Knowing True Costs is a Competitive Advantage
Many entrepreneurial companies face challenges in calculating their true cost of doing business. The ability to overcome these challenges can create a significant 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.
Category: Business Growth & Strategy
Tags: Costs, Management, Marc Emmer, Strategy
About the Author: Marc Emmer
Marc Emmer is President of Optimize Inc., a management consulting firm specializing in strategic planning. Emmer is a sixteen-year Vistage member and a Vistage speaker. The release of his second book, “Momentum, Ho
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As you’ve noted, a properly-executed cost accounting system creates value and competitive advantage. The ability to align cost, the “motive” behind that cost, and how each impacts specific product profitability can only lead to better decision-making. And it’s here where, I believe, the power of cost accounting lies – in its ability to influence or direct strategic thinking. By providing management with an understanding of what drives their profit, cost accounting allows a company to change course, adapt product offerings, accelerate development, or terminate product losers and customers. That is, of course, if a company acts on the information cost accounting provides.
A cost accounting tool, like activity-based costing, works much closer to real-time analysis than any standard GAAP report or “budget/forecast vs. actual” variance analysis. By aggregating cost along clear lines-of-causation, it anticipates questions and provides insights that are only hinted at in standard after-the-fact reporting. Used properly, cost accounting, and specifically ABC, can provide management with glimpses into CPI opportunities, inefficient processes or activities, and product profitability.
Cost accounting can support a variety of business motives or decisions. What you implement and how you proceed varies based on the issue you are trying to solve. Are you trying to resolve an outsourcing decision? A full-blown cost accounting system would be a waste of time and resources; MS Excel would better serve your needs. Do you have many products and/or customers and want to discern the winners from the losers? Activity based costing may best serve your needs. Are you concerned with scope, schedule and cost? Earned Value may fill that need.
And yet, cost accounting may not be right for every company. If you have one or two products with little overhead, your existing financial reporting system is all you need. A full-blown cost accounting system requires time, staff and money to implement. Do you have the appetite and resources to see the effort through to its conclusion and beyond? Most activity-based costing systems miss staff capacity (TDABC may be an exception); be careful when identifying your needs and building a solution.
It’s the consultant’s role to help sr. management clearly define their needs. They are more than just working hands; consultants help with establishing strategic direction and designing a roadmap to get there. Yes, they may eventually build a tool that satisfies a client’s needs, but their primary value is crystallizing a vision to reach greater profitability – and isn’t that what every company wants? Start with strategy, build with clarity, train and transfer, and end with implementation. There’s the real value in cost accounting!