathering inputs for things like raw material prices, labor rates, machine and labor productivity, department spending, etc.
- The cost accountants determine how to allocate overhead costs across departments and product groups.
- At the end of the process, the cost accounting team rolls the cost from raw materials through work in process, and then, finally, through finished goods.
As the final step, business stakeholders receive a summary of the costs per product for the next year when performing calculations in decision-making.
What we need to be aware of is that the moment a standard cost is produced, it is out of date – and understanding the relationships between all of the inputs, processes, and calculations is nearly impossible.
Even more, the standard cost activity and cost rates are all determined using a singular scenario for production and sales volumes. The moment any of the following shifts, the standard cost’s accuracy is in serious trouble:
- Labor rates
- Production/sales volumes
- Production yields
- Labor/machine efficiency
- Product mix
- Product raw material input and skin board packaging prices
- Shipping costs
- Contract manufacturing rates
Should standard costing be used for decision support?
So, if these costs are changing, and your standard cost isn’t, should you still use it for decision-making? Can you really wait until the next budget cycle when the standard cost is updated again to get an updated cost of producing and selling your products? And how is this all affected at a time in increasingly competitive and volatile economic conditions?
How should standard costing be used in a business?
The above may not be a true revelation or “ah-ha” moment for product costing teams; “Yeah, we know this stuff already,”…“It’s the only tool we’ve got. What else should we do?”…sound familiar?
There is a two-part answer to solving the standard cost problem for manufacturing organizations:
- First, a business does need a standard cost; something in place to value inventory movements throughout the production environment. The standard cost can’t be $0 – so, instead, use a relatively simple process to create a standard cost. All inputs can be $1 or $.01, so long as everything has a value in the ERP system.
- The second part of the solution is that organizations need to recognize the limitations of working through an ERP system that is not purpose-built for a specific organization or industry and takes a long time to produce outputs of little value. Instead of working through the ERP system, organizations should work around the ERP System to get better results.
What should organizations do instead of using standard costs for decision-making?
Let’s talk about how best-in-class organizations are arriving at their true cost to manufacture their product – thus understanding product/customer profitability and optimizing decision-making.
We all know there are many things an ERP system does well: it captures transactions from receiving, consuming, inventorying, and issuing goods for shipment. The ERP captures data from business processes – that is what it should be used for.
The second part of the solution is identifying and implementing a product costing software that integrates with your ERP and other business systems that house crucial data related to product costing and customer profitability.
With specialized product costing software, one advantage is that the same standard costing process can be replicated with even more flexibility; adjustments to actuals are able to be incorprated into the costing model in real-time. Even more, each step of the standard costing process can be seen, understood, and explained – so your team will know where costs and inefficiencies accumulate across the business.
Additionally, with specialized product costing software, you can update all or some of your product cost estimates at any time (And yes, they have write-back capabilities to the ERP). Perhaps the best part of this setup is that an organization can even create multiple product cost estimates for various scenarios.
Leveraging the appropriate tools to calculate the actual, standard, forecasted, and simulated costs of products accounts for the real variables and drivers that exist in an organization. With this improved systems setup in place, your organization can finally get the product costing insights needed for intelligent decision-making and a process to help your organization thrive instead of just trying to survive when seeking to maximize product profitability.
For organizations that wants to leverage their understanding and insights into product profitability as a competitive advantage, there has never been a better time to make a change and adopt the right tools to facilitate this transition. For too long, organizations and product costing teams have had to make do with rusty ERPs and out-of-the-box standard costing processes. However, the technology is finally ready for organizations who understand that product cost clarity is and should be a critical competitive advantage.
Investing in the right tools to fully (and finally) grasp each element of product cost and profitability is a strategic move that pays dividends. Because, remember, your competitors probably haven’t figured out how to solve this problem yet, either. = )
Supply chain cost transparency is a critical aspect of business operations that enables companies to gain a comprehensive understanding of the costs involved in moving products from manufacturing sources to the end customer. By identifying and analyzing various cost elements within the supply chain, businesses can optimize their operations, pricing strategies, and customer relationships.
This article explores the importance of cost transparency in the supply chain and highlights how visualizing the cost and profitability waterfall, calculating customer profitability, and employing a cost-driver approach can lead to enhanced profitability and informed decision-making.
Understanding Supply Chain Cost Elements
To achieve end-to-end supply chain cost transparency, it is essential to identify and analyze all the costs incurred throughout the supply chain. The simple answer is – supply chain costs include all the costs incurred to move products from the manufacturing location to the final customer location. It’s a two-step process. First, identify each step in the supply chain and calculate its fully loaded costs. And second, determine how each of these fully loaded costs is differentiated by product and customer.
This diagram lays out the basic cost components of a typical supply chain where products are sourced from a variety of manufacturing points, shipped to distribution points, and then delivered to customers.
- Cost of Goods: Differentiating shipping terms, inbound freight, customs clearance, tariffs, and demurrage costs.
- Inbound Handling: Assessing costs associated with receiving, labeling, packaging, and putaway of products.
- Distribution Network: Breaking down costs related to storing products and moving them to the final point of distribution.
- Outbound Handling: Analyzing pick, pack, and ship costs based on product requirements and customer orders.
- Outbound Freight: Understanding the costs associated with different shipping modes and aligning them with customer delivery requirements.
- Reverse Logistics: Measuring costs related to returns and identifying customers and products that drive significant returns activity.
- SG&A and Overhead Costs: Identifying and measuring the costs of sales, customer service, and other customer-facing functions.
The Cost and Profitability Waterfall:
The cost and profitability waterfall provides a holistic view of the cost and profitability of the entire supply chain. By visualizing the cost components and their impact on profitability, businesses can make data-driven decisions.
Generate cost and profitability waterfall views at various levels within the business hierarchy, allowing for a comprehensive understanding of costs and profitability. The lowest level of granularity, such as individual sales transactions, allows you to analyze the cost and profitability of each transaction. Then summarize this detail at each level by aggregating the costs and profitability at higher levels, such as by the delivery or order, customer, or product.
At the customer level, the cost waterfall helps identify customers with high service costs, enabling targeted conversations for improving efficiency and reducing costs. Similarly, analyzing product costs supports informed negotiations with vendors and suppliers, optimizing pricing, terms, and agreements. Additionally, benchmarking different nodes in the supply chain facilitates operational improvements and better overall performance.
Overall, the cost waterfall visualization enables transparency and clarity in assessing the end-to-end cost structure of the business, facilitating informed decision-making and identification of areas for optimization and improvement.
Calculating Customer Profitability:
Calculating customer profitability can be complex, especially when allocating operating expenses to individual customers. Many companies use a simplistic approach based on the proportional allocation of operating expenses to sales. However, this method has limitations, as it assumes a direct correlation between sales and associated expenses.
This means that the percentage of operating expenses to sales at the corporate level is assumed to be the same for each customer. For example, if operating expenses represent 17% of total sales at the corporate level, both customer A and customer B would be allocated 17% of their respective sales as operating expenses.
However, there are limitations to this method. Sales do not always correlate directly with the associated expenses incurred to serve each customer and using sales as a sole basis for allocating operating expenses can lead to misleading profitability analysis. The relationship between sales and expenses is often directional at best, and there is no guarantee that higher sales automatically translate into higher profitability.
To gain a more accurate understanding of customer profitability, a cost-driver approach is recommended. This involves breaking down the income statement and identifying specific activities or services associated with operating expenses. By allocating costs based on these drivers, businesses gain a more accurate understanding of how costs are incurred for each customer. This approach considers factors beyond sales and provides insights into the profitability generated by individual customers. It allows management to take targeted actions to improve efficiency, reduce costs, and optimize pricing, service levels, or processes.
In the example provided, it turns out that customer A is more profitable than customer B based on gross profit and gross margin analysis and a sales based allocation of operating expenses. This insight may guide the company in decision-making, such as exploring opportunities to expand and grow the business with customer A while potentially entering negotiations with customer B to adjust prices or reduce discounts. This makes sense based on a proportional allocation of OPEX but may be wholly inaccurate if it turns out that customer A’s share of OPEX is higher than customer B’s based on their service requirements.
A real-world example illustrates the impact of different profitability calculation approaches on business decisions. Initially, using a generic cost allocation approach, the customer concluded that orders with gross margins below 8% were unprofitable. However, when a cost driver-based approach was applied, it was revealed that the level of service required to fulfill each order significantly impacted profitability.
By considering specific cost drivers, it was revealed that these orders actually generated an overall profit of $175K when actual costs were calculated using the cost driver approach, as opposed to a loss of $375K when using the generic cost allocation approach.
This example highlights the importance of using a more accurate and detailed approach to profitability analysis. By incorporating cost drivers and aligning costs based on the specific activities and services associated with each order, the customer shifted their focus from setting minimum gross margin targets to optimizing customer behavior in order to reduce the expenses incurred in servicing their demand. By understanding the true profitability of each order, they were able to make more informed decisions about pricing, customer segmentation, and operational improvements.
Achieving end-to-end supply chain cost transparency is crucial for businesses to optimize their operations and enhance profitability. To learn how 3C Software helps companies improve their product and customer profitability analytics process, visit www.3csoftware.com