Supplier prices are not always easy to evaluate. A quotation tells the buyer what a supplier wants to charge, but it does not necessarily explain why the price is at that level or how the price should develop when material, labor, energy, or other input costs change.
This is where should cost analysis can support procurement.
By breaking a product or service into relevant cost elements, a buyer can build an independent view of the underlying cost structure. The purpose is not to calculate one unquestionable “correct price.” The purpose is to understand the major cost drivers, test supplier assumptions, follow cost development, and enter supplier negotiations with better facts.
For Tactical Buyers, this makes should cost analysis an important method when market competition alone does not provide enough price transparency.
LHTS Procurement Framework
Role: Tactical Buyer
Process: Sourcing preparation, quotation evaluation, supplier negotiation, and price follow-up
Level: Advanced
Related course: Should Cost Analysis by Prognos
Quick answer: What is should cost analysis?
Should cost analysis is a method used by procurement professionals to estimate what a product or service should reasonably cost based on its underlying cost drivers.
A buyer identifies relevant cost elements such as raw material, labor, manufacturing processes, overhead, logistics, and supplier profit. The analysis can then be used to evaluate quotations, understand price changes, prepare negotiations, and create a more fact-based supplier dialogue.
A should cost is therefore best viewed as an estimate or cost range based on defined assumptions, rather than an exact statement of what a supplier must charge.
What is should cost analysis?
A supplier quotation provides a price. A should cost analysis tries to understand the economics behind that price.
For a manufactured product, those economics could include:
- raw materials;
- production processes;
- direct labor;
- machine costs;
- energy;
- scrap and yield;
- tooling;
- quality control;
- packaging;
- logistics;
- factory overhead;
- administrative costs; and
- supplier profit.
The exact structure will depend on what is being purchased.
The buyer’s task is therefore not simply to collect as many cost elements as possible. The important question is:
Which cost drivers actually explain the supplier’s price?
For one product, raw material may dominate the cost. For another, labor content may be critical. For a highly automated product, machine utilization and production volume may have a greater impact. For a service, labor rates, productivity, staffing levels, and overhead may be more important than physical materials.
A useful should cost model reflects the economics of the specific category being sourced.
Why should cost analysis matters in procurement
Procurement frequently needs to make decisions without perfect price transparency.
Competitive bidding can provide strong information about the market price when several qualified suppliers are competing under comparable conditions. But not every sourcing situation provides that transparency.
There may be few qualified suppliers. The specification may be unique. Switching costs may be high. The incumbent supplier may have strong technical knowledge or a difficult-to-replace position. A supplier may also request a price increase and justify it with general statements such as increasing raw material, energy, or labor costs.
In these situations, should cost analysis can give the Tactical Buyer another source of information.
1. Prepare fact-based supplier negotiations
A cost model helps the buyer move the conversation from:
“Your price is too high.”
to questions such as:
“What has changed in the cost structure?”
“How much of the product cost is actually exposed to this raw material?”
“What index supports the requested increase?”
“Has productivity changed since the previous agreement?”
“What assumptions are being used for labor, yield, or overhead?”
The quality of the negotiation improves when both sides can discuss the factors behind the price.
2. Evaluate supplier quotations
A should cost model can help identify where a supplier quotation differs from the buyer’s expectations.
The objective is not automatically to reject the quotation. A difference should create a question.
Perhaps the buyer has underestimated a manufacturing step. Perhaps the supplier has lower production volumes than expected. Perhaps logistics, quality requirements, tooling, risk, or capacity constraints explain part of the difference.
The analysis therefore helps the buyer identify where further investigation is required.
3. Understand price development over time
Should cost analysis is not only useful when establishing an initial price.
Once the major cost drivers are understood, the buyer can follow how they change.
If a significant share of the product cost is aluminum, steel, polymers, energy, or another market-driven input, an appropriate index can support discussions about how that part of the price should develop.
The same principle can apply to labor rates or other measurable cost components.
This becomes particularly relevant in longer supplier relationships and contracts with price-adjustment mechanisms.
4. Identify cost-reduction opportunities
Understanding the cost structure can also move the discussion beyond price negotiation.
A high-cost element may create opportunities to investigate:
- alternative materials;
- specification changes;
- improved manufacturing methods;
- higher production volumes;
- improved yield;
- reduced scrap;
- packaging changes;
- logistics optimization;
- design changes; or
- process improvements.
Should cost analysis can therefore support both commercial negotiation and cross-functional cost improvement.
Where should cost analysis fits in the procurement process
Should cost analysis is mainly a Tactical Procurement tool and can support several stages of the Source-to-Contract process.
A simplified sequence is:
Market understanding → sourcing preparation → RFQ → quotation evaluation → negotiation preparation → supplier negotiation → contract and price follow-up
Should cost analysis can contribute throughout this sequence, but its strongest role is usually during market understanding, quotation evaluation, and negotiation preparation.
Before the RFQ
The buyer can start identifying important cost drivers before requesting quotations.
This can improve the RFQ because procurement understands which commercial information may be useful to request from suppliers.
During quotation evaluation
The buyer can compare quoted prices and, where appropriate, supplier cost breakdowns against the internal should cost model.
Large differences become topics for clarification.
Before negotiation
The cost model helps procurement identify:
- important assumptions;
- cost elements that require evidence;
- market data or indexes that should be prepared;
- areas where supplier arguments may need to be challenged; and
- potential cost-reduction opportunities.
During supplier negotiation
The analysis becomes a tool for asking better questions.
A good should cost analysis should not be used simply to tell the supplier that procurement knows its costs better than the supplier does.
Instead, use the model to create a structured commercial discussion.
How a Tactical Buyer builds a should cost model
A useful should cost analysis usually starts with product understanding rather than a spreadsheet.
Step 1: Understand what you are buying
The buyer needs to understand the specification, manufacturing process, supply chain, and commercial requirements sufficiently well to identify the important cost drivers.
This often requires cooperation with:
- engineering;
- product development;
- manufacturing;
- quality;
- logistics;
- finance; and
- suppliers.
Procurement does not need to become the technical expert in every detail. But the buyer must understand enough to recognize what drives cost.
Step 2: Create a cost breakdown structure
Break the product or service into logical cost elements.
For a manufactured component, a simplified structure could be:
Material + conversion + labor + overhead + packaging + logistics + supplier profit
A more advanced model may include additional factors such as machine time, cycle time, scrap, yield, tooling, depreciation, energy consumption, or production volume.
The required level of detail depends on the decision you are trying to make.
Step 3: Identify the major cost drivers
Not every cost element deserves the same attention.
If raw material represents 50% of the estimated cost, improving the material assumption may be more valuable than debating an administrative overhead representing 2%.
Focus the analysis on the variables that materially influence the result.
Step 4: Build and document assumptions
A should cost model is only as useful as its assumptions.
Typical assumptions might include:
- material consumption;
- material price;
- scrap rate;
- production cycle time;
- labor hours;
- labor rate;
- machine rate;
- production volume;
- overhead allocation;
- freight cost; and
- supplier markup or profit.
Document where each important assumption comes from.
The source could be market information, engineering data, historical purchasing data, supplier information, quotations, benchmarks, price indexes, or another estimation method.
Step 5: Test the model
Do not assume that the first calculation is correct.
Ask what happens if the production volume changes, raw material prices increase, productivity improves, or another assumption moves.
This sensitivity analysis helps identify which assumptions procurement needs to understand most accurately.
Step 6: Compare the model with supplier information
The difference between the supplier’s quotation and the should cost estimate is where the commercial investigation starts.
The objective is not simply:
Supplier price – should cost = savings target.
Instead ask:
Why is there a difference?
Understanding that difference is often more valuable than the initial calculation itself.
Example of a simple should cost analysis
Consider an illustrative example: a high-quality stainless-steel kitchen knife.
The purpose of the example is not to establish an actual market price. It is to demonstrate the logic of building a cost model.
Raw material
Stainless steel for the blade and relevant handle components, including expected material loss:
$2.50
Manufacturing
Forging and shaping:
$1.20
Heat treatment:
$0.80
Handle assembly:
$1.00
Quality control:
$0.50
Overhead
Factory overhead:
$1.00
Administrative cost allocation:
$0.70
Packaging
Packaging material:
$0.30
Packaging labor:
$0.20
Logistics
Transportation:
$0.80
Total estimated cost before supplier profit
The estimated cost before supplier profit is:
$9.00
Assume, for this simplified example, that the supplier applies a 15% markup on cost.
15% × $9.00 = $1.35
The estimated should cost becomes:
$9.00 + $1.35 = $10.35
The important output is not simply the figure of $10.35.
The more valuable output is the cost structure behind it.
The buyer can now ask:
- Is $2.50 a reasonable material assumption?
- What amount of stainless steel is required?
- What yield and scrap rate have been assumed?
- Are the production steps correct?
- Are factory overhead assumptions reasonable?
- Could production volume change the conversion cost?
- Is logistics included on comparable delivery terms?
- Is the supplier’s commercial return reasonable for the situation?
Changing the assumptions will change the should cost.
For that reason, an Advanced buyer should normally regard the result as an evidence-based estimate or range, not an absolute truth.
Markup and profit margin are not the same thing
This distinction is important when building a cost model.
In the example above, adding 15% to the $9.00 cost gives:
$9.00 × 1.15 = $10.35
That is a 15% markup on cost.
A 15% profit margin calculated as a percentage of the final selling price would produce a different result.
If the cost is $9.00 and the supplier requires a 15% margin on sales:
$9.00 ÷ (1 − 0.15) = approximately $10.59
Procurement professionals should therefore clarify whether commercial assumptions are expressed as markup, margin, or another measure before using them in a should cost model.
Product knowledge is the foundation of good should cost analysis
One of the most important lessons in should cost analysis is that procurement cannot understand cost without understanding the product or service.
Product knowledge helps the buyer determine:
- which materials matter;
- how the product is manufactured;
- which processes consume time or energy;
- what quality requirements influence cost;
- where waste or yield losses occur;
- what logistics are required; and
- what changes could reduce total cost.
This is also why cross-functional cooperation matters.
Engineering may understand technical alternatives. Manufacturing may understand production methods. Logistics may understand freight and packaging. Quality may understand testing and compliance requirements.
Procurement combines these perspectives with supplier and market knowledge to build a commercial view.
Using price indexes to understand cost development
Should cost analysis becomes especially useful when procurement needs to understand how a supplier’s price should change over time.
Suppose a supplier requests an 8% price increase and explains that raw material prices have increased.
A buyer should not automatically accept or reject the request.
Instead ask:
- What share of the product price is exposed to that raw material?
- Which index best represents the material?
- How much has the relevant index actually changed?
- What time period should be compared?
- Are other cost elements moving in the opposite direction?
- Has productivity changed?
If material represents 30% of the relevant cost base, a 10% increase in the material itself does not automatically justify a 10% increase in the total product price.
The buyer needs to understand the weighting of the cost driver.
This is where cost breakdowns and indexes become powerful negotiation tools.
Should cost analysis and the Kraljic Matrix
The Kraljic Matrix helps procurement consider supply risk and business impact when selecting an appropriate sourcing approach.
Should cost analysis can complement that thinking.
It becomes particularly useful where price transparency or competitive tension is limited.
This can often occur in bottleneck and strategic supplier situations, where alternative suppliers may be difficult to access or switching may involve substantial risk.
However, should cost is not limited to those categories.
In leverage categories, where competition may already be strong, should cost analysis can help procurement understand the cost drivers behind bids, test long-term price development, and prepare for negotiations after the competitive sourcing event.
The important principle is therefore not:
“Use should cost in one specific Kraljic quadrant.”
Instead:
Use should cost when deeper cost understanding can improve the procurement decision or supplier negotiation.
How to use should cost analysis in supplier negotiations
Should cost analysis is most effective when it improves the quality of the commercial discussion.
Imagine that a supplier requests a price increase because of “market volatility.”
A weak procurement response is:
“We cannot accept the increase.”
A stronger response could be:
“Help us understand the cost drivers behind the requested increase. Our analysis indicates that raw material represents approximately 35% of the relevant cost structure. The index we follow has increased by 4% since the agreed reference period. How does this result in the total increase you are requesting?”
The buyer is now asking the supplier to connect the requested price to the underlying economics.
This creates a fact-based negotiation.
The supplier may have valid information that is missing from the buyer’s model. If so, procurement should learn from it and update the analysis.
A good should cost model is therefore not only a negotiation weapon. It is also a structured way to learn.
Common mistakes when using should cost analysis
Treating the should cost as an exact supplier price
A cost model contains assumptions. Presenting the result as unquestionable fact can damage credibility.
Use the result to ask questions and understand differences.
Starting with the spreadsheet instead of the product
Detailed formulas do not compensate for poor understanding of what is being purchased.
Start with the product, process, specification, and supply market.
Using outdated or irrelevant data
Indexes, labor rates, material prices, freight assumptions, and currency relationships may change.
Important inputs need to be relevant to the time period and geography being analyzed.
Focusing on insignificant cost elements
A model can become unnecessarily complex.
Spend analytical effort where it can materially change the result.
Confusing markup and margin
Commercial terminology matters. Make sure calculations match the terminology being used.
Ignoring supplier-specific circumstances
A benchmark factory and the actual supplier may have different volume, equipment, location, productivity, capacity utilization, quality requirements, or risk.
Those differences may be commercially relevant.
Using should cost only to demand a lower price
Cost transparency can also identify opportunities for specification changes, process improvements, productivity discussions, logistics changes, or supplier development.
The objective is better value, not simply a lower number.
Failing to maintain the model
A should cost created once and never updated quickly loses value.
The model becomes more useful when important assumptions and indexes are reviewed as markets change.
Should cost analysis is a tool for better procurement judgment
Should cost analysis gives procurement an independent perspective on supplier economics.
It can help a Tactical Buyer understand what drives a quotation, identify the assumptions behind price changes, prepare negotiation questions, and explore cost-reduction opportunities.
But the model should not replace professional judgment.
A supplier’s price is influenced by more than its theoretical manufacturing cost. Capacity, risk, intellectual property, market position, required investment, business attractiveness, innovation, service level, and commercial strategy may all influence the final offer.
The buyer’s objective is therefore not to prove that one spreadsheet contains the “correct” answer.
The objective is to become better informed.
That is the real strength of should cost analysis.
Continue learning: Should Cost Analysis by Prognos
If you want to develop this method further, the Learn How to Source Should Cost Analysis by Prognos course provides the structured knowledge foundation for this article.
The course is designed for the Advanced level and Tactical Buyer role and develops topics including:
- should cost analysis;
- cost breakdown structures;
- cost elements;
- parametric estimating;
- analogous estimating;
- learning curve analysis;
- market, price, and cost indexes;
- selecting relevant indexes; and
- using should cost information to prepare supplier negotiations.
The natural next step after understanding the principles in this article is to practice how cost data can be translated into a stronger commercial position before meeting the supplier.
Related LHTS learning
To continue the learning journey, useful related topics include:
- The Kraljic Matrix — understand how supply risk and business impact influence sourcing strategy.
- Sourcing Process – Preparation — understand the work required before approaching the supply market.
- Carve-Back Negotiation — apply cost information when addressing supplier price increases.
- Cost-based and value-based pricing — understand different perspectives on how prices are established.
Frequently asked questions about should cost analysis
What is should cost analysis in procurement?
Should cost analysis is a method for estimating what a product or service should reasonably cost based on relevant cost drivers such as material, labor, manufacturing, overhead, logistics, and supplier profit. Procurement uses the analysis to improve price understanding and prepare fact-based supplier negotiations.
How do you calculate a should cost?
Start by understanding the product or service and identifying the major cost elements. Estimate the quantity and cost of each relevant input, add conversion and overhead costs where appropriate, consider logistics and other commercial factors, and then include a reasonable supplier return. Document the assumptions behind the calculation.
What should be included in a should cost model?
The answer depends on the category. Typical elements may include material, labor, machine cost, energy, manufacturing processes, scrap, yield, overhead, packaging, logistics, and supplier profit. The model should concentrate on the cost drivers that materially influence the price.
What is the difference between a supplier price and a should cost?
The supplier price is the commercial amount the supplier offers to sell for. A should cost is the buyer’s estimate of the underlying economic cost based on available information and assumptions. Differences between the two should be investigated rather than automatically treated as supplier overpricing.
When should procurement use should cost analysis?
Should cost analysis is particularly useful when price transparency is limited, when competition alone does not provide sufficient market information, when a supplier requests a significant price change, or when procurement needs deeper understanding of cost drivers before negotiation.
Can should cost analysis be used for services?
Yes. The cost structure will be different from a manufactured product. For services, important drivers may include labor categories, hourly rates, staffing levels, productivity, utilization, management overhead, tools, travel, and other delivery costs.
How can should cost analysis support negotiations?
It helps the buyer identify which cost assumptions to question, what evidence to prepare, which indexes to review, and where differences exist between the supplier’s proposal and the buyer’s understanding. This creates a more fact-based negotiation.
Is a should cost always the price the supplier should accept?
No. A should cost is an estimate based on assumptions and available information. Supplier-specific circumstances and market conditions can justify differences. The analysis should guide investigation and negotiation rather than be treated as an unquestionable market price.
Conclusion
Should cost analysis helps procurement move from negotiating only around a supplier’s quoted price to understanding the economics behind that price.
For the Tactical Buyer, the method can strengthen quotation evaluation, negotiation preparation, price-development discussions, and cross-functional cost improvement.
The most important principle is simple:
Do not use should cost analysis only to produce a number. Use it to understand the cost drivers, challenge assumptions, ask better questions, and make better procurement decisions.
That is where should cost analysis creates real value.