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Costing and Pricing Models –  Basic Concepts

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This section attempts to move the discussions into more practical areas, by suggesting some tips and traps when building a Costing and/or Pricing Model. We openly admit that it is these practical guidelines are the most difficult to present in a manner that will cover the breadth of the sector. Indeed, it is hoped as more experience is gained by the sector in the practical aspects of the new funding regime that more specific guidelines and resources are developed and made available.

Driving the Logic Highway

In building Costing Models we often refer to logic-drivers; these can be defined as the assumptions, reasoning or logic behind an estimate of expenditure by Account. Most of this work is undertaken and held on spreadsheets, but we stress again, it’s not about the form, it’s about the content. A good list if logic-drivers written done on the back of a beer coaster is better than a heap if spreadsheet formulae that no one can decipher. Own your numbers and good things will become of you. 
Let’s say we are building a Costing Model for an Activity we’ve defined as “Youth Program A”. If we are looking to estimate the wages expense, we may start by predicting the number of employees required for the Activity, their associated annual rates of pay including Super, workers compensation etc for one year, break our result into pay periods and insert into the Costing Model in the wages Account by month. Simplistically shown as:

Activity: Youth   Program A
Account Jul Aug Sep Oct Nov Dec
6-1000    Wages xxx  xxx xxx  xxx  xxx xxx

What is important here is not so much the resulting numbers but the logic behind the numbers, the capacity of individuals responsible for the program to understand that logic and for all parties to be able to refer to it during the Activity itself. For instance if actual wage costs emerge as being over budget, it imperative you can analyse the original logic to ascertain whether the variance is likely to be ongoing or a minor timing issue. 

The above is a simple example; however it is worth noting that we often prepare our Costing Models, not from the perspective of one specific Activity, but all our Activities at once.  For example; when estimating wages expense, we may start with all of the organisation’s employees by position and calculate a cost per employee including Super, LSL, workers compensation insurance etc for one year as above. We can then, in theory, allocate each employee to an Activity (or apportion them across a series of Activities), break our result down into pay periods and insert into the Costing Model by Account (wages) by month for each Activity. In this example we have estimated our total organisational wages cost first and then allocated that total cost to each known Activity. This approach is known as a “top-down” cost estimate, the first example is known as a “bottom-up” cost estimate.

In a nutshell: a “top-down” cost estimate occurs when we calculate an organisation-wide expense for a particular Account and then allocate across our Activities as a whole. A “bottom-up” cost estimate occurs when we build up an estimate cost for all relevant Accounts one Activity at a time. 
In the real-world, we often see more “top-down” cost estimation when organisations are undertaking annual budgets of known (and often funded) Activities, and more “bottom-up” cost estimation when applying for funding for a new Activity. The balance between the two is often a reflection of the organisation’s complexity, its internal resources and relative financial management maturity. Both are appropriate, both can work well and can be combined in the same Costing Model.

The lesson so far is, regardless of the approach, try to build reasonable (and understandable) logic behind your numbers, whether “bottom-up” or “top-down” and keep that logic on hand for future reference, whether that be spreadsheet-based or written.

Before moving onto indirect costs, it’s worth a short word on in-kind and/or volunteer costs. These notional direct costs present a dilemma to the extent organisations are not inclined to simply ignore them because without volunteer support some funded Activities simply wouldn’t exist. Depending on your viewpoint, funding can be seen to be supporting volunteers or volunteers can be seen to subsidise funding. There is no clear approach other than to say it would seem appropriate to include notional volunteer costs in their relevant Activity at a logical rate/hour and then price accordingly – i.e. deduct them from the price if funding is not requested or include them if it is. Using this approach ensures the ‘real’ costs are shown in the Costing Model, but still provides an opportunity to ‘price them out’ should that be the organisation’s intention. 

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