How to Leverage Different Should-Cost Models

Amid soaring inflation and rising manufacturing costs across the world, it is important for procurement organizations to track the parameters that drive should cost models and how they can leverage these should cost models.

Some of the key indicators on the should cost drivers are:

Cost Model Evaluation

This gives buyers an insight into how prices have fluctuated and what kind of trend they can expect in future pricing.

The various factors driving these costs include: -

• Material
• Manpower
• Administrative
• Overhead
• Manufacturing
• Other costs

Let’s look at a case where 10,000 metric tons of wheat is produced in a specific region. 

• The cost evaluation is based on the current cost versus the should cost of 10,000 MT of wheat.
• The cost is further sliced and diced into total cost versus unit cost.
• This provides us an insight into the fluctuating cost associated with growing wheat. It also helps estimate how much wheat production would currently cost you versus what it should cost you.

These numbers will help you estimate:

• The base cost and the base quantity to produce wheat.
• The cost margins you would have and the margin percentage.

Associated Market Indices

The cost model evaluation also provides buyers with more information and understanding of the wheat market. Therefore, there will be data pulled in from within the organization or externally to highlight the associated market Indices.

These indices will help drive should-cost estimates and margins. For example, logistics, fuel, commodities, labor, fertilizer, harvesting, etc.

You need to understand these market indices associated not only with wheat production but also storage and distribution.

Associated market indices are just the means, but critical from an analytical standpoint to manage the should-cost model.

There are other parameters too, such as:

Top Cost Drivers:

Cost drivers are a part of various cost models. Without cost drivers, it would be challenging to manage cost estimation, risk assessment and forecasting, etc. Yes, there is an element of associated market indices that provides us this information. However, cost drivers and market indices go hand in hand with cost models. Everything is connected.

Would you not want to know -- based on historical data, benchmarking analysis and market indices -- what are your cost drivers that influence current costs versus the should cost?

Cost Estimation:

Cost estimation is similar to the above process but is more detailed. There is a lot of drilling down into costs that influence your product or service or whether you’re a manufacturer or producer or reseller.

Cost estimation provides a near-estimated cost based on several factors such as historical pricing data (based on the number analytical data points associated with the should cost model), and the baseline cost analysis. These are dependent on strategic sourcing activities, savings methodologies, number of negotiating factors, economic factors, product/service categorization, market trends and analysis. And the list goes on.

Parametric Modelling:

The above parameters under cost evaluation can also be termed parametric modelling. It is used to determine in simple terms the historical cost analysis based on different parameters, some of which we just stated above.

It helps you determine the cost of a product or service even if there is no historical data. The cost model evaluation and associated influencing factors would provide a near-accurate estimate of your current and should cost.

What-if Scenario:

This looks at factors identified above but that can alter costs. For example, natural disasters, wars and pandemic. We should also factor in these events into the cost.

Therefore, what-if scenarios are a critical measure to insure and secure risks. It may not fully mitigate risks but provides an insurance against such risks occurring even if the chance is small.

The Bottom Line

There are many other models and influencing factors that drive should cost. It all depends upon the markets your organization is targeting. It also depends upon whether you a manufacturer, producer, buyer or reseller. The bottom line is that should cost models help determine costs based on many influencing factors, markets, trends and other conditions.

Once cannot accurately determine should cost. However, you can accurately and efficiently provide a near-accurate narrow range that determines should cost.

Author: Apurva Malewar

Read the first part of the blog — "Should-Cost Modeling Made Simple".