Should cost modeling is 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 form a supplier to a purchaser, especially for strategic purchases.
To the best of my knowledge, there are not a lot of solution providers out there that specialize in the productions of tools and methodologies for should-cost models, but one such vendor is Akoya, a company that Spend Matters‘ own Jason Busch likes to blog about frequently (in such posts as “In-sourcing” Outsourcing, Direct Materials Costing and Spend Management, and Akoya: Next Generation Spend Analytics?). Recently, Akoya produced a short paper entitled Analytically Derived Should-Cost Information is Critical for Improving Product Margins: An Example for Cast Parts that, despite being focused on a specific commodity, had some sound generically applicable advice for should-cost modeling.
When a purchaser knows what a part should-cost, then she knows what she should pay for it. Thus, this knowledge is critical for identifying mis-priced parts, parts with high markups, parts improperly sourced with vendors who are not suited to produce the part, and overly complex parts in need of simplification and re-engineering. Knowledge of should-cost is critical for efficient design, sourcing and procurement. And, as indicated above, should-cost is much more than the price of metal. In other words, until you know roughly how much you should be paying, you do not know whether or not there is enough of a savings opportunity to justify a considerable sourcing effort.
If the difference between the approximated should-cost and actual cost of a product is roughly 20% or more, than that product represents a considerable savings opportunity and should be part of a strategic sourcing initiative in the near future. If the difference is 10% or less, than you are probably getting a good price on the product and should not spend too much time trying to negotiate a better price when much more significant savings opportunities await. If the difference is somewhere in the middle, then, once you have tackled all of your high discrepancy commodities, you should refine your analysis and tackle any for which the expected difference increases.
What should you do when you identify a potential savings opportunity from a should-cost analysis? According to Akoya, three things. First, the parts can be submitted to the vendors for re-quoting. It is frequently the case that when asked for a re-quote that the vendors will recognize and correct pricing problems. Second, it is sometimes the case that the parts are sourced with a vendor that cannot efficiently produce the part. In these situations, the part can be resourced with other, more appropriate suppliers. Third, the part may be redesigned to reduce its complexity and thereby reduce its manufacturing costs.