Should-cost analysis

- Wouldn't it be great if the next time you bought a car, you knew exactly what it cost the company to make that car and deliver it to the dealer? Not the suggested retail price, not the invoice amount, the exact cost of the car, broken down into specific categories. It would definitely help you to negotiate the price for that car. As a buyer for your company, that's the kind of information you're looking for to determine a fair and reasonable price to pay the supplier. You can get that information in one of two ways: By receiving a cost breakdown from your supplier or by doing a should-cost analysis yourself. Here's an example of how this works. In an ideal world, your supplier will provide every detail of their costs. With this supplier cost breakdown, you can do a little research and plan your upcoming negotiation. For example, you notice that their cost for copper is about 10% more than the cost you find on the producer price index, or PPI for copper. The PPI provides buyers with average prices for materials and commodities like copper and oil and wheat. You also notice that copper has been rising historically at a rate of 2% per year, but your supplier is listing a cost that is 5% greater than their cost last year. Because you have their exact cost breakdown and you have done your research, you certainly want to ask him about both of these copper related costs when you negotiate a contract. In short, why is he charging so much for copper? You do this research and compare process with every major item in their cost breakdown, and you are ready to sit down at the negotiation table. More often than not, however, the supplier will not give you this detailed cost breakdown. Perhaps he's concerned that you might use this information to negotiate a better price with another supplier; one of his competitors. Or perhaps he simply does not want you to know his profit margins. In any case, you do not know his actual costs, so you must take your best guess at what they might be. This is where a should-cost model comes in. In this situation, you research the cost of copper and every other major component and material. You research labor rates in this industry and average overhead and typical profit margins and anything else you can find in the public domain. For example, the Bureau of Labor Statistics can tell you average labor rates for technicians or operators in this particular industry and in your region also. Now, after doing all this research, you can determine if the supplier is charging the proper price based on your should-cost analysis. You have the quote and you have what it should cost in your opinion. You might say to the supplier that their quoted price for the item is 40% more then you believe it should cost. I think copper should be $1 per pound. What are you paying for copper? Again, this is the beginning of a conversation. You may discover that you priced copper out at grade three, but your engineers have specified grade one and that's the majority of the cost difference. Bottom line is that a should-cost analysis is your best guess. You could be wrong, so you don't want to come on too strong. Now here's the really cool thing about a well done should-cost analysis and negotiation. If you can get the supplier to talk openly with you about the major components and materials and labor costs, then at the end of this negotiation, you actually come away with a pretty good understanding of the supplier's costs. The exact information he would not share with you previously. So for the next negotiation with this supplier, your should-cost analysis has become a supplier cost breakdown. The supplier has now actually shared their costs with you. So you simply need to update some key figures. Doing a should-cost analysis is a lot of work because most products are a complex mix of materials, components and labor. You don't put in this kind of effort on every single negotiation. Now, although it is a lot of work, the good news is that it is pretty easy to practice this skill. Pick an item you buy routinely, break it down into major categories and research prices. Everything you need is available in the public domain.