Knowing True Costs is a Competitive Advantage
We live in age of nickels and dimes. Customers split hairs over price, and make purchasing decisions based on marginal differences in the way that their providers deliver products and services. Knowing true costs opens the door to making better decisions that impact the value proposition, pricing and other strategic considerations.
Most commonly, the problems with calculating costs stem from poorly integrated systems, and a lack of cost accounting. Gross margins are typically understood (by senior management) but overheads are allocated with a lack of specificity. They are applied evenly based on the volume of a category or division, even though there may be significant differences in corporate overheads from one to the next. If the systems do not allow for true cost accounting, even true margins which reflect things like discounts and the like may not be accurate.
Problems can be exacerbated by an inherent lack of financial acumen. Non-financial managers need to be taught how profit is earned and how it is calculated. That may not mean opening the books, but education at a gross margin level is critical for companies wishing to empower mid-management to make better decisions on their behalf.
There are two tools that we advocate clients use to better understand costs and their relationships to value:
Activity Based Costing – A well executed Activity Based Costing (ABC) analysis can yield meaningful results. In an ABC, (often conducted by a CPA or consultant) the organization measures which of its activities are tied to specific products, segments or divisions. This is painstaking work. For example, all corporate staff may be required to track their time for a fixed period (maybe 2-4 weeks) so that such allocations can be calculated. Once such costs are understood, a provider can make better decisions on where to reduce costs, what products and services to offer and what prices they SHOULD charge (which in some cases is very different than what the market will bear).
Value Chain Analysis – Value chain analysis breaks down the activities of a firm in its basic elements such as R&D, product development, product launch, etc. Then the value of these activities (as perceived by customers) is weighted against the ability of the firm and its competitors to deliver value. For example, customers may value warranties as a differentiator amongst companies. Some competitors (such as BMW or Hyundai) may excel in this area, which may be the source of some advantage, but what is critical is that the providers measure the perceived value of the feature vs. the incremental cost to provide it.
In a world where customer’s cost sensitivities are heightened, having a laser focus on costs allows the provider to manipulate its offering and prices to create the optimum perceived value.