Managing costs is a fundamental activity for ensuring profitability and maintaining a competitive edge. Companies seek methods to understand their expenditures, not just by tracking what they spend, but by analyzing what they should be spending. This proactive stance is the basis of a should cost model. It moves beyond accepting a supplier’s price at face value and involves a detailed examination of all inputs and processes that create a product or service. This knowledge empowers organizations to make more informed decisions, from negotiating with suppliers to shaping product designs.
Defining a Should Cost Model
A should cost model is an analytical tool used to determine the expected cost of a product or service based on a detailed, bottom-up analysis of all its components and manufacturing processes. It is a calculated estimate of what a product should cost to produce if the supplier operates with reasonable efficiency. This approach differs from traditional methods that rely on historical pricing or competitive quotes. The model asks what a product should cost, providing a benchmark grounded in data and analysis.
The principle behind this model is to create a transparent, fact-based foundation for understanding a supplier’s pricing structure. The analysis encompasses a wide range of factors, including the cost of raw materials, labor rates in a specific geographic region, machine time, and expected scrap rates during production. By assembling these individual cost elements, a company can construct a comprehensive and defensible estimate of the final price. This detailed breakdown allows a business to move beyond surface-level price discussions with suppliers, shifting the dynamic from simple price acceptance to a collaborative discussion about cost drivers.
Key Components of a Should Cost Model
A should cost model is built by analyzing several distinct cost components that together form the total price of a product. These elements provide a structured way to deconstruct a supplier’s price into its fundamental parts.
- Direct Material Costs: This component represents the expense of all the raw materials and purchased parts that go into the final product. The analysis includes primary materials, such as steel or plastic resin, as well as any finishing materials like paint. An accurate calculation also accounts for material yield and scrap, recognizing that not all material purchased will end up in the finished good.
- Direct Labor Costs: Direct labor encompasses the wages and benefits paid to the workers directly involved in the manufacturing process. This calculation is based on the standard time required to complete a task and the prevailing labor rates for the specific skill level and geographic location. The model must also factor in labor efficiency.
- Manufacturing Overhead: This includes all the indirect costs associated with the production facility that are not directly tied to a single product. These costs are allocated across the products made in the factory and include expenses like factory rent, utilities, and the salaries of production supervisors and maintenance staff.
- Logistics and Freight: This part of the model covers the expenses required to transport the finished goods from the supplier’s factory to the buyer’s location. It includes packaging costs, warehousing fees, and the actual freight charges, which can vary significantly based on distance and shipping volume.
- General, Sales, and Administrative Costs: Often abbreviated as SG&A, this component includes the supplier’s non-manufacturing expenses. These are the costs of running the business, such as executive salaries, marketing expenses, and administrative functions. These costs are a legitimate part of the supplier’s overall cost structure.
- Supplier Profit Margin: The final component added to the model is the supplier’s profit margin. This is the amount the supplier adds to its total costs to arrive at the selling price. A reasonable profit margin can be estimated based on industry benchmarks and the level of competition in the market.
How to Create a Should Cost Model
Building a should cost model is a systematic process that transforms raw data into a strategic tool. The first step is to clearly define the scope of the analysis. This involves selecting a specific product or service to be modeled and understanding its specifications, from the bill of materials to the manufacturing processes involved. A narrow and well-defined scope is important for creating an accurate model.
With the scope defined, the next phase is intensive data gathering. This requires collaboration across departments, including engineering, procurement, and finance. Key data points include detailed material specifications, current market prices for raw materials, regional labor rates, and estimates for overhead and logistics costs. This information can be sourced from internal databases, third-party market intelligence providers, or by disassembling a product to understand its construction.
Once the data is collected, the calculation model is built, typically using spreadsheet software. The model is structured to mirror the key cost components: direct materials, direct labor, overhead, and others. Formulas are created to calculate the cost of each element, allowing for a clear breakdown of the total estimated cost.
The final step is to validate and refine the model. The initial results should be reviewed by internal experts to check for accuracy and reasonableness. Comparing the model’s output to existing supplier quotes or market data can help identify discrepancies and areas for improvement.
Benefits of Using a Should Cost Model
The application of a should cost model provides strategic advantages that extend beyond simple price reduction. Its primary benefit is the empowerment it gives to procurement professionals during supplier negotiations. Armed with a detailed, data-driven cost breakdown, negotiators can move the conversation from a general haggle over price to a specific, fact-based discussion about cost drivers. This strengthens their position and enables them to challenge a supplier’s quote with credible evidence, leading to more favorable pricing.
The insights generated from a should cost analysis also inform strategic sourcing and supplier selection decisions. By understanding the cost structure of a product, a company can better evaluate the efficiency and competitiveness of different suppliers. It may reveal that a supplier in a different region with lower labor costs is a more viable option, or that a vertically integrated supplier has a significant cost advantage.
The model also serves as a tool for identifying cost-reduction opportunities, both externally and internally. The analysis can pinpoint specific areas where a supplier’s costs seem inflated, opening the door for collaborative cost-improvement projects. Internally, the findings can guide product design and engineering decisions. By understanding the cost implications of different materials or manufacturing processes early in the design phase, engineers can make choices that optimize for cost-effectiveness without sacrificing quality.
Common Challenges and Best Practices
Implementing a should cost model presents several practical challenges. A primary hurdle is the availability and accuracy of data. Gathering the detailed information required, such as a supplier’s specific labor rates or overhead structure, can be difficult, as this information is often proprietary. Inaccurate or incomplete data can undermine the credibility of the model.
Another challenge is the complexity of the models and the resources required to build and maintain them. Developing a comprehensive model demands significant time and expertise in cost engineering and data analysis. For complex products, the modeling process can become highly resource-intensive, which can be a barrier for smaller organizations.
To overcome these challenges, fostering cross-functional collaboration between procurement, engineering, and finance teams is fundamental for gathering accurate data and validating assumptions. It is also advisable to start with simpler models focused on high-spend categories, gradually building complexity and expanding the program’s scope over time.
Continuously updating the model with the latest market data is necessary for its long-term relevance. Market conditions, such as raw material prices and labor rates, are constantly changing, and an outdated model will quickly lose its value as a negotiation and decision-making tool. By treating the should cost model as a dynamic instrument rather than a one-time project, organizations can ensure it remains a reliable source of insight for managing costs.