Manufacturing insight: Competitive advantage from your cost-price model

Effective cost price models are a genuine competitive advantage. GrowthPath has seen revised cost price models completely transform two companies both facing a maelstrom of unfavourable external developments. That's because a cost-price model built according to the way customers make decisions allows much faster response to opportunities.

Commercially-oriented cost-price models give three key advantages:

1. A faster response. The early bird gets the worm. When it comes to competing with cheaper overseas competition, one advantage of being local is speed of response to market demand. This starts by your response to an opportunity.
2. A more flexible response. Added value often comes in complexity and customisation. If you can quickly quote for an offer customised to a particular opportunity, you will stand out from competitors who quote with generic specifications.
3. A more precise response. Fattening your prices to cover a risk you impose on yourself due to lack of confidence about your costs is opening the door to better-informed competitors.

A good model is optimised for a precise purpose

The main value of a model is simplicity. Simplicity makes model easy to build, maintain and use.

But simplicity has its price: a model is only useful for the specific purpose it was made. And a lot of accounting models were made by traditional accountants for traditional purposes.

Nothing illustrates this better than the standard-cost model.

Direct costs, such as component costs, are added together. An assumed volume is taken, and overheads are then divided on the basis of the volume. Sometimes, a part of total labor costs get called "direct labor" and end approximated by a method half-way between.

To be fair, the standard cost model really has only two weaknesses: It's not accurate, and it's not helpful for decision making. It is however, quite acceptable for making tax returns and with a bit of tidying up with "variance accounts", it can produce profit and loss statements. It has a specific purpose,  and it's not too bad at it.

Unfortunately, those two weaknesses are deadly for business hoping to respond quickly in a highly competitive market.

The weaknesses of standard costing have been recognised for years, leading to improvements like "Activity Based Costing" (ABC).

ABC is an impressive idea but expensive to implement and expensive to maintain. (Search google for "the failure of Activity Based Costing"). In summary, ABC is too theoretically pure. It takes a long time to establish, a lot of effort to maintain, and probably its worst problem is that it takes a lot of effort to understand.

The right approach is to first decide what types of decisions your customers make, and design improvements to your cost price system that suit.

What determines the right cost price model?:
The way decisions are made by customers

I was asked once how manufacturers can really take a short term perspective when fixed assets are long term investments. For the answer, look at customer behaviour. If your customers are locked in to your long term decisions, fine. But usually they aren't. Customers don't care that your new production line has a seven year payback. To win business, you need to answer questions the way customers ask them.

In reality, every business is different. But usually, decision-making depends on the competitors and the market, and changes affecting the market. Ultimately, customers should determine the decision making approach, because it is their decision that a company tries to influence.

For most manufacturers, volume and capacity are very important factors since the contribution margin, or leverage, is higher for businesses with more sunk costs. 

Beyond this obvious point, deviations appear. For example, an FMCG business in a diverse and large retail environment, such as Europe, wins business via medium-term contracts and short-term promotions and seasonal deals. The product ranges tendered will be manufacturer-owned brands, and house brands (or private labels). A tender portfolio is assembled from a stable of core products, but there may be large variation in packaging configurations (and distribution options). Decision making requirements focus on a strong insight into short-term variable costs (cash costs), but this insight needs to come from highly customised product portfolios. During negotiations for longer-term contracts, account and sales management want to be innovative and flexible. If they succeed, they have a good chance of winning the business.