Costing As A Superpower
An attempt to bestow this to you
If you spend any time in an industry that manufactures a physical product then you will eventually spend time looking at the costs behind producing that product. Knowing your costs across the supply chain and production process of a product from raw materials to being available to a consumer sounds like it should be easy. Bill of Materials + Energy + Labor = Cost. It sounds easy, but it isn’t because each of those components are individual domains composed of a bunch of different people. To get the equation to work they all need to work together.
If you are a product manager who deals with costing on a regular basis then you’ve likely run into the issue of “the cost of these materials in SAP are wrong.” Costing is so important to get right because it determines your pricing and the profitability of your company. Knowing the true cost is everything.
A good way to tell if you are in the specialty chemicals business versus commodity chemicals is knowing your pricing model. Commodities generally utilize a cost plus model, if it costs us $1.00 to make a pound of product then you might price it at $1.30 to capture a 30% mark up and a 23% gross margin [($1.30 - $1.00)/$1.30]. The sales and general administrative (SG&A) costs then get taken out after that sale is realized as well as R&D costs (tax deductible usually) and more. Maybe a net profit of 15% gets realized. If that $1.00 initial cost is wrong, then the 15% of net profit could be lower or even negative. Specialty chemicals can typically charge a flat 50% or higher margin on their products because the buyer is paying for either specialized performance or is prohibited due to patents on the technology. Cost plus pricing doesn’t really play in specialties and its why that business is so good and why others want to enter.
Over the last 12 months we have seen price inflation for numerous reasons such as higher crude oil prices, shipping prices, energy prices, demand and this has pushed costs up for everyone. In order to keep those increased costs from destroying margins companies have to raise prices. This is one driver of inflation, but some of the inputs to these higher prices are softening. Getting visibility into how and where cost increases are coming from can be difficult to pinpoint as can the solutions to reducing costs. This is because when it comes to costing it’s kind of like a game of hot potato.
You might be thinking, “it’s the responsibility of sales and/or marketing to know the costs and profit margins,” but the reality is more complex. True raw material pricing and costs actually are the responsibility of procurement teams who typically negotiate the pricing contracts or determine which index raw material pricing will be set against. If for instance your company buys actual boatloads of polyethylene your prices are going to be indexed to ethylene pricing. Who sets the index?
ICIS or IHS Markit (now part of S&P) are two examples of companies that set these indices and when they report the price of ethylene moving you either save money or have to spend more. Essentially, these two companies report pricing indexes on raw materials and have incredible sway when it comes to raw material costs. While the procurement team might know the high level details they are often not the ones actually buying the raw materials.
It’s actually the “buyers” at the manufacturing locations who know the full cost because they are the ones cutting the checks. If you are in sales and you are selling to factories you want to know who the buyers are in those plants. Actual changes in pricing need to be communicated from the buyers to the procurement team who then often need to communicate this to marketing who can communicate what the price increase/decrease should be to their sales team who then communicate that to the customer. To make things even more complex this pricing needs to somehow get accurately reflected to the finance team so that quarterly earnings are actually accurate. This whole convoluted scenario is just what happens for a product that is already commercialized and being sold. Things get worse when trying to develop something new.
In developing any new product, being able to accurately provide a cost is like trying to thread a needle on a roller coaster. In an ideal world your marketing team knows enough about your end market that they can back calculate the absolute highest cost possible to the technical team. Knowing the boundaries of what your costs have to be is critical and any project where someone says, “oh we don’t want to put boundaries on you” should be considered suspicious.
Boundaries are how people come up with creative solutions to problems. If the product can only cost “X” in order to yield “Y” sale price then figuring that out early and starting from there can help determine if a project is even worth starting. If the technical team says, “not possible at X, but maybe at X+Z to get Y” then that is a conversation worth having early and often. Any disconnect early on just gets worse the longer it goes on and is not a problem you want to have during the launch of a new product.
I’ve seen products with such bad costing information that the company actually lost money on every sale (this has happened more than once in more than one place). When it comes to how prices and costs get communicated I believe it is rare to find someone willing to meet with all of the internal and external functional groups and facilitate the cross-functional communication.
If you can accurately cost something then you can determine pricing and realize profits—a fundamental principle when operating a business. When supply chains tangle or energy prices sky rocket that superpower of being able to know where those increases originate and how to either a) pass those costs on or b) mitigate the impact can be the difference between ensuring everyone having a job in a year or getting a bonus.
Knowing exactly how much it costs to run a reactor for an extra hour or how much more energy it costs to operate at 200 versus 125 Celsius sets up really easy to define cost savings projects. Getting operations to be lean and in fighting shape is just the first step and essential to the trickiest: growing on new products while still maintaining current business.
More on that hopefully next month. If you’ve got an amusing costing story or are frustrated by the whole process let me know in the comments.
This is really interesting to hear from your perspective! It brought to mind John Sterman's writing on supply chains in his book Business Dynamics, which I'm working through with a friend. The different stakeholders, where to draw model boundaries, and delays in the process all are covered. Curious: have you encountered anyone using system dynamics to try to improve accuracy of the costing process?
Thanks for the piece Tony!
Just a small edit: if a product costs $1.00 to make and that you price it at $1.30, that is a 30% markup but effectively a 23% Gross Margin.
I think your piece is a great segue into another very relevant topic which is pricing: it is for sure fundamental to understand your costs when thinking about the pricing of a product, however many companies use this bottom-up approach only, without taking into account what the customer would ultimately be willing to pay for it.
It is not because your product costs X to make that a customer would necessarily be willing to pay X + 30% : in some cases it could be X+ 15% and in some X + 80%, depending on how much is the perceived value of the product to the customer.
Having transparency and control over your cost base is therefore an imperative from an operational standpoint but COGS should never solely determine a company's pricing strategy, a top-down approach to pricing (i.e. value based pricing) should always be preferred.