One powerful approach, that has been around for many years, is Should Cost analysis. This method not only aids in predicting the price a supplier should meet but also provides insights into how a price should evolve over time, ensuring procurement teams are equipped to secure the best value in their sourcing endeavors. 

Understanding Should Cost Analysis

Should Cost analysis is a cost estimation technique used by procurement professionals to determine what a product should cost to manufacture. It considers various factors, including materials, labor, overhead, and profit margin, among others. By breaking down the product into its components and analyzing each cost element, buyers can gain a clear understanding of what drives the price and where there might be room for negotiation.

Why Should Cost Matters

1. Informed Negotiations: Armed with detailed cost insights, buyers can approach supplier negotiations with confidence, challenging prices that seem inflated and discussing costs transparently.
2. Strategic Sourcing: Should Cost enables more strategic sourcing by identifying potential suppliers who can meet desired cost structures and by fostering competition based on value rather than just the lowest bid.
3. Price Evolution Over Time: Understanding the factors that affect production costs allows buyers to anticipate how prices might change due to market trends, technological advancements, or changes in raw material costs. This insight is invaluable for long-term contracts and future sourcing strategies.

Implementing Should Cost in Your Procurement Strategy

Incorporating Should Cost analysis into your procurement strategy involves several steps, starting with identifying key categories or products for analysis. Collaboration with engineering or product teams is crucial to understand the technical aspects that influence cost. Additionally, staying updated with market trends and supplier capabilities can refine your Cost Models over time.

Should cost and Kraljic’s Matrix

Incorporating Should Cost analysis into the framework of the Kraljic Matrix offers procurement professionals a more nuanced approach to managing their supply chain and enhancing supplier negotiations, especially when it comes to identifying and strategizing around different types of categories. The Kraljic Matrix categorizes procurement items based on two dimensions: profit impact and supply risk, dividing them into four quadrants — non-critical items, leverage items, bottleneck items, and strategic items. Integrating “Should Cost” analyses within this matrix can significantly improve decision-making processes across these categories, particularly regarding quadrant on the right side of matrix the where market competition do not guide you to the right price level. 

Example Should Cost

Let’s consider an illustrative example of a Should Cost analysis for a simple product: a high-quality stainless steel kitchen knife. This example will break down the costs associated with manufacturing and delivering the knife to the buyer, helping procurement professionals understand the price they should expect to pay.

Product: High-Quality Stainless Steel Kitchen Knife

1. Raw Materials:

Stainless Steel (blade and handle): The cost of stainless steel required for one knife, considering waste and efficiency in cutting and shaping.

Cost: $2.50

2. Manufacturing Costs:

Forging and Shaping: Cost of labor and machine use to forge the steel into the blade shape and refine the edges.

Cost: $1.20

Heat Treatment: Strengthening the blade through heat treatment to enhance durability.

Cost: $0.80

Handle Assembly: Adding the handle components and finishing touches.

Cost: $1.00

Quality Control: Inspection and testing to ensure each knife meets quality standards.

Cost: $0.50

3. Overhead Costs:

Factory Overhead: Including utilities, maintenance, and indirect labor costs allocated to each knife.

Cost: $1.00

Administrative Costs: Administrative expenses allocated to each product.

Cost: $0.70

4. Packaging:

Materials: Cost of materials for packaging the knife securely.

Cost: $0.30

Labor: Cost of labor to package the knife.

Cost: $0.20

5. Logistics:

Transportation: Cost to ship the knife from the manufacturing facility to the distribution center or direct to the buyer.

Cost: $0.80

6. Profit Margin:

Supplier’s Profit Margin: The desired profit margin that the supplier aims to achieve on each knife.

Margin: 15% of total cost before profit.

Calculation:

Let’s calculate the total cost before profit and then apply the profit margin. Total Cost Before Profit: $2.50 (Raw Materials) + $1.20 (Forging) + $0.80 (Heat Treatment) + $1.00 (Handle Assembly) + $0.50 (Quality Control) + $1.00 (Factory Overhead) + $0.70 (Administrative Costs) + $0.30 (Packaging Materials) + $0.20 (Packaging Labor) + $0.80 (Logistics) = $9.00

Applying Profit Margin: 15% of $9.00 = $1.35

Total Should Cost Price: $9.00 (Total Cost Before Profit) + $1.35 (Profit) = $10.35

In this “Should Cost” analysis, the procurement professional can determine that the price they should expect to pay for a high-quality stainless steel kitchen knife is approximately $10.35. This analysis provides a clear breakdown of the costs involved in producing and delivering the knife, empowering the buyer to negotiate effectively with suppliers and make informed purchasing decisions.

The Importance of Product Knowledge

Understanding the product you are purchasing is foundational to grasp its relevant cost components, a principle that stands at the core of effective procurement and strategic sourcing. This knowledge not only enables procurement professionals to conduct detailed Should Cost analysis but also enhances their negotiation capabilities, ensuring they secure the best possible value for their organization.

1. Identifying Cost Drivers: Deep product knowledge allows buyers to identify the primary cost drivers, which could range from raw materials and manufacturing processes to logistics and packaging. Knowing what contributes most significantly to the cost of a product enables targeted strategies to control or reduce these expenses.
2. Enhancing Supplier Negotiations: Armed with a thorough understanding of the product and its production process, buyers are in a stronger position to challenge suppliers on pricing. They can question cost allocations and negotiate more effectively when they know exactly what goes into making the product and what each component should cost.
3. Spotting Opportunities for Cost Savings: Understanding the product intricacies allows procurement professionals to identify opportunities for cost savings, whether through alternative materials, improved design, more efficient manufacturing processes, or optimized logistics.
4. Assessing Quality and Compliance: Knowing the product extends to understanding the quality standards it must meet and any regulatory compliance it must adhere to. This is crucial for ensuring that cost-saving measures do not compromise product integrity or lead to regulatory issues.
5. Strategic Sourcing: With comprehensive product knowledge, procurement can move beyond price negotiations to strategic sourcing. This involves selecting suppliers that can offer the best overall value, considering factors like innovation, quality, reliability, and sustainability, in addition to cost.

Gaining Product Knowledge

Gaining in-depth product knowledge requires a multifaceted approach:

• Collaborate with Internal Stakeholders: Engage with product design, engineering, and manufacturing teams to understand the product’s specifications, design rationale, and manufacturing process.
• Supplier Engagement: Work closely with suppliers to gain insights into their manufacturing processes, cost structures, and any challenges they face.
• Market Research: Stay informed about market trends, raw material price fluctuations, and technological advancements that could affect product costs.
• Continuous Learning: Attend industry conferences, workshops, and training sessions to keep up-to-date with new materials, technologies, and procurement strategies.

Understanding of cost components and their price evolution

In procurement, knowledge is power. Understanding the product you are buying in-depth equips you with the necessary insights to dissect its cost components accurately, engage in meaningful negotiations with suppliers, and ultimately secure optimal value for your organization. This approach not only contributes to cost efficiency but also fosters innovation, sustainability, and strategic supplier relationships, aligning procurement activities with broader business objectives.

A noteworthy player in this field is the company Prognos, an organization offering specialized services around Should Cost analysis, helping businesses uncover cost-saving opportunities and strengthen their negotiation positions.

Prognos specializes in providing “Should Cost” analysis services, offering procurement teams an edge in their sourcing and negotiation processes. By leveraging Prognos’s expertise, companies can benefit from:

• Detailed Cost Breakdowns: Prognos delivers comprehensive cost analyses, identifying areas where savings can be achieved without compromising on quality.
• Market Insights: With access to extensive market data, Prognos helps buyers understand the broader market forces at play, influencing the cost of materials and components and its evolution over time.
• Customized Reports: Tailored to specific industries and products, Prognos’s reports equip buyers with the precise information needed to make informed decisions regarding the specific category or product family.

Summary Should Cost Analysis

Should Cost analysis is not just about cutting costs; it’s about spending smarter and building more sustainable, value-driven supplier relationships. With the support of services like those provided by Prognos, procurement teams can navigate the complexities of sourcing and negotiations with greater assurance and success. As we move forward, the ability to analyze and understand costs will become increasingly critical in achieving competitive advantage and operational excellence in procurement.

If you want to learn more about sourcing and conduction a sourcing event we recommend LHTS’ Sourcing basics – get started as Tactical buyer. A bundle of courses providing the basic tactical procurement knowledge needed to deliver as a Tactical buyer. Learn standard sourcing process, supplier development, supplier audit and more.

As alternative you can the online course about Should cost analysis. It is sponsored by Prognos, free and accessible immediately after login in your Dashboard.

For more information on how Prognos can assist your organization in leveraging Should Cost analysis for better procurement outcomes, visit Prognos.

What Wikipedia say about Cost break down.

Cost based and Value based pricing explained

About Learn How to Source

Learn How to Source (LHTS) is an online platform based in Sweden, offering a range of procurement courses accessible globally. It serves as a community where procurement experts share their knowledge through online courses, designed for various experience levels from introductory to expert. Courses are concise, about 30 minutes each, and cover different aspects of procurement, tailored for different buyer roles. The courses focus on practical knowledge, presented by seasoned professionals, and include quizzes and certificates. They can be accessed from any device, emphasizing microlearning for flexibility and efficiency.

Note: Illustration is created by CHAT-GPT on February 7, 2024.