COST MODELLING STRATEGIES CAN HELP TO COUNTER FORECASTING UNCERTAINTY

As any financial director will know, cost uncertainties can make it difficult for companies to forecast business performance accurately, which can make it more difficult to plan for growth.

Understanding where costs lie in the business and the factors that might cause them to alter is the first step to managing them efficiently – but this is easier said than done.

Depending on the operating model of the business, there are many uncertainties that can impact on business profitability. Changes in international labour rates can affect supply costs and erode margins as a result. For those trading or sourcing internationally, fluctuations in commodity prices as well as shifting exchange rates and duties can also have a direct impact on the company’s bottom line.

Ben Bird
Ben Bird

In the case of exporters for example, recent fluctuations in the value of sterling and corresponding rates of exchange have been blamed by some companies for a lack-lustre performance. Conversely, other exporters have been able to manage such uncertainties and achieve growth in spite of the uncertain trading conditions. So what’s the difference? In most instances, it comes down to the company’s ability to adopt innovative sourcing and cost-modelling strategies that give them a cushion of resilience.

In order to produce an effective cost model for the business, financial directors need to take a step back and ensure they understand the total cost of acquisition of a specific product or service. Potentially there are also opportunity costs linked to time spent managing the supplier instead of doing something else that could have greater value to the business overall. This will include an assessment of how overheads such as salaries, or other specific running costs, should be attributed. This kind of cost-modelling exercise will bring clarity and enable the business to manage costs more efficiently and effectively.

Following an analysis of all indirect/support activity costs impacting an individual product or service, it is not uncommon for financial directors to discover that some of their previously thought profit-making activities are in fact making a loss.  Such news can of course come as a shock but, once this has passed, finance directors are usually keen to help drive through the radical and lasting changes needed to transform the fortunes of the business.

In today’s world of disruptive technologies such as 3D printing and a step change in consumer habits, as well as uncertainty surrounding currency exchange rates, some manufacturers are facing extreme challenges on a day-to-day basis just to break even. For these businesses, forecasting is becoming increasingly difficult. In such situations, cost-modelling strategies can perform an important role in helping to drive through the sometimes radical changes needed to reposition the business for growth.

A recent cost-modelling exercise at a major dairy producer revealed that despite a range of yoghurts being sold at the same price, some were making a significant profit, while others were making a loss. Further investigation revealed that this was down to two factors: the route to market and the sourcing of the ingredients. The yoghurts that were being delivered in bulk to large retailers were making a profit, but the products going to local distributors were making a loss due to higher overhead costs. It was also found that blueberries sourced from the US were much more expensive than strawberries sourced from Turkey which was impacting on the overall profitability. This cost transparency allowed the business to re-evaluate where to focus sales and market resources, and understand the measures needed to ensure all products are profitable.

In some cases, a cost-modelling exercise may confirm that it would be more efficient to outsource a specific product or area of production. However, global sourcing strategies can be complex and require a granular approach to cost analysis – usually on a component-by-component basis.  For example, an engineering business may decide it costs less to source a particular component in China, but it could take six weeks to ship it back to the UK and there are likely to be additional management costs associated with monitoring quality in situ. Some stock may not meet the required standard and there may also be extra insurance costs. All of these factors will impact on the total cost of acquisition of the activity.

From a currency perspective, many companies with global supply chains choose to hold a reserve of US dollars to hedge against fluctuations in the value of sterling. This money is typically left sitting in a UK bank account and can represent a significant cost to the business. Again, cost modelling strategies can help to reduce cost intelligently by re-evaluating such costs and making sure they are still right for the business.

When implementing cost-modelling strategies, it is vital to have the full support of the financial director and the Board. All need to have a good grasp of the multiples being applied to every piece of cost-modelling carried out and how the total cost of acquisition figure is arrived at. The recommendations spinning out of this work are likely to involve some challenging decisions and it is important that all are on board from the start. The financial director will also be required to sense check recommendations for how to remove specific costs ensuring they are practical.

While cost-modelling strategies are disruptive by nature, they are also an opportunity for businesses to transform its trading position in order to shore up or win back market share. Those that do it right have a great deal to gain and those that don’t are likely to find that hidden costs continue to erode value, almost without them realising.

Ben Bird is a director at Vendigital, a firm of procurement and supply chain specialists operating globally and across industry sectors.

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