Important Decisions Influenced by Cost Modeling
In the previous article, we studied the cost modeling process. We understood the various steps which have to be undertaken in order to model costs. However, we also need to understand that cost modeling is an iterative process. This means that a company creates a cost model, runs the numbers, compares those numbers with their competitors, and then makes some changes to ensure that they are on par or better than their competitors.
This is because, to a large extent, costs are the only component which a business has total control over. Revenues are driven by the market, and hence, the business cannot completely control them. It is common for companies to use financial modeling to make many important decisions. Some of these important decisions have been mentioned below:
- Research and Development Decisions: Cost modeling is used to make important decisions about the research and development process. Earlier companies used to run their research department as an independent function. Often, this would mean that the ideas produced by the research department were not of much use to the company. They would often create patents for products or technologies which were too expensive to produce. Nowadays, cost models serve as the input for research and development decisions.
R&D departments usually model costs from a process point of view. They then use these models to identify pain points so that the output of the research has immediate application for the firm.
- Inventory Management Decisions: The cost model also influences important decisions such as whether the company wants to hold on to inventory or whether it wants to appoint suppliers which provide just in time delivery.
Suppliers providing just in time delivery are usually on the expensive side. However, holding inventory also has a cost. The company has to pay rent for the godowns. There is a cost associated with maintaining those godowns. Often times there is breakage as well as pilferage.
Lastly, the company also has to pay interest on the funds blocked by inventory. Creating a financial model which can compare both these expenses has wide applications in decision making.
In some places where rents, as well as interest rates, are low, holding on to inventory might be a good idea. On the other hand, if these rates are high, paying a premium to the supplier might be a better idea. In both these cases, cost models help the company accurately compare costs and make the right decision.
- Lease vs. Buy Decision: Companies across the world want to expand their operations. Whenever they want to do so, they are always faced with a lease-vs.-buy Decision. Both leasing and buying may be the financially prudent option depending upon various factors such as rent and the cost of capital which the company has to pay.
Cost models allow the company to decide whether they want to rent or buy. This decision then has an effect on the larger financial model.
For instance, if the company decides to rent, they are increasing their operating leverage since now they would have an additional fixed expense.
On the other hand, if a company decides to buy, they may have to pay interest if they have borrowed the capital to do so. The line items, as well as the amounts in the financial model, get impacted by the lease vs. buy decision.
- In-house vs. Outsource Decision: Cost models also help companies make outsourcing decisions.
For instance, Nike has outsourced most of its production to companies in poor countries like Bangladesh.
Instead of outsourcing to other suppliers, Nike could have set up an in house center in Bangladesh themselves. However, the problem is that Nike would have to comply with a lot of regulation. This would have cost a lot of money. This is the sort of decision making that is enabled by a detailed cost model.
Cost models enable companies to simulate where they would be if they took both the decisions. Decision-makers can look at the probable finances in both cases and choose the probable option.
- Onshore vs. Offshore Decision: Lastly, important decisions like where production needs to be undertaken are also taken with the help of cost models. The modern supply chain has a lot of complexity. There are a lot of factors like the cost of fuel and the cost of labor which impact the offshoring decision.
However, nowadays, because of the trade war, import duties have also become an important factor. Cost models help to identify all these factors as well as the quantum of impact which they have on the overall cost. Simulations are then run based on the variables which are likely to change.
The bottom line is that offshoring vs. onshoring decision requires a lot of complex calculations. These calculations are easily accomplished with the help of cost models.
There are many more such decisions which are made with the help of a cost model. Cost modelling is an important tool for making strategic as well as operational decisions.
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- What is Financial Modelling?
- Objectives of Financial Modelling
- Steps to Create a Financial Model
- Financial Modelling Heuristics
- Financial Modelling: Advantages and Limitations
- Why is Financial Modelling so Complex?
- The Future of Financial Modelling
- Creating a Revenue Model
- What is Cost Modelling?
- Important Decisions Influenced by Cost Modeling
- Financial Modeling: Important Metrics
- Scenario Analysis: A Primer
- Risk Management in Financial Modeling
- Modeling Discounted Cash Flows
- Debt Schedule in Financial Modelling
- Managing Assumptions During Financial Modelling
- Financial Modeling for Banks
- Financial Modelling for Insurance Companies
- The Merger Modeling
- Merger Modelling: The Accretion/Dilution Analysis
- Financial Modelling For Leveraged Buyouts (LBOs)
- Circular References in Financial Modelling
- Financial Modelling in Real Estate
- Why is Excel Not the Best Tool for Financial Modelling?
- Testing the Financial Model
- The Last Step: Handing Over the Financial Model
- How to Incorporate Ethical and Social Elements in Financial Modelling