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Business Insights from Andrea Hill

When combined with other prudent cost management strategies, this simple method will point out cost erosion rapidly and can set you on a path to correcting problems before they become devastating.

Catch Cost Erosion Before It Catches You

Originally Published: 17 April 2008
Last Updated: 28 October 2020

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First of all, thanks to all my email pals who checked in with me to see if I was OK, and more to the point, where was my blog? I'm afraid customer travel/conferences got the best of me and I got behind. I'll get back on track now.

In a presentation earlier this week, I spoke with a jewelry industry group about a cost-tracking strategy. The format of the forum was a lot of fun. It was a panel presentation offering 75 Business Ideas in 75 Minutes. The downside was that if I went over a minute per business idea a normally mannerly fellow named Rich Youmans would honk a loud bicycle horn at me. Though I am not generally very rule-bound, that horn was a true behavior modifier. I knew this concept was hard to describe effectively, and I knew Rich would be holding a bike horn, so I had spent a bit of time prior to the panel getting it down to one paragraph. Now I’d like to give it a little more attention.

Here’s the tip:

Compare your company's cost curve with the industry's price curve. Costs and prices usually decline (looking at inflation-adjusted numbers). By comparing your cost curve with the industry's price curve, you can tell if your costs are declining at the rate necessary for your company to remain competitive. This doesn't mean you have to drop your prices – it just means you've maintained enough operating, supply chain, and management efficiency to do so if challenged. Keep your margin as long as you can, but don't price yourself out of the market simply because you have no other option. If your costs are declining faster than the industry price curve is declining, make sure you understand why! It's not unusual for a company to achieve a competitive advantage that they do not understand, and therefore, do not exploit.

Now that I have more than a minute, let’s break this down a bit:

“Compare your company’s cost curve with the industry’s price curve.” It is next to impossible to learn about competitors’ costs, but it is not hard to watch their selling prices. Anyone can monitor overall price trends in a spreadsheet and create a graph. The best way to do this is to select specific products and group them into product categories. If you and your competitors sell hundreds of products, you may want to monitor key products or products that are representative of groups of products. Conduct a competitor selling price analysis quarterly or twice annually, and plug in the selling price for each of the items you are tracking. Don't get caught up in trying to figure out what price your competitors charge for bulk sales. That information is important for your own sales negotiations. But for this analysis discount strategies lack value and can keep you from achieving your purpose.

Once you have collected competitor selling prices, do the same analysis for your own products, only this time, you're plugging in your product costs (not selling prices). Track only variable costs for this exercise. Yes, marketing, operations, and shipping all play a role in your product cost. But your purpose for doing this project is to see if your cost trends are mirroring industry price trends, to make sure you are managing your variable costs commensurate with the industry. If you are adamant about seeing freight costs, do a separate freight cost analysis rather than combining freight costs with variable product costs. Freight costs follow their own trends and can skew your understanding of your variable cost management. Variable costs include costs of raw materials, direct labor costs, and packaging costs.

Now here comes the hard part. You don't get any gratification out of this exercise unless you 1) go back in time and recreate all the information for previous quarters, or 2) wait until you have collected several quarters of data. Most people opt to start collecting data and do their first trend analysis at some point 1-2 years down the road. For those of you who think "That's crazy, why do it at all then?" . . . hey, the time is going to go by anyway.

To compare your cost trend with the price trend of the industry, calculate the average cost of your products and the average selling price of your competitors' products. If you are tracking a few dozen (or less) directly comparable products, you can compare product to product. What is more likely is that you are tracking generally comparable products. In that case, lump the competitor products and your own products into comparable product categories, then calculate the average for each category. Finally, create charts out of the average selling prices and costs. Your final analysis will look something like this:

What you are measuring is whether or not your cost trend mirrors the industry pricing trend. In the example shown, the trendlines for the baby doll category are roughly equivalent, suggesting that costs are not decreasing at a slower rate than competitive pricing. However, the trendline for the dollhouse category indicates that costs are decreasing disproportionately to competitor selling prices, indicating a need for deeper analysis.

One last possibility, not shown in the graph, is that your costs are declining more rapidly than competitive pricing. This would indicate an opportunity to exploit a competitive advantage through lower pricing, or even better, to rake in additional margin while the getting is good. I would only consider dropping selling prices if the product or product category was one that would lead to considerably greater market share and sales growth on related products for the effort. Too often, companies drop their selling prices and simply shrink revenue as a result.

It is not uncommon to be retained by a company to dig into why they are no longer competitive, and upon doing the analysis, find out that their cost-erosion problem began years ago. This simple method requires a few hours once every quarter or twice a year. When combined with other prudent cost management strategies, it will point out cost erosion rapidly and can set you on a path to correcting problems before they become devastating.

(c) 2008. Andrea M. Hill