What is Should-Cost Analysis in Procurement?

Should-cost analysis in procurement involves a full examination of cost components to estimate and evaluate the reasonable price of a product.

By Hugo Britt | May 7, 2024

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If you, as a consumer, have ever exclaimed, “How can they charge that much when it probably only cost them ($X) to make??,”  then you have performed a very basic version of should-cost analysis.

You know the feeling: outrage at a seller’s aggressive markup (a markup percentage is the percentage of the selling price not represented in the cost of the goods) that really pushes people’s credulity (and wallets) to the limit.

One of the most recognizable examples is a bag of movie theater popcorn, which may cost around 37 cents to make but commonly sells for $5, or a 1,275% markup. Brand-name drugs (don’t get me started) can be marked up 200% to 3,000%, a cup of coffee is often marked up by 300% over its cost to make, and wine at a restaurant is also usually marked up by 300%. 

As consumers, there’s usually nothing we can do about a significant markup. Standing at the movie theater snack bar arguing with the popcorn guy about should-cost and gross profit margins won’t get us very far.

But in the world of procurement, should-cost analysis is a valuable exercise that can: 

  • Provide a benchmark for negotiating prices with suppliers
  • Identify potential cost-saving opportunities, and
  • Ensure that the prices being quoted are fair and reasonable.

Should-cost analysis in procurement is a methodology used to evaluate and estimate the reasonable cost of a product, service, or solution.

What is should-cost analysis?

Should-cost analysis in procurement is a methodology used to evaluate and estimate the reasonable cost of a product, service, or solution. It involves a comprehensive examination of cost components, such as materials, labor, overhead, profit margins, and other relevant factors.

Should-cost analysis isn’t just an academic exercise. It can be used for: 

  • Negotiation: Should-cost serves as a powerful tool during negotiations with suppliers. By estimating the reasonable cost of a product or service, buyers can challenge suppliers’ pricing proposals and negotiate more effectively to secure fair and competitive prices.
  • Supplier Evaluation: Should-cost analysis provides a basis for evaluating suppliers objectively. By understanding the cost structures and pricing models of different suppliers, organizations can compare and select suppliers based on their competitiveness, value-added services, and alignment with cost targets.
  • Benchmarking: Should-cost analysis allows organizations to establish benchmarks for pricing and cost performance. It helps in comparing current or proposed prices against industry standards, historical data, or market benchmarks to assess the reasonableness and competitiveness of pricing.
  • Contract Management: Should-cost analysis can be used as a reference point for contract management activities. It helps in monitoring and validating pricing adjustments, contract renewals, and change orders by ensuring that the agreed-upon prices align with the estimated reasonable costs.
  • Supplier Relationship Management: Should-cost analysis supports the development of strong supplier relationships. By engaging suppliers in cost discussions and sharing insights from the analysis, organizations can foster collaboration, transparency, and continuous improvement in the supply chain.

And, if you’re also a manufacturer:

  • Cost Reduction: Should-cost analysis helps identify cost-saving opportunities by examining the various cost components of a product or service. It enables organizations to explore areas for optimization, value engineering, and process improvements to drive cost reduction initiatives.
  • Product Design and Development: Should-cost analysis can be used during the product design and development phase. By analyzing the cost implications of different design choices, your designers can make informed decisions that balance functionality, quality, and cost considerations.

Fair and reasonable pricing

Suppliers need to make a profit, too. The purpose of should-cost isn’t to force suppliers to accept the barest margin over the cost of the manufactured product or service. Instead, the focus should be on agreeing on a fair and reasonable price.

Understanding the need for suppliers to cover their overheads and make a reasonable gross profit margin is an important aspect of should- cost. Suppliers incur various expenses, such as rent, utilities, salaries, research and development costs, and marketing expenses, to operate their businesses efficiently.

Additionally, they need to generate a profit to sustain their operations, invest in growth, and provide value to their shareholders or owners. It’s therefore crucial to recognize that suppliers must cover their overhead costs and earn a reasonable profit margin to maintain a healthy and sustainable business.

In other words, don’t use should-cost as a “gotcha” technique or a blunt weapon for beating down suppliers on price. Best practices include conducted a detailed analysis (rather than guesswork) that examines all cost components, market trends, and industry benchmarks. Gather reliable and up-to-date data from multiple sources, including historical data, market research, and supplier cost breakdowns.

Make sure the supplier knows what you’re up to. Engage them in open dialogue to gather valuable insights about their cost structures and cost drivers to validate your assumptions.

Mistakes to avoid in should-cost analysis

  • Inadequate Data or Assumptions: Relying on incomplete or inaccurate data, or making flawed assumptions, can lead to errors in your cost estimations. Ensure data accuracy and validate assumptions through research and collaboration.
  • Overlooking Hidden Costs: Failure to consider hidden costs, such as quality issues, warranty expenses, or environmental regulations, can result in underestimating the true cost of a product or service.
  • Neglecting Market Dynamics: Ignoring market dynamics, such as supply and demand fluctuations, currency exchange rates, or geopolitical factors, can impact cost estimations and negotiation outcomes.
  • Lack of Supplier Collaboration: Not involving suppliers in the analysis process can lead to incomplete or biased results. Engage suppliers to gain a better understanding of their cost structures and negotiate effectively.
  • Ignoring the Supplier’s Need for Profit: While striving for fair pricing, it is essential to recognize that suppliers require a reasonable profit margin to sustain their business operations and invest in growth.
Ready to give it a try? Should-cost analysis is a versatile tool that can help procurement optimize costs, negotiate effectively, evaluate suppliers, and make better-informed decisions.

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