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Cost Models: Examples and Their Purpose in Business

Updated on June 3, 2013

Cost models assist owners and executives in determining the cost for particular activities and processes. Through the use of economic computations or cost accounting allocations, organizations could take fundamental information about resources – such as basic materials or direct labor – and change the data into effective costs for establishing the price of goods and services. Companies can easily create assorted fee designs based upon their cost requirements, whether financial or functional, based on cost models.

Numerous businesses utilize cost models in their day-to-day operations. Since the objective of for-profit firms is to increase the economic value for proprietors and shareholders, identifying ways to lower costs is an important action in attaining this goal. Another objective for cost models is to create a repeatable method that lets proprietors as well as managers to use the design in many different scenarios. Through this business method, the organization is able to establish a measurement that becomes the criterion when anticipating expected financial return for jobs or products. This safeguards the provider from expending cash when participating in new sales possibilities that look lucrative but truly are not.

A basic example of a cost model stems from the activity based costing strategy identified in management accounting methods. Under this style, business ought to identify the tasks that drive production costs, the complete direct materials for a good, and employee labor required to perform processing activities. Additionally, a cost driver is necessary to determine general manufacturing overhead, which are indirect production costs. Through this method, a business can effectively identify precisely how to allot production costs to items from every task within the organization. With a few changes, the cost model is relevant to a variety of different situations and traditional sales ventures.

The utilization of cost models additionally permits an investigation of external aspects that affect an organization. For instance, a decision tree model takes into account the possibility of rivals entering the marketplace; it also can show low, expected, and high sales from customer response to brand-new items. This tree is able to additionally consist of information on prospective taxes or regulation from controlling authorities or government that will affect a firm’s cost of business. Ultimately, the decision tree design operates for both incomes as well as expenses together, adding a secondary layer to the cost modeling procedure.

Pitfalls do exist with the cost modeling procedure. For example, not all costs are known if the business attempts to model future, unknown products. These presumptions could trigger decisions based upon assumptions that will definitely not occur. In addition, organizations may have to experience various product styles or production methods in order to identify one that works well for the company. This can result in numerous attempts that increase ancillary business costs until the organization develops a tested design, if one is possible at all.

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