Should-Cost Modeling Helps Control Costs

Let’s say you’re the purchasing manager for your company, and you buy a fair amount of customized products.  Word has come down that costs need to be reduced by 15-20 percent.  Oh, and of course you are not allowed to cut corners on quality, performance or any metric.  What to do?

This is a conundrum in which purchasing managers routinely find themselves, especially since the black cloud of the economic downturn took hold.  Increasingly, managers are turning to “should-cost” modeling as a way to gain better insight into costs, as well as a bit of leverage with suppliers during negotiations for customized products.

Should-cost modeling is not new – in fact it was developed by the Department of Defense as a way to try and trim costs of some highly specialized manufacturing products.  While most businesses don’t have the time, manpower and financial resources of the DoD, we can all learn a lesson from their approach.

Should-cost modeling, as defined by Sourcing Innovations, refers to “the process of determining what a product should cost based upon its component raw material costs, manufacturing costs, production overheads, and reasonable profit margins.  Knowing roughly what a product should cost transfers pricing power from a supplier to a purchaser, especially for strategic purchases.”

The should-cost concept is especially helpful for businesses in need of “customized” materials that can’t be cost-compared on the open market.  By drilling down to determine component and other costs, a purchaser can have much greater visibility and awareness of a product’s true costs.

“If the difference between the approximated should-cost and actual cost of a product is roughly 20 percent or more,” Sourcing Innovation notes, then the buyer could have an opportunity for considerable savings.  But if the savings is less than 10 percent, then the quoted price is probably fair.

Tim Reis, sourcing manager for industrial cleaning products manufacturer Continental Commercial Products, says the key to successful implementation of this strategy is to do your homework and make sure you have your facts straight.  This is essential because “you know with 100 percent certainty that the supplier will challenge your assumption in attempt to turn the cost discovery negotiation process back to their side.”  You need to be certain, he added, that a supplier can raise only minor objections to your should-cost model, and will have no choice but to negotiate a new price.