Cost Modeling or Cost Forecasting is a common activity for any business. However it can also be a very challenging activity. In this introductory article, we will briefly talk about what it is, why small businesses should use it, the typical challenges a small business may face in doing cost modeling or forecasting and finally what tools and techniques are best suited for this activity.
What is Cost Modeling?
Product development and manufacturing requires transforming raw materials into finished goods. This requires obtaining the raw materials, processing them to produce the desired goods, storing and distributing the finished goods. Obviously all of these activities involves cost from the business' point of view. But these costs are not constant and fluctuate on a daily, monthly or annual basis.
Why should a Small or Mid-sized manufacturer (SMM) do cost modeling?
The typical customer for an SMM is a large original equipment manufacturer (OEM) such as an automotive or aerospace company. They however do not allow an SMM to vary the price of the finished good in tune with the market prices of raw materials or processing costs. If you are an SMM, you of course already know this! In order to produce a part profitably, and yet compete successfully in the market, an SMM must have solid estimates of input factors' (material, labor and transportation) cost variability and how this would impact the ultimate cost of the finished part. Cost Modeling allows you to capture all these costs, relate them to the final cost of the product and help you develop accurate forecast ranges for the input factors' costs.
Two major barriers for cost modeling
The first barrier is the information required for building an effective cost model: it typically resides with multiple stake holders in the business as well as outside the business. The challenge is to successfully integrate these disparate sources of information, capture them in a "living" document or database in order to build effective models.
The second one is the presence of uncertainty in the information. This uncertainty could come from both the supply side and demand side. We already talked about the supply side uncertainty. However what if the demand is also uncertain? When production volumes must swing between 100,000 to 200,000 parts, it adds additional life-cycle costs. How do you account for these variabilities and still come up with a cost estimate that allows managers to make a decision about production? Under such situations, we must invariably resort to risk analytics techniques and focus more on cost distributions than single point cost estimates.
Techniques for Cost Modeling
There are three main types of techniques that can be applied to cost modeling and forecasting depending upon the situation:
- Roll up or Generative costing
- Split each activity or material into smaller and smaller models of cost and then roll them up to arrive at the final cost model
- Parametric Estimation
- Establish relationships between design parameters and costs using statistical techniques
- Technical Models
- Incorporate the effects of quality and reliability into your cost models
In an upcoming series, we will interview an SMM which has successfully applied advanced analytics techniques to address cost modeling in their business.
How can you identify the best method for your business? Try our free online analytics portal, visTASC, to get started.