Should-Cost Modeling: Because You Must Get the Cost Right

Understanding the drivers behind raw materials and manufacturing costs is imperative to creating cost savings opportunities for procurement and supply chain organizations.

However, this isn’t an easy task.

How do you determine the underlying factors that impact the input costs of products or services you want to procure at the best prices?

The task is more challenging since input costs tend to constantly change based on market conditions.

What is Should-Cost Analysis?

A should-cost model is a documented calculation of an estimated price of a product or service that you create by researching all material costs, labor costs, overhead costs, and profit margins.

Should-cost analysis is a powerful cost estimation tool that empowers procurement and supply chain professionals to furnish viable evidence to suppliers as part of negotiation efforts, helping them achieve a final cost estimate that is closer to their target price.

This requires cross-functional collaboration between product development, cost engineering and supply chain teams.

Insights obtained via such analysis help the teams understand detailed cost drivers and create an objective and fact-based view on expected price points.

Also known as cost breakdown analysis and cleansheet costing, should-cost analysis supports strategies for effective supplier negotiation and operations improvement. The broad objective is to close the gap between what a product ‘should cost’ and what it ‘does cost’ (the price quoted by the supplier or the distributor).

The challenges in should-cost analysis

Arriving at a product’s ‘should cost’ is not easy. That’s because assessing a product’s underlying cost drivers can be a complex task.

The challenge is to develop a should-cost model that can estimate projections for costs that are market driven, such as a change in the price of steel.

Besides, for a new product, it must be created quickly to facilitate the fastest possible time to market. Linking to external and internal sources of data to dynamically update cost is another key challenge.

Using should-cost modeling software

Today, procurement and supply chain teams conduct should-cost analysis with the help of artificial intelligence-powered technology that can aggregate and process historical and real-time data from multiple sources.

The technology can automate the process to provide detailed cost estimates at different stages of the procurement process. Algorithms help determine various cost estimates with minimum manual input, thereby reducing the possibility of error.

This should-cost model software can integrate easily with the existing cost modeling infrastructure. It can work seamlessly with internal analytics and market intelligence teams. Additionally, after the one-time setup, future models can work on their own and only require ongoing management.

How is should cost calculated?

Here are some brief steps involved in determining a product’s should cost:

1. Collect data:

The first step involves identifying the product or service data from multiple sources such as enterprise resource platforms, bill of materials, invoices, spend data, open data sources and third-party databases.

2. Expand cost:

The next step is to expand upon all components of the key cost drivers, namely materials, labor, conversion costs, overheads, logistics and profit.

3. Determine cost drivers:

Assess all the available internal and external sources to determine the underlying cost drivers.

4. Develop cost insights:

Analyze the information obtained via multiple sources to develop meaningful cost insights that can add business value.

Finding the true cost of goods:

Should-cost modeling can be an extremely valuable tool to determine the true cost of goods and services purchased at any point of time.

Here are some of the key benefits of the model:

⚬ Creates a fact-based negotiation platform:

Should-cost modeling provides a deep understanding of supplier cost drivers. You get a clear visibility of the entire cost structure, including labor, equipment, overhead and profit.

⚬ Enhances transparency:

Stakeholders from different teams, such as category, sourcing and finance, can create and view structured and multi-layered should-cost models. With complete visibility into the cost structure, they will be better placed to identify suppliers that deserve long-term relationships.

⚬ Reduces costs:

By providing information about cost components, cost drivers and causal factors, should-cost modeling enables procurement leaders to eliminate maverick spend and reduce unnecessary costs. Done right, it can help a business realize incremental savings.

⚬ Provides a base for negotiation:

Advanced should-cost methodologies provide a competitive edge to supplier negotiations by helping to understand what it really costs to design, manufacture and deliver a product or service. If a supplier’s quoted price exceeds your estimate, the should-cost model sets the stage for future negotiations.

⚬ Build long-term supplier relationships:

By shifting the focus from price to cost, should-cost analysis can help a business and its suppliers find mutually beneficial solutions. It can also benefit suppliers by helping them identify areas where they can improve and reach a better cost position. With insights into cost drivers and economics, you can better collaborate — and build long-term relationships — with suppliers.

⚬ Accelerate product development:

Digital should-cost models allow design engineers to generate robust cost projections without having to wait for supplier quotes. This allows engineers to design and test multiple product design alternatives and speed up development.

In some companies, the widescale adoption of should-cost analysis requires a cultural shift as well. At times, some teams consider the calculation of should cost as merely an academic exercise. What is required in such cases is a change in the mindset and the ability to convince staff that should-cost analysis is a practical model that can be achieved over time.

Companies across several industries now leverage should-cost analysis to enhance their cost savings. Combined with an effective vendor management program, it can help firms realize significant savings on an ongoing basis.