Are product (or service) cost standards really that important?  Consider the classic case of UPS.  For years UPS failed to appreciate the different cost to serve business and residential segments.  Charging the same rates for all customers opened the door for a host of competitors to take a share of their profitable business volume.  It has taken years to win that business back, even with their scale and cost advantage.

Many managers simply don’t recognize that understanding product cost is essential to many critical business decisions.  Take pricing for example.  It is commonly accepted that price should depend on the market.  In practice however, pricing is rarely transparent to those bidding.  As a result, suppliers often significantly underbid the competition because they don’t know what price they have to beat, even bidding below cost.

“What are they thinking?” the question often is asked by those outside of sales.  The answer, “they” don’t believe the cost standards.  If the competition is selling the product at or below our cost, the standard must be wrong.  In practice, many businesses don’t understand their costs and unknowingly bid below the real cost.  Others know their costs and consciously undercut the competition on some items to win a larger contract or simply take share.  In these cases, an accurate and credible understanding of product cost is essential to understanding your competitors’ pricing strategy.

So how does a company avoid this fate?  Understand cost and set firm minimum pricing guidelines.  A competitor with poor cost models is essentially “under costing” some products and “over costing” others.  By avoiding contracts priced close to or below cost, you are burdening your competitor with unprofitable volume that isn’t making a sustainable contribution to profit or helping cover fixed costs.  At the same time, other products in their portfolio must be over burdened.  Winning the bids on these products improves your margins, and best of all, your competitor will never know.  They will continue to believe these products to be unprofitable.

Pricing is just one example.  Accurate product costs are essential to determining product mix, sourcing products from the right locations, managing the trade-offs between higher local manufacturing costs vs. inventory and transportation.  Often product cost is the primary factor driving the decision to open or close a facility.  Accurate inventory, gross margins, and divisional P&L’s (where transfer pricing plays an important role) all depend on a solid understanding of product cost.

Developing good standards starts with pulling the key stakeholders together to understand the business decisions that rely on the cost standards.  It is important to model the sensitivity of these decisions with respect to changes in product cost to determine how accurate the standards must be and the cost elements that are likely to change as a result of these decisions.

Next comes the modeling, which is best done at a granular level for each major type of operation or service initially. While this task may look like an accounting function, good cost modeling should be done by a team that straddles both manufacturing processes and accounting. It can’t be done well without both an accountant and an industrial engineer.  Once the key drivers and relationships are understood, a more generalized, less complex model can be implemented for most products and services representing the right balance of effort and accuracy.

Understanding cost is not just some administrative function.  Product costing plays an essential role in a wide range of crucial business decisions that affect the future of a company and the lives of many of its employees.  Getting it right can give a business an important competitive edge.

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