Making Good Choices
A scholarly father and his strategic sourcing son share insights into the benefits of cost modeling
Victor Sower is a professor of management at Sam Houston State University’s College of Business Administration. Recently, he -- along with his co-author and son Chris Sower -- published a book entitled “Better Business Decisions Using Cost Modeling: For Procurement, Operations, and Supply Chain Professionals,” in which they discuss how the implementation and usage of cost-modeling techniques can greatly improve the operations and effectiveness of businesses.
Who is your target audience for this book, and why should they buy it?
As the title states, we wrote this book primarily for procurement, operations, and supply chain professionals. Cost accountants, process auditors, process engineers, development engineers, faculty who teach operations and supply chain courses, and logistics professionals are also part of the target audience. We know of several potential adoptions of the book for use in university-level supply chain management courses. This book is written to be easily read and understood. Our intent was to develop a book that a professional could purchase in California, read while flying to New York, and land with new ideas to pursue the next day in the office. We spend little time on theories in this book, although there are references for those who wish to delve deeper into the theories behind the models. We believe all readers regardless of their prior knowledge of cost modeling will find new ideas of interest in this book. The examples are simple enough to be easily followed, but complete enough to convey the process used and the results obtained. Professionals who wish to derive similar results to those in the examples should read this book.
How can your models and theories be applied to other supply-chain type settings besides businesses? Such as government agencies or military operations?
Every type of organization--service providers, manufacturers, non-profits, government agencies, the military, and healthcare--can benefit from using cost modeling. They all have procurement and operations functions, though not always referred to by those names. External cost modeling can be of significant value in controlling procurement costs, while internal cost modeling can help control operation costs. Both greatly increase the efficiency with which organizations transform inputs into outputs. What governmental agency has not been faced with trying to increase its effectiveness in the face of flat or decreasing budgets? Every tax dollar saved in procurement and operations is a dollar that can be devoted to the agency’s primary mission or to deficit reduction. The military has long been a user of cost models. For example, some military contracts for capital items such as military aircraft utilize learning curve cost models to adjust the per unit price to reflect lower costs associated with increased manufacturing labor efficiency over the life of the contract. Cost models can be of significant value in decreasing cost without negatively impacting efficacy. Cost models are not as difficult to use as some might think, and because they can be of significant value to all types of organizations, the effort to master their use is always worthwhile.
Could your models be applied to a household setting to increase utility for consumers?
Many consumers are already using cost modeling concepts in their decision making processes. When consumers obtain dealer cost data published by consumer organizations to use in negotiations with new car dealers, they are using a form of projected cost modeling. Consumers who consider fuel efficiency, depreciation, reliability, and maintenance costs as well as dealer price when they consider which automobile to purchase are using total cost of ownership (TCO) concepts. Consumers increase utility when they use the TCO model to consider whether the lowest price option for other large purchases (e.g. air conditioners, kitchen appliances, HD TVs) is really the lowest total cost option when longevity, energy efficiency, and reliability are considered. Home buyers can use time value of money concepts when purchasing an existing home by calculating the net present value of a roof which might need replacing within a few years and using that to justify a lower than list price offer. Consumers often use cost modeling concepts intuitively when they consider whether to purchase a large quantity of a grocery store item at a lower per unit price or a smaller quantity at a higher per unit price. Often consumers use cost modeling concepts when they consider make-or-buy decisions such as when it is better to hire a contractor rather than doing the job yourself. Especially in difficult economic times where it is important to maximize the utility from every dollar spent, consumers can benefit greatly from using cost models.
How did you develop these models that can be so readily and widely applied?
We don’t claim to have developed these models in a vacuum on our own. Rather, my coauthor and I created the techniques for constructing and using the models used in the book based on our experience and on published best practices. We also included some progressive techniques for creating and using the models to improve business decision making. What we have tried to do in this book is to discuss many of the different types of cost models in very clear terms and with many examples of their use both individually and in combination. This collection contains the cost models we have found to be of great utility in supply chain management, procurement, logistics, and operations.
What was your inspiration to write this book?
Our basic premise is that business decisions are only as good as the information upon which they are based. Cost models are important business analytics that can support fact-based decision making. External cost models can provide information which is invaluable in negotiations with suppliers and in collaborative efforts to reduce costs throughout the supply chain. Internal cost models can provide information that can assist in a variety of decisions such as make-or-buy, new product feasibility and pricing as well as supporting continuous improvement and cost reduction efforts. I worked in manufacturing process engineering and general management for 18 years before becoming a professor. I have incorporated cost modeling in my more than 20 years of teaching operations management. My co-author has worked for 11 years in a variety of supply chain, procurement, and strategic sourcing positions in the specialty retailing and oil and gas industries. We have seen first-hand the value of cost models. We have both worked for organizations steeped in the use of cost modeling and their bottom lines reflect that. We both have also worked for organizations that made little or no use of cost models. By introducing those organizations to cost modeling, we have saved those organizations millions of dollars. Many in the business community are a bit fearful of mathematical models. We wanted to take away that fear and introduce cost modeling in a more user-friendly, but no less rigorous way. Cost models are not some sort of magic touchstone that will solve all problems, but they can be a significant part of the solution to many problems such as rising healthcare costs, governmental budget deficits, and stagnate or declining profits in some business organizations. We want to be part of the solution to these problems by sharing our experience with cost models.
What possible negative implications can come from strictly following these models?
One potential negative implication is failure to realize that costs are just one aspect to be taken into account when making business decisions. Relying exclusively on cost information when making business decisions can lead to short term thinking to the detriment of the organization. In complicated business systems, multiple factors—cost being but one of these--must be considered in combination in order to arrive at the best possible decision. Another possible negative implication involves the way information from cost modeling is used in business negotiations. Information is power, but power can be used in more than one way. Procurement professionals can use projected cost models to understand the cost structure of products purchased from suppliers. This is a productive use of power if this information is used to drive fact-based negotiations that result in suppliers receiving a fair profit and buyers receiving a fair price. However, power can also be used to “beat up” a supplier so that “no money is left on the table.” This is a non-productive use of power in the long term. This can induce suppliers to take short cuts to reduce costs but which also reduce quality or even to decide to exit the market. Internal cost models can be used as drivers of continuous improvement programs. Improvement means change and change can be difficult for organizations if it is not managed correctly. Another risk comes from using the models as the exclusive input to business decisions. No business support model can effectively analyze all aspects of any decision. They are not a substitute for good management judgment. Cost modeling is not a substitute for good managerial judgment and decision making—it is a valuable input to that process. Significant negative results may occur if cost models are not effectively married with good managerial decision making processes.
If more Texas businesses adopted your tactics, how profound of an effect do you think they could have (on the state/nation)?
We know of many Texas organizations that use cost modeling effectively. Many of the large oil companies operating in Texas make extensive use of cost modeling. We know of hospitals and educational systems that use cost models to a greater or lesser level of intensity. My co-author and I believe that increased use of cost modeling can be a component in increasing competitiveness for Texas businesses, reducing costs for Texas healthcare providers and educational institutions, and increasing efficiency for Texas governmental agencies. Will cost modeling alone solve these problems? Absolutely not! But it can be part of the solution. Cost competitiveness is often the primary motivator for outsourcing operations. Widespread use of cost modeling can result in increased efficiency and lower cost making outsourcing less attractive with obvious effects on employment in Texas. Reduced costs can result in increased competitiveness leading to increased sales and profits which in turn lead to more jobs, more spendable income for Texans, and increased tax revenues for local, state, and national governments. Cost modeling can be a contributor to solving the increased costs of education and healthcare, and it can do it without efficacy trade-offs. We believe there are significant numbers of Texas organizations that could benefit significantly from more frequent and more effective use of cost modeling.