What are Cost Models?

Osmand Vitez

Cost models help business owners and managers figure out the cost for certain activities and processes. Through the use of financial computations or cost accounting allocation, companies can take basic information relating to resources, such as raw materials and direct labor, and transform the data into useful costs for setting the price of goods and services. Companies can put together different cost models based on their needs, whether financial or operational.

Activity-based costing, common in manufacturing facilities, takes into account the overhead costs of running the factory.
Activity-based costing, common in manufacturing facilities, takes into account the overhead costs of running the factory.

Many different companies use cost models in their daily operations. Because the goal of for-profit firms is to maximize the economic value for owners and shareholders, finding ways to lower costs is a crucial step in achieving this goal. Another purpose for cost models is to create a repeatable process that allows owners and managers to apply the model to multiple situations. Through this business process, the company can develop a metric that becomes the standard expected rate of return for projects. This safeguards the company from losing money when engaging in new business opportunities that look profitable but really are not.

A basic example of a financial cost model comes from the activity-based costing method found in management accounting practices. Under this model, companies must identify the activities that drive costs, the total direct materials and labor needed to complete production activities and the cost driver for applying manufacturing overhead (indirect production costs). Through this model, companies can accurately identify how they can allocate production costs to products from every activity within the company. With a few adjustments, the cost model is applicable to a number of different situations within traditional business operations.

The use of cost models also allows for an analysis of external factors to a company. For example, a decision tree model takes into account the possibility of competitors entering the market or low, average and high sales from consumer reaction to new products. This tree can also include information on potential taxes or regulation from government agencies that will affect the cost of business operations. Ultimately, the decision tree model works for both revenues and costs together, adding a secondary layer to the modeling process.

Disadvantages do exist with the cost modeling process. For example, not all costs are known if the company uses the model for future costs. These assumptions can lead to decisions based on expectations that will not occur. Additionally, companies may need to go through multiple models in order to find one that works. This can lead to multiple attempts that increase ancillary costs until the company develops a proven model, if one is possible at all.

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If you are planning to start a small business, understanding cost models associated with your business is vital to your financial success. For example, if you are opening a restaurant, your cost models will consist of your food, supplies, and personnel costs that make it possible to run your business. Cost models are necessary economic tools that can help you estimate current and future costs associated with your daily operations. In turn, understanding the cost models associated with your particular business will allow you to plan accordingly and save money as your company grows.

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