Cost models help businesses understand the cost of activities and processes, allowing them to reduce costs and create a repeatable process. Different models can be used based on financial and operational needs, but there are also disadvantages such as assumptions and the need for multiple attempts to find a proven model.
Cost models help business owners and managers understand the cost of certain activities and processes. Through the use of financial calculations or cost accounting allocation, companies can capture basic information about resources, such as raw materials and direct labor, and transform the data into costs that can be used to price goods and services. Companies can put together different cost models based on their needs, both financial and operational.
Many different businesses use costing models in their day-to-day operations. Since the goal of for-profit businesses is to maximize economic value for owners and shareholders, finding ways to reduce costs is a crucial step in achieving this goal. Another purpose of cost models is to create a repeatable process that allows owners and managers to apply the model to multiple situations. Through this business process, the company can develop a metric that becomes the standard expected rate of return for projects. This protects the company from losing money when it enters new business opportunities that appear to be profitable but aren’t.
A basic example of a financial cost model comes from the activity-based costing method found in management accounting practices. According to this model, companies need to identify the activities that determine the cost, total direct materials and labor required to complete the manufacturing activities and the cost factor for applying manufacturing overhead (indirect manufacturing costs ). Through this model, companies can accurately identify how they can allocate production costs to the products of each activity within the company. With some modifications, the cost model is applicable to a number of different situations within traditional business operations.
The use of cost models also allows you to analyze external factors for a company. For example, a decision tree model takes into account the likelihood of competitors entering the market or low, medium, and high sales from consumer reaction to new products. This tree may also include information about potential taxes or regulations by government agencies that will affect the cost of business operations. Ultimately, the decision tree model works together for revenue and cost, adding a secondary level to the modeling process.
Disadvantages exist with the cost modeling process. For example, not all costs are known if the company uses the model for future costs. These assumptions can lead to decisions based on expectations that will not happen. Also, businesses may have to go through multiple templates to find one that works. This can lead to multiple attempts that drive up the ancillary costs until the company develops a proven model if possible.
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