What is Should-Cost Analysis?
Should-cost analysis, also known as cost breakdown analysis, is the process of breaking down why a product or service costs what it does. This process considers factors such as the cost of materials, production and labor costs, profit margin, and market conditions such as demand and competition.
For procurement teams, should-cost analysis is necessary to gain a competitive edge in supplier negotiations. Should-cost analysis allows procurement professionals to understand what expenses go into the design, manufacturing, and delivery of a product; with this insight, professionals gain an understanding of fair pricing and can build relationships with suppliers based on mutually beneficial outcomes.
Read on to learn how to perform a should-cost analysis, and how to use should-cost analysis to improve your procurement function.
Steps in a should-cost analysis
A should-cost analysis allows the organization to estimate the product cost before an RFP is issued, providing a benchmark against which to measure competitive bids. It helps buyers understand the supplier’s cost structure and negotiate with suppliers collaboratively. A well-performed should-cost analysis can form the backbone of a long-term, mutually beneficial supplier relationship. Here’s how to get started.
Carry out an input study
An input study seeks to understand what parts are required to produce the final product. Imagine that your organization is planning to issue an RFP for sneakers. The input study would consider the features such as rubber soles, shoelaces, leather, and other basic inputs that go into constructing sneakers. The study should use design specs, assembly procedures, and testing to understand the full product lifecycle of the product.
Understand what processes are involved
Following the input study, a procurement team should analyze the processes that go into putting the product together. In the case of sneakers, for instance, what machinery and equipment are needed to assemble the shoes? What compliance requirements are involved? This piece should reveal the manufacturing locations, cost of labor, overhead costs, and any other equipment requirements that go into the product.
Perform cost modeling
Next, outline how these costs total according to annual volumes, batch quantities, and various units of measure. Here, you’ll want to test a number of different scenarios.
“Should-cost calculations inevitably depend on numerous assumptions, both physical (such as the machines used in fabrication, the number of workers on the assembly line, the cycle time to process, or the set-up time for a batch) and financial (such as material cost, labor rates, overhead rates, profit, and payment terms),” wrote McKinsey. “In many ways, the final cost number does not matter as much as the assumptions behind it, since those assumptions determine both the gap between should-cost and quoted prices, and the opportunities to close that gap.”
Cost modeling should result in a few key outcomes, specifically:
- Cost driver models
- Cost parameters, e.g. the range of costs between the theoretical minimum cost to the final quoted cost.
- The estimated time it takes each individual process
- The breakeven cost for different order quantities or production volumes
Consider which functions in the product development process are frozen in time (“upstream”) and unchangeable, versus fluid and actionable (“downstream”). This will give you areas in which to work with your suppliers collaboratively.
Create a report
Create a cost summary that includes a breakdown of processes, material, any other inputs, and process time. Include any non-recurring engineering cost estimates and the amortization costs. This report will inform stakeholders who evaluate competitor bids and set a baseline for your RFP process.
How to use should-cost analysis
The immediate benefit of should-cost analysis is that it empowers procurement teams to start to cut down on direct and indirect spend. Cost breakdown analysis allows procurement teams to see where they could capture potential savings by proactively working with vendors or partnering with new ones. Indirect spend can be reigned in by identifying the key suppliers you use and potential savings opportunities.
Likewise, McKinsey notes that organizations that use cost breakdown analysis in combination with an effective vendor-management approach are able to gain long-term benefits. Building strong supplier relationships allow procurement teams to consistently negotiate better agreements closer to the should-cost baseline.
Effective vendor management starts with data. And technology can help you triangulate the results of your should-cost analysis with vendor recommendations. Fairmarkit’s vendor recommendations tool surfaces the best vendors for your requests using historical purchase data, product and service category information, and vendor response behavior.
For more advice on optimizing your direct and indirect spend, check out Fairmarkit’s blog, The Source.