Should-cost analysis
Should-cost analysis builds up what a product or service should cost based on analysis of materials, labor, overhead, and reasonable profit margin. This independent cost estimate provides leverage in negotiations by demonstrating what fair pricing looks like and identifying where supplier quotes may include excess margin or inefficiency.
Examples
Component cost model: Before negotiating with a supplier, procurement builds a should-cost model for a machined part: raw material cost based on weight and material price, machining time estimated from part complexity, labor rates for the supplier's region, typical overhead and margin. The resulting should-cost informs negotiation positioning.
Service pricing analysis: A should-cost for an outsourced service estimates labor hours by task, applies appropriate labor rates, adds overhead and margin, and compares to supplier quotes. The analysis reveals whether quotes are competitive or include excess margin.
Supplier proposal evaluation: When receiving quotes significantly higher than should-cost estimates, procurement asks suppliers to explain the variance. Valid reasons might include capabilities the model didn't capture, while unexplained gaps suggest negotiation opportunity.
Definition
Should-cost analysis shifts the negotiation dynamic from simply pressing for lower prices to fact-based discussions about cost drivers. When buyers demonstrate understanding of cost structure, suppliers are less able to maintain inflated pricing.
Building credible should-cost models requires understanding of manufacturing processes, access to cost data (material prices, labor rates, equipment costs), and analytical capability to construct models. The quality of analysis depends on input accuracy and understanding of the supplier's actual processes.
Should-cost models have limitations. Every supplier's actual cost structure is different, and models rely on assumptions and averages. Should-costs work best for understood, stable processes where cost drivers are transparent. Novel technologies or unique supplier capabilities may not fit standard models well.
Procurement uses should-cost analysis for supplier negotiation, proposal evaluation, make/buy decisions, and identifying cost reduction opportunities. The discipline of constructing should-cost models also deepens procurement's understanding of what drives costs in their supply base.
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