Should-Cost Modelling: Your Secret Weapon Against Inflation

Behind every consumer asking, “how much does it cost?” is a team exhaustively analysing “how much SHOULD it cost?” and inflation will really put them to the test!

Consider the average cup of coffee in your favorite coffee house: how much should it cost? 

In the U.S., the average mug of black coffee runs about $2.70. Of course, your fancy cold brews and frozen drinks may be twice as much. In Vietnam, you’ll pay about $1.98. In Brussels, about $2.90. For a cup of Java in Oslo, it’s about $3.88. 

What you’re willing to pay has little relation to what it costs. Small farmers grow the beans from coffee plantations in Brazil, Vietnam, and Columbia. Then there’s a complex chain of exporters, roasters, distribution layers and then the retail store. Coffee is a commodity, so the price changes by the minute. The rate for coffee bears no connection to the farmers’ production costs. As it moves through the supply chain, businesses add value through roasting, packaging and marketing. 

Coffee is a personal example of the should-cost pricing model that many organisations use to better understand their suppliers’ costs and negotiate competitive pricing. Do you know the costs of the inputs that go into the products and services you procure? 

As inflation and global pressures drive prices higher, it’s one way for procurement pros to know they’re getting the best possible deal. Your organisation must have a deeper insight into what goods and services cost beyond what you’re willing to pay. 

Start With a Clean Sheet

Should-cost modeling, also known as cost-breakdown or clean sheet analysis, enables procurement teams to develop real-time visibility into primary cost drivers and negotiate reasonable pricing for essential materials.  

The analysis reviews what a product or service should cost based on raw materials, manufacturing labor, overhead and markup costs. 

In these inflationary times, the costs for most everything have skyrocketed, from fuel to labor to raw materials like sand, lumber, and copper. Previous pricing models just can’t keep up. What model could have predicted ocean container rates would increase 10 times or more? Or the cost of coffee would boil over? 

As their costs rise, your suppliers are raising prices in response. Your company has also likely raised its prices. 

Amid this domino effect of rising prices, is anyone getting a good deal? With the rapid, record-setting inflation of recent months, procurement organisations don’t have enough visibility into their cost drivers. Your organisation could struggle with its financial forecast due to incorrectly priced inputs. 

Rather than accepting price hikes as a cost of doing business these days, dig deeper into the numbers behind the new rates. You may be able to secure pricing that puts your organisation at a competitive advantage in this volatile marketplace. 

Use the should-cost as a process and toolset to calculate a projection of the total cost of a given product if efficient manufacturing and distribution practices are followed. 

The analysis may range from a simple estimation that itemises raw material estimates to software that analyses cost elements at a granular level for product development and manufacturing. 

A “should-cost” is a projection of the total cost of a given component if efficient manufacturing and distribution practices are followed. Procurement can bring a competitive edge to supplier negotiations by understanding the total costs to design, manufacture, and deliver a product or service. 

Your should-cost model reflects the dynamic nature of modern procurement operations and supplier relationships. Procurement must lead cross-functional collaboration efforts to align product development, cost engineering, and procurement. 

Thorough should-cost analysis requires sophisticated analytics, supported by advanced computing power and digital applications that enable your organisations to tackle the challenges along the product lifecycle. Artificial Intelligence applications can help large enterprises sort through thousands of products and examine potential cost opportunities previously unnoticed in product catalogs or pricing sheets. With the right tools, the analysis could take hours or days – instead of weeks or months on a manual basis. 

Cross-functional teamwork and analysis will give procurement leaders insights into detailed cost drivers to create an objective view of expected price points and provide information for supplier negotiations and operations improvements. 

American Airlines used a model to develop bid quotes for full-truckload, point-to-point transportation services for its $1 billion inventory of maintenance equipment and inflight service items. Each year, the airline issued about 500 RFQs and quotes varied by as much as 200 percent. Using analytics software, the airline’s procurement team developed a model for the cost structure for each shipping route and negotiated prices based on the should-cost assessment. 

Be Aware of Assumptions

Often a should-cost analysis is compared to the supplier’s price quote. There’s usually a gap, of course. What company would want to pay more than they think it’s worth? 

Underlying every should-cost analysis is a layer of assumptions. Some are based on thorough research. Others are based on informed speculation. Others are barely more than wild guesses. Procurement pros don’t always have insight into the cost of materials, the complexity and setup of machines used in manufacturing, labor productivity, cycle times, and a reasonable profit. 

At some point, there will be a theoretical minimum cost, according to McKinsey. It’s the lowest amount that an acceptable product or service can be delivered, given the set of assumptions you have made. However, most battle plans don’t survive contact with the enemy. As soon as the real world intrudes on the process, costs will stray from the minimum. Every step in the process will drive the prices higher than estimated. Design decisions might call for more parts or expensive materials, while vendors’ labor costs might be higher. Inventory and supply chain decisions drive up distribution costs. 

A should-cost analysis can be used on a smaller scale. If a vendor passes on a rate increase citing higher transportation costs due to increased fuel prices, get an understanding of the actual impact. If trucking costs are 40% higher, but transportation costs are only 10% of the landed price of the product, don’t accept an overall 40% price increase. 

Suppose you’re involved in developing new products or updating existing ones. In that case, the analysis has to occur early enough in the process to make decisions that will impact costs. Some decisions are upstream enough to be frozen, while others are still actionable. 

Keep in mind that should-cost models are not easy to build. Automation and artificial intelligence tools can do the heavy analytical lifting. Research into industry trends and vendor interviews will build the pricing models. 

Organisations that adopt a should-cost analysis often see immediate savings in the cost of the products and services. However, to find the most savings, the procurement organisation must realise that it will be an ongoing process rather than a one-time effort. 

Remember, as you raise your cup of coffee, there’s a complex supply chain behind every sip.

The Faculty Roundtable is proud to host a complete Strategic Cost Management masterclass series with the brilliant Jimmy Anklesaria – find out more here.