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Consider the typical price of a cup of coffee at your favorite coffee shop: how much should it be?
In the United States, a mug of black coffee costs roughly $2.70. Your expensive cold beers and frozen drinks, on the other hand, may cost twice as much. In Vietnam, the price is around $1.98. In Brussels, it costs around $2.90. In Oslo, a cup of coffee costs roughly $3.88.
What you’re willing to spend has little to do with how much it costs. Small farmers from coffee plantations in Brazil, Vietnam, and Columbia grow the beans. Then there’s a complicated system of exporters, roasters, distribution levels, and retailers. Because coffee is a commodity, its price fluctuates by the minute.
The coffee price has little to do with the growers’ production costs. Businesses add value to the product as it passes through the supply chain by roasting, packaging, and selling it.
Coffee is a personal illustration of the should-cost pricing model, which many businesses use to better understand the prices of their suppliers and negotiate competitive pricing. Do you realize how much it costs to produce the goods and services you buy?
As inflation and global pressures drive up prices, it’s one way for procurement professionals to ensure they’re getting the best bargain possible. Your company must have a better understanding of what goods and services cost beyond what you’re willing to pay.
Begin with a Blank Sheet of Paper
Should-cost modeling, also known as cost-breakdown or clean sheet analysis, allows procurement teams to gain real-time visibility into major cost drivers and negotiate fair price for critical components.
The study considers how much a product or service should cost in terms of raw materials, manufacturing labor, overhead, and markup.
Costs for almost everything have risen in these inflationary times, from fuel to labor to raw resources like sand, lumber, and copper. Previous pricing models just cannot compete. What model might have forecast a tenfold or more growth in ocean container rates? Or would the price of coffee skyrocket?
As their costs rise, your suppliers’ prices climb in response. Your company has most likely upped its prices as well.
Is anyone getting a decent bargain amid this domino effect of escalating prices? With recent record-breaking inflation, procurement organizations lack visibility into their cost drivers. Your company’s financial outlook may suffer as a result of poorly priced inputs.
Rather simply taking price increases as a cost of doing business these days, dive further into the data underlying the increased rates. You might be able to negotiate pricing that gives your company a competitive advantage in this turbulent market.
The dynamic nature of modern procurement operations and supplier relationships is reflected in your should-cost model. To coordinate product development, cost engineering, and procurement, procurement must drive cross-functional collaborative activities.
Thorough should-cost analysis necessitates sophisticated analytics, backed up by enhanced computing power and digital technologies that enable your organizations to address difficulties across the product lifecycle. Artificial intelligence technologies can assist huge organizations in sorting through thousands of products and examining previously missed cost opportunities in product catalogs or pricing sheets. With the correct tools, the analysis may be completed in hours or days rather than weeks or months.
Cross-functional collaboration and analysis will provide procurement professionals with insights into detailed cost factors, allowing them to construct an objective view of predicted price points and provide data for supplier negotiations and operational improvements.
For its $1 billion inventory of maintenance equipment and in-flight service items, American Airlines employed a model to generate bid bids for full-truckload, point-to-point transportation services. Each year, the airline issued over 500 RFQs, with quotations varying by up to 200 percent. The airline’s procurement team used analytics tools to create a model for the cost structure of each shipping route and negotiated costs based on the should-cost evaluation.
Avoid Making Assumptions
A should-cost analysis is frequently compared against a pricing quote from a supplier. Of fact, there is generally a chasm. What business would want to pay more than it is worth?
Every should-cost analysis is based on a set of assumptions. Some are based on extensive research. Others are based on educated guesswork. Others are merely educated assumptions. Procurement professionals are not always aware of the cost of materials, the complexity and configuration of production machinery, worker productivity, cycle times, and an acceptable profit.
According to McKinsey, there will be a theoretical minimum cost at some point. Given the assumptions you’ve established, it’s the smallest amount for which an acceptable product or service can be delivered. However, most war plans are destroyed when they come into contact with the enemy. Costs will deviate from the minimum as soon as the actual world enters the picture. Every stage of the process will result in higher prices than anticipated. Design considerations may necessitate more parts or more expensive materials, while vendor labor expenses may be greater. Distribution expenses are driven up by inventory and supply chain decisions.
On a smaller scale, a should-cost analysis can be used. Get a grasp of the true impact if a vendor passes on a rate hike citing higher transportation expenses owing to increased gasoline prices. If trucking expenses are 40% higher yet transportation charges are just 10% of the product’s landing price, don’t accept a 40% price rise overall.
Assume you’re working on new items or modifying existing ones. In that situation, the analysis must take place early enough in the process to allow for cost-effective decisions. Some judgments are far enough upstream to be frozen, while others remain actionable.
Keep in mind that should-cost models are difficult to construct. Automation and artificial intelligence systems can handle the heavy lifting in terms of analysis. Pricing models will be developed by research into industry trends and vendor interviews.
Organizations that use a should-cost analysis frequently achieve immediate cost savings in their products and services. To find the biggest savings, however, the procurement organization must recognize that it will be a continuous exercise rather than a one-time effort.
Remember that every taste of coffee is supported by a complex supply chain.