NOVEL ANALYTICAL APPROACHES: SQUARE ROOT COSTING
Wilson Perumal & Company is the innovator and originator of Square Root Costing, or Complexity Costing, which dramatically simplifies the task for companies seeking to understand their costs.
Square Rooting Costing—or SQRT costing, for short—is a faster, more dynamic alternative to methodologies such as Activity-Based Costing for organizations looking to quantify the impact of complexity on cost and operations. It is also a key input for: price setting, asset rationalization, customer and product profitability analysis, sales force alignment and portfolio optimization.
SQRT Costing is a direct outgrowth of our understanding and analytical research on the issue of complexity costs. It is the fastest, most dynamic approach for helping companies:
Understand and quantify complexity costs
Create a Whale Curve to understand the degree of profit concentration in the business
Assess which products benefit from scale and which do not
Optimize operations to minimize the impact of complexity
Below, some FAQs:
How have companies used SQRT Costing? Read more
As one example, a $10B Consumer Goods company recently engaged us to use SQRT Costing to analyze the impact of product complexity on manufacturing productivity and product and customer profitability within a short timeframe. The result was eye-opening for the client as there was a significant difference between real and previously reported profitability across several product and market segments, leading to a 12% immediate gross profit opportunity plus additional benefits from more informed portfolio management, greater alignment and integration across operations and commercial functions, and a means to better evaluate new market opportunities.
How is this better and faster than Activity-Based Costing (ABC)? Read more
Activity-based costing can be precise, but requires significant time and resources to undertake. It is essentially a bottom-up approach to costing, building up the cost picture piece by piece. As a result, the answer isn’t clear until the all the work has been completed, and when you are done the answer often doesn’t add up to the total since some costs will have fallen between the cracks. Also, ABC provides only a static result—a snapshot—which quickly becomes stale as soon as the business changes, which often happen post-analysis, not to mention during the analysis. To understand costs after changes are made requires doing much of this work all over again.
SQRT costing is a fundamentally different approach. We work top-down, starting with your current costing, and then use our analytics and understanding of complexity to rapidly making corrective adjustments. This reallocation approach to costing means you are not waiting for months to get insights around your costs. Essentially, we start with what you have and then make it better until it is good enough. The result is a faster, more complete understanding of your cost structure and one that adjusts as your business changes. In sum, it is an analytical method that puts the onus on assembling sufficient information for insight generation and confident decision-making.
Why do executives prefer SQRT Costing to ABC and other approaches? Read more
For most executives, the value of understanding true costs and how costs change is the emerging insights and clues about how to improve the business and make better decisions going forward. Therefore, a faster, more dynamic, more complete picture is preferred to a longer, more static, even if more precise picture. Unfortunately, many ABC implementations become activity traps, consuming a lot of resources with little payback in the way of insights and opportunities. Conversely, SQRT Costing provides insights about the business in a matter of weeks, and is almost as easy to apply on an ongoing basis as Standard Costing.
What’s behind SQRT Costing? Read More
Everything else being equal, low volume products contribute disproportionately to inventory, setup time, and variation according to the inverse square root of volume relationship.
We discovered this relationship in our work, first empirically, then analytically, which led to the development of equations and proprietary techniques that underlie this powerful costing technique.
Our approach contrasts with what most companies do: allocate their costs by volume, leading to over-costing of high-volume items and under-costing of low-volume items.
How does SQRT Costing enable profitable growth? Read More
Because SQRT Costing is mathematically derived, it is possible to use it to test growth scenarios to answer questions around scale such as:
- For a particular product segment, what is the growth required to reach profitability?
- Which product segments deserve greater (or lesser) investment to maximize profitability?
To answer these questions, we help companies develop Profit/Cost Scaling Curves that test the impact of scale on a product’s profitability. It is often assumed that a particular product or service is unprofitable because it is currently sub-scale. What we test is whether that is the case, or whether it is due to the inherent complexity of that particular segment. What we find is significant differences between perception and reality on these issues. The value of this analysis is that it guides the executive in decisions around portfolio optimization, growth forecasting and capital allocation, with a degree of understanding previously unattainable.
