Should-Cost Modeling Made Simple

Should cost modeling and analysis is a method of arriving at a pre-determined cost estimate for a finished product by breaking down various cost dependencies and finding a pre-determined final price. 

Should-cost models allow us to measure what it takes to build a finished product. The name 'should cost’ says it all — what something should cost versus what it actually costs.

These costs can include:

• Overhead costs (rent, lease, utilities, salaries, etc.)
• Variable costs (shipping, labor, direct materials, storage, etc.)
• Supplier margins 
• Sunk costs 
• Production costs

In all honesty, should-cost models, if done right, provide simplicity in costing. 

That being said, one should also be aware that these cost models (which we will come to later) will not provide 100% cost accuracy. 

They provide a near-accurate cost estimate by using various factors on how that cost is determined, through one or more than one should-cost model and/or analysis. 

To be more precise, it gives the user a ballpark figure of what should the cost be. 

Also Read: How Should-Cost Modeling Can Help Utilities Optimize Costs and Boost Profitability

What Kind of Benefits Do Should-Cost Models Provide? 

Let’s take the example of the cost of making a simple product like a jump rope or skipping rope that everyone uses to stay active.

The design of a jump rope and the quality of the rope determines how efficient and effective your jump rope is going to be. Therefore, you have heavy ropes, speed ropes, beaded ropes, leather ropes, etc. 

Now, based on the fundamental cost estimate, let’s figure out the should cost. 

Model 1: Should Cost of Manufacturing a Product 

• To produce ropes in bulk, you need a manufacturing unit and a factory that can make various types of ropes.
• You need a machine to make the handles 
• You need labor to assemble the ropes
• You need a warehouse to store the ropes
• You need packaging material to pack them
• You need boxes to ship the ropes
• You need logistics

Now, try to estimate the cost of one rope by adding your margin from a manufacturing point of view. You, of course, need economies to scale. 

Model 2: Should Cost of Assembling, Repackaging and Marketing the Product

• Let’s say you purchase ropes in bulk from a manufacturer (Model 1)
• Assemble it in your warehouse/office/apartment
• You will now add your brand to that rope
• You will advertise the rope on affiliate websites (e-commerce)
• You will market, advertise and promote the product on social media and through PR initiatives 
• You have your own branded packaging (another distributor provides it)
• You finally put it out there in the market

Try adding a cost to your rope now with the margins you need. 

The user in Model 2 will now want to estimate what the cost of each rope should be if she contracted the manufacturer from Model 1. You get the point here.

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

Positives of Should-Cost Modeling:

• Should cost helps users negotiate better with suppliers. 
• Suppliers still make a profit but it’s more realistic.
• There is more visibility into the costs that can help in estimating savings.
• Should cost helps to stay on top of market volatility and determine costs in case of price fluctuations.
• You build good supplier relationships.
• Should cost helps manage supply chain functions.
• Should cost drives Innovation 
• Should cost helps optimize costs
• Should cost helps in forecasting spend, budgets, expenses and revenue.

Negatives of Should-Cost Modeling:

• Should cost models are not always 100% accurate. 
• Sometimes they are not easily understood by everyone 
• The modeling process can get complicated due to bureaucracy and red tape in certain regions

Yet, should cost remains a good starting point in any organization, and best-in-class procurement and supply chain platforms are an excellent way to leverage these models. 

We all need guidance, a benchmark to know where to start, how to start and when to start. How do I gather data? Is there any historical data within my organization? If I don’t have it, how do I proceed? If there is no internal historical data, there is data available in the market. A lot of consulting firms can help provide such data, and soon you can start capturing data internally and maintain a repository for future use.

Have the right people analyze the data. They can find out missing parts, gaps, risks and improve key data indicators that will help with any should-cost model. 

Remember: should cost can be applied anywhere and everywhere. It’s not complicated unless you make it. 

Author: Apurva.Malewar@gep.com