Best Practices

Using Should-Cost Models for Actionable Transparency

Modeling is powerful. It not only lets procurement know what price they should be paying, it also provides compelling arguments during negotiations.

Not everything a company buys is as simple as a tin can or a pallet where it is possible to track the cost of a single commodity like steel or wood. Many things are made from a combination of materials and justify the building of a should-cost model.

Don’t stop reading! Should cost modeling is much simpler than you may think.

Modeling is powerful. It not only lets procurement know what price they should be paying, it also provides a compelling argument for negotiations.

It is also surprisingly easy to do. Copper cable is a good example. It is made from copper and some sort of insulator, such as PVC. A should cost model will combine these two commodities and one other input: the supplier’s gross margin (overheads, profits and unknowns). It may seem that a supplier’s gross margin is not a procurement professional’s concern, but it absolutely is – suppliers have to make a profit to be healthy. And healthy suppliers make the best supply chains.

Start off by taking an educated guess at the cost importance of each raw material. Assuming the copper accounts for about 35% of the price of the cable, and the PVC costs 15%, the remaining 50% is the supplier’s gross margin.

Clearly, a simple model like this won’t be totally accurate from the start, but that’s a good thing. Think of the first-pass model as a “discussion piece” to show and explain to your supplier’s sales rep. At this stage, the main point to make to your rep is that the model is fair to both parties. Explain how the model recalculates prices as input costs change, but holds his company’s margins constant to make sure their overhead coverage and profitability are preserved and respected.

Because of price creep, first-pass models will almost always calculate lower prices than the supplier is proposing. Show the model (with back-up assumptions) to the sales rep. He or she likely cannot make a new deal on the spot and will ask for some time to respond. Provide a copy of the model so the rep can share it with his management team.

Sales reps usually respond by asking for corrections to the model (which is a good thing). Make them on the spot and show the revised output to your rep. Good news – revised outputs rarely reverse your original model’s findings. Better news – since a corrected model now includes the supplier’s input, they own the results too!

More importantly, the model becomes a mutually agreed to pricing mechanism going forward. The supplier’s costs are transparent and his margins are protected.

No more hassling over price!

Should-cost modeling creates a negotiating process that favors the buyer but is also fair and constructive for both parties. It leads to lower costs and a stronger, more resilient supply chain. By modeling, procurement forces suppliers to play fair and guards against price creep while preserving their margins and covering their overheads.

There is another advantage: the best suppliers (aka low-cost producers) will like transparency – and so will the buying organization. Procurement will be creating a long-term competitive advantage by building a strong, low-cost, robust supply chain.

Call to Action:

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