Adaptive costing: A CFO’s survival guide
Inflation and supply chain disruptions are having a significant impact on profitability. How quickly are you able to adapt to these changes and pass to protect your margins?
The cost of innovation today is high, and strategic decision-making is paramount. Yet, historically, cost and margin intelligence has been seen as an accounting functions rather than a strategic one. No longer. If your organization is going to thrive in this new ecosystem, you need to maximize agility, decision support, and profitability. Having the right costing model — one that’s adaptive and predictive — is critical to understanding the impacts of changing cost drivers, pricing structures, inflation, and market and customer demands.
Depart from old models and methods
How should you restructure your finance function to meet the challenges of the transforming manufacturing landscape, a landscape characterized by an integrated mix of new technologies and business models?
To overcome disruptive market forces and truly understand changing cost drivers, CFOs need to look at the story behind the numbers to make informed strategic decisions and effectively manage risk. As your business and operations models evolve, so must your costing and estimating approach.
Go with the flows
In the past, costing was focused primarily on financial statement generation; today, the real value comes from generating decision support information through “adaptive costing,” from understanding key cost drivers and how cost flows through your organization and its impact on your margins. This means you need a cost-modeling approach designed to evolve with the rapidly changing value chain if you want to maximize the return on your investments.
As an example, let’s look at SG&A (selling, general and administrative expenses) and “cost-to-serve.” As supplier opportunities shift from heavy manufacturing to technology and tech development, your costs to service your customers will rise significantly. From a cost-accounting perspective, these look like below-the-line costs, a component of SG&A. Yet, cost-to-serve can have a significant impact on customer-level margins.
The impacts will vary widely by organization, based on your size, supply chain complexity, type of products, how you support your customers, and many other factors. Without a deep understanding of cost drivers and flows throughout your business, you won't fully understand the effects on pricing and profitability of your products and service.
Minimize risk, improve decision support
In this inflationary environment, companies are faced with any number of game-changing strategic decisions. Consider the following questions:
- Has the business case for automation changed with labor inflation?
- How much of the labor cost increase is due to turnover, labor shortages, and seniority mix versus rate changes? How much of this can be passed on to the client?
- What leverage do we have to minimize cost increases? What if labor inflation continues to increase beyond amounts customarily countered with productivity?
- How much of your increased labor costs are due to productivity woes from temporary workers and staff turnover? How much is due to pure wage increases? Which of these can be passed on to your customers?
- Do historically high air and sea freight costs from Asia justify near-shoring or finding alternative sources in the short and long term?
- Should you invest now to streamline production of a part that’s likely to be obsolete in five to eight years, or put that money into products that will be competitive in the next 10?
- As production mix changes rapidly due to supply chain volatility, how does that impact risk?
- Do you have the data necessary to mitigate poor supplier performance and supply risk due to extended supply chains, sole sourcing, and the like?
How would each of these scenarios affect your business? How should you adjust your cost and margin expectations based on changing risk profiles? Your decisions are only as good as your costing models.
Spot red flags
To determine whether your costing model is as adaptive and predictive as it could and should be, take a step back and assess.
How well does your costing and estimating approach reflect the cost drivers in your current operating environment? Don’t forget to include those below-the-line items, such as customer service, technology, high inventory carrying costs, assembly operations, R&D, and engineering.
You need a cost-modeling approach designed to evolve with the rapidly changing value chain if you want to maximize the return on your investments.
Now, assess how adaptive your approach is to cost drivers that will come from changes in your industry. Some clues that your costing and estimating approach might not be as adaptive and predictive as it needs to be include:
- Consistent disconnects between expected and actual profit margin performance.
- Difficulty explaining variations in margins as product volumes and mix shift.
- Market feedback or surprises in market response. (Ever think you’re super-competitive on a part you’re quoting and, come to find out, you were 20 percent too high?)
- Pro forma cost models based entirely on today and historic cost drivers.
Results, and surprises, indicate the need to reassess your costing and estimating models for their adaptability and predictiveness.
Rethink financial management
To evolve your cost and margin intelligence approach, you’re going to need an integrated market volume-forecasting model to challenge assumptions and develop strategies that adjust to emergent conditions and tell the story from a cost-and-margin perspective.
But updating your costing approach and models isn't a once-and-done exercise. Every time you consider possible future scenarios, ask yourself these three questions:
- Are these drivers still appropriate?
- What’s changed in the market and our customers?
- What’s likely to change in the market in the coming years?
Incorporate these new variables into your costing models on an ongoing basis, and certainly no less than annually. Be mindful that poorly designed or implemented costing and estimating processes can do more harm than good, giving you inaccurate information that can lead you down the wrong path.
Drive profitable decisions
An adaptive costing and estimating approach helps you find your way, and strategically identify your value proposition in the market during this time of industry transformation. Adaptive costing and estimating lets you:
- Increase the speed and accuracy of cost estimating and quoting.
- Make informed make-vs.-buy decisions.
- Test your current core competencies against the industry’s future.
- Interpret your data accurately and use it to make smart strategic decisions.
Take product rationalization, for example. Adaptive costing aids in understanding how each product offering contributes to financial results. And truly understanding the margin impact of what you produce — and service — today helps you know whether to stay the course or invest in future, higher-profit, higher-margin offerings instead.
Technology and inflation are changing dramatically, and costing and estimating play a critical role in directing our new strategies. To innovate with confidence and improve competitiveness and profitability, you need an adaptive, flexible approach.
The challenge for every CFO is to provide actionable information to the rest of the business, so that leaders can make intelligent decisions about how to respond to the market in the face of disruption — quickly. Adaptive costing helps suppliers do just that: quantify key variables, accurately predict likely scenarios, understand impacts on profit margins, and, at the end of the day, make better decisions to maximize ROI for the shareholders.