Profit Modeling: An Alternative to Standard

Product Costing
Most manufacturers rely on standard costing techniques to calculate product cost, profit margins, and appropriate price
levels. And for many manufacturers, these methods yield adequate results. Under certain circumstances, however,
standard costing may not generate accurate product costs.

Some manufacturers have had success with a relatively new technique: profit modeling. This article outlines some of the
disadvantages of standard costing and the potential benefits of profit modeling. We do not mean to suggest that
manufacturers should discard their current costing systems. But for some manufacturers, profit modeling may be an
interesting alternative.

Standard Costing May Not Generate True Product Costs

Standard costing is generally based on forecasts of sales volume, sales mix, and expense budgets. However, if these
forecasts are not accurate, the numbers generated by standard costing may not represent true product cost. In addition,
standard costing is usually driven by burdened labor hours, which may or may not yield an accurate picture of actual
product costs.

Beating the System

Standard cost allocation may prompt shop workers to focus on labor efficiency and setting “standard” hours. Since the
shop must report actual hours against jobs, shop workers may be encouraged to increase batch sizes to “reduce” the
allocated cost of setups. Inventory may rise if workers make more product in order to better “absorb” overhead. Some
manufacturers believe that standard costing encourages employees to work to beat the system instead of making true
progress.
Another common complaint is that managers become preoccupied with getting the most out of “direct” labor, taking
great pains to manage the “direct-to-indirect” ratio. But in most manufacturing businesses, labor is less than 15% of cost.
It may make more sense to focus on the other 85% instead of wringing additional savings out of direct labor.

Reporting Requirements
It takes time to set up and maintain labor standards on a job-by-job basis, and even more time to report on how these
standards have been met. Labor-based allocation systems generate detailed reports of hours by employee, individual
efficiency, departmental efficiency, labor variance by job, labor variance by department, and so on. Some manufacturers
using MRP-based manufacturing execution programs have found adjusting allocations to be burdensome.

Misleading Decision-Making Tool?

Standard cost may sometimes overstate new product cost. For example, if a company is bidding against stiff competition
for a new sales contract and the additional volume is not in the standard pricing forecast, the use of standard costing to
set prices may be misleading. Such inaccuracies may cause manufacturers either to ignore allocations in decision-
making or to make bad decisions.

Activity-Based Costing
To improve accuracy, a number of manufacturers have adopted activity-based costing (ABC). Although ABC may
significantly enhance accuracy under the appropriate circumstances, its data collection requirements can make it
expensive to implement. In addition, ABC is based on assumptions regarding allocation parameters that must be
accurate for this method to be effective.

The Profit Modeling Solution

Most manufacturers say they use standard costing for one primary reason: price setting. Conventional wisdom says that
to set an appropriate price for a product, you must know how much it costs to produce. But the truth is, competition has
a far greater impact on pricing than product cost.

Many of the same tasks manufacturers try to accomplish with standard costing, such as measuring progress and
determining which products to add or eliminate, can be accomplished with a dynamic, easy-to-use profit model.

© 2009 Principa. All Rights Reserved. 49

 Profit Modeling: An Alternative to Standard
Product Costing (Cont’d)
A profit model is a scenario-based, mathematical representation of the manufacturer’s business or a part of the business.
The manufacturer constructs the profit model by entering information about the business in its current state. Then, when
changes are contemplated, variables in the model are adjusted to account for these assumptions. Changes that can be
analyzed with a profit model include:
• Shifts in product volume and/or mix
• Addition or deletion of products from the product line
• Price adjustments
• Cost reduction opportunities
• Scrap reduction
• Just-in-time inventory approaches
• Flow manufacturing

Getting Started
There are a variety of profit modeling tools to choose from, ranging from simple spreadsheets to complex dynamic
simulators. Since profit modeling is a means, not an end, the best strategy is to start simple, and make the model only as
detailed as necessary.

If you operate a large, complex business, consider breaking it up into reasonable business units for simplicity. Making
the model valid while keeping it uncomplicated can be a tough balancing act, but a simpler model will get more use.

You will need to collect some data, although your company may have much of what’s needed in place if costs are
already allocated through an MRP system. Capacity, cycle times, and variable costs are the most critical sets of data
needed in developing a profit model.

The profit model must be validated by plugging in historical data and matching profit numbers to actual results. If the
model numbers match the actual results, the model is valid. If not, the model must be adjusted. Built-in limits must be
plugged into the profit model. Linkages to plant capacity and other business constraints are necessary to keep the model
in line with reality, so that decisions aren’t made based on unrealistic scenarios.

The best profit model is a comparative tool, where the baseline represents the current state of affairs-including
manufacturing techniques and product mix. The baseline must be carefully managed and protected under a logical “lock
and key.” New opportunities, ideas, and scenarios are then compared to and measured by the baseline.

Many CFOs and controllers are already using simple profit models to analyze business decisions. The next step is to
legitimize profit modeling as part of their normal business process. Ideally, the workforce should understand the model
and have access to it. An accessible profit model is a good way to tap into employee talent, keep employees mindful of
profitability, and let people with good ideas test them. In addition, because the profit model forces people to consider the
entire organization when recommending improvements, it reduces “empire building” and the “local-optimum” mind set.

When properly implemented, the profit model should be so easy to use that it becomes the standard tool for all
management decisions, whether those decisions involve investing in new equipment, dropping a product line, or
resetting pricing.

This article was based on an interview with John Auger of Operations Associates in Greenville, S.C.

© 2009 Principa. All Rights Reserved. 50