Procurement professionals face the challenge of ensuring the prices they pay for goods and services are fair and competitive. Lacking full transparency into a supplier’s cost structure makes it difficult to validate quotes and negotiate effectively. This reliance on historical pricing or competitive bids alone may not reflect the true cost of efficient production, leading organizations to seek more advanced cost analysis methods.
What Is a Should-Cost Model?
A should-cost model is an analytical tool used to calculate an estimated price for a product or service by summing all potential material costs, labor expenses, overhead, and a reasonable profit margin. The model aims to determine what a product should cost if the supplier operates with high efficiency, providing an evidence-based benchmark. This bottom-up approach analyzes each element that contributes to the final price.
This method differs from simply comparing price quotes or reviewing past purchase orders. While historical data shows what a company has paid, a should-cost model estimates what it should pay by focusing on underlying cost drivers. The objective is to close the gap between a supplier’s quoted price and the calculated efficient cost, providing a data-driven foundation for negotiation.
Key Components of a Should-Cost Analysis
Direct Material Costs
This includes the cost of raw materials and purchased parts that become a physical part of the final product, such as steel, plastic resins, or microchips. The analysis must account for material quantities and include an allowance for scrap and waste generated during the manufacturing process.
Direct Labor Costs
Direct labor includes the wages and benefits for employees directly involved in the production process. The calculation requires estimating the manufacturing time per unit and the necessary skill level. Labor rates vary by geographic region, so the model must use rates relevant to the supplier’s location.
Manufacturing Overhead
Manufacturing overhead includes all indirect costs associated with production that are not direct materials or labor. These are broken down into variable overhead, like electricity to run machinery, and fixed overhead, such as factory rent and equipment depreciation. Accurately estimating these costs can be a complex part of building the model.
Selling, General, and Administrative (SG&A) Expenses
These are the non-production costs necessary to run the business, including expenses related to sales teams, marketing, and administrative functions. In a should-cost model, SG&A is calculated as a percentage of the total manufacturing cost, based on industry benchmarks for similar companies.
Logistics and Transportation
This element accounts for the expenses required to transport finished goods from the supplier’s facility to the buyer’s location. The calculation considers factors like shipping distance, transportation mode, fuel surcharges, and any specialized packaging. These costs fluctuate with fuel prices and carrier capacity.
Supplier Profit Margin
A should-cost analysis is not designed to eliminate a supplier’s profit. A reasonable profit margin is included in the final calculation to ensure the supplier’s business remains viable. This margin is estimated as a percentage of the total calculated cost, with the percentage varying based on industry and product complexity.
The Benefits of Using a Should-Cost Model
Employing a should-cost model provides a data-driven foundation for procurement activities, leading to more informed decision-making. A primary advantage is strengthening a company’s position during supplier negotiations. By using fact-based conversations about specific cost drivers, procurement teams can challenge price justifications with quantitative data.
The detailed nature of the analysis allows teams to identify specific opportunities for cost savings. The model can highlight areas where a supplier’s quote seems inflated, whether in material costs or labor efficiency. This insight enables buyers to work with suppliers to target inefficiencies and explore joint cost-reduction initiatives.
Should-cost models also enhance a company’s internal financial planning. A more accurate understanding of what products should cost improves the accuracy of their budgets and financial forecasts. This allows for better resource allocation and helps the business anticipate market changes.
How to Implement a Should-Cost Model
The first step in implementation is to define the scope of the analysis. It is effective to start with a specific product or commodity category that represents a high area of spending or is of strategic importance to the business.
The next phase is to gather the necessary data for all cost components. This research-intensive step involves collecting information from sources like public commodity market data, labor rate surveys, supplier financial reports, and tear-down analyses of physical products.
With the data collected, the team can build the model, often using spreadsheet software. The model should have distinct line items for each cost driver, such as material type, labor hours, and overhead rates. Formulas are used to calculate the total cost based on the inputs, allowing for easy updates.
After the initial model is built, it must be validated by comparing its output to actual supplier quotes or market prices. If there are discrepancies, the team must investigate the root cause. The final step is using the model in negotiations as a tool to facilitate a transparent, data-based discussion with suppliers about cost structures.
Challenges and Considerations
Developing and using a should-cost model presents several challenges. A primary difficulty is obtaining accurate and granular data. Information on a specific supplier’s labor efficiency or overhead structure is proprietary, forcing analysts to rely on industry benchmarks and estimates which may not perfectly reflect reality.
Building a model is also a resource-intensive endeavor. It requires a considerable investment of time from skilled analysts with deep category expertise. For organizations without dedicated cost engineering teams, the effort can limit the practice to only the most important procurement categories.
The manner in which the model is used can also impact supplier relationships. If the analysis is presented as an ultimatum or a blunt negotiation tool, it can create an adversarial dynamic. The intent should be to foster a collaborative dialogue about cost optimization, not to unilaterally dictate pricing.