Here at Anklesaria, we believe that in order to manage costs you need to understand them first and a simple and straight forward way of doing that is building a Cost Model. The objective of a Cost Model is to breakdown a cost into its various sub costs, to help understand and track it better. The more accurate your Cost Model, the better you understand the cost, the better your ability to negotiate, and the more cost you save. Despite the importance of an accurate Cost Model, a very important first step to building a Cost Model is often missed by most. What is the important first step that most seem to miss out on, and yet, is so important?
If you have recently attended our Strategic Cost Management seminar you will feel empowered with a great new set of techniques to estimate and analyze costs, leading to more advanced negotiations with your suppliers. Are you ready to develop your first cost model?
Let me share an important first step that will help you prioritize and define the cost model you should develop. You might miss this preparation step as you engage head down in your first cost modelling project, either because you have not yet performed a thorough supply market analysis -- including an assessment of the market price trends -- or simply because you are under time pressure and since this is your first cost model, you’d better just get to it.
The US Bureau of Labor Statistics is a great free source of historical price trend data for all sorts of products and services, materials as well as labor costs. More specifically, their database on Producer Price Index (PPI) is where you should be able to find time series matching spend categories as well as underlying costs.
When plotted on a chart many of the time series have the shape of an upward sloping straight line, as in this example for the price of valves used in industrial applications:
There may be short-term variations around this trend, as in the following examples, but the overall long-term trend is still upward and linear:
This shape - an upward-sloping straight-line - usually indicates conditions where prices are primarily driven by inflationary underlying costs, where the market is competitive and supply adjusts quickly to demand. This inflationary trend should also be seen in the price trend of the major underlying cost elements themselves. Here is the historical trend for labor and utilities costs, two underlying cost elements of many manufactured goods:
When you observe such an upward linear price trend for a purchase category and want to understand the price drivers as well as the potential outlook for where market prices may be heading, your model may simply need to focus on and track a few cost elements such as labor and utilities costs. An Industry Cost Profile will inform you about the magnitude of these cost elements to track (click to learn about Industry Cost Profiles).
On the other hand, certain categories exhibit a price trend that is non-linear, sometimes a combination of linearity and randomness, or even cycles. Here are three examples:
These non-linear price trends are either driven by significant changes in underlying material costs and/or by shifts in supply and demand for the product or service. In such cases your cost model will need to focus on closely tracking specific cost elements over time. This type of dynamic model is what we call a Price Discipline model (click here to learn how to do this). The starting point of a Price Discipline model will usually be an Industry Cost Profile as well however the cost proportions will quickly start to change over time, so tracking the individual changes in each cost element becomes essential.
If price changes are mainly driven by shifts in supply and demand, then the profit portion of the price is the main “cost element” to track and try to manage as a buyer. In such cases, the use of a cost model may boil down to tracking the profit element in the market price, and the prospect of trying to use the cost model to get into more advanced, cost-based negotiations becomes limited.
Trying to forecast the movement in the market price in the short-term, for hedging strategies for example, may become the only option to try to manage the cost of such market-driven, commodity-type purchases. Forecasting such movements in the profit element becomes a complex exercise that requires a detailed understanding and forecasting of the underlying shifts in supply and demand.
Instead it could be simpler and still effective to use price analysis techniques used in commodities and equities trading for example, which help you assess whether a market is in an uptrend (“bull”) or a downtrend (“bear”).
A simple technique is to add a moving average line to the price line on the chart and visually assess whether the market is in an uptrend or downtrend by looking at the position of the moving average line vis-à-vis the position of the price line. Here is the same data as in the previous three examples where I added a line (in blue) for the 8-period Exponential Moving Average of the PPI data:
The moving average line (in blue) serves as a ‘limit’ that indicates whether the market is in an uptrend or a downtrend, and as a simple rule you can think of it this way:
· As long as the PPI stays above its moving average line you can assume the market is in an uptrend; and
· Once the PPI line crosses below the moving average line -and stays below it- you can assume the market is in a downtrend.
So, this could work well for market-driven, commodity-type purchases where a cost model may not be as useful to develop market price trend outlooks for your sourcing strategies, or for negotiations purposes.
Do you agree with us? Please do share your views on how to build an accurate Cost Model in the comments. For more services, training material and information on building accurate Cost Models, write to us at email@example.com and for more exciting updates on Cost Management, be sure to follow our Linkedin Page The Anklesaria Group .
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