Friday, August 07, 2009

The Calculus of Cost

@fbjk2000 (Florian Krueger) poses a set of questions about costs, under the heading Review your calculus of cost. The questions are fair, but the heading is wrong: Florian's questions are all about reviewing cost, and nothing about the calculus of cost.

Cost review looks either at the total cost (is this too much for customers to bear) or at individual cost items (are we paying too much for this item)?

Cost calculus looks at how the total cost is composed from individual cost items, understanding how costs are added and subtracted and multiplied, getting an appropriate balance between fixed costs and variable costs, clustering expenditure to achieve cost synergies, and so on.

Here are some examples
  • In a traditional high-volume non-volatile business, cost reduction can be based on economies of scale, with high fixed costs and low variable costs.
  • In a volatile business, it may make more sense to reduce the fixed costs and accept higher variable costs.
  • Purchasing several different items from the same supplier reduces transaction costs and allows bulk discounts to be negotiated, but may not achieve the lowest price for every item.
  • Allocating costs to a given project can yield widely different results, depending on the formula that is used.
For any reasonably large business or IT operation, questions like these require non-trivial mathematics. And you shouldn't use words like "calculus" unless you are prepared to do that.

Is this just quibbling about semantics? Not at all. Business people may worry about costs, but business analysts and business architects need to pay attention to the structure of costs rather than the tactical details.

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