Procurement professionals have an array of practices and tools to leverage supplier-related value for organizations. These include contracts to memorialize critical terms, negotiations to uncover better cost positions, and of course, the RFQ/RFP to reveal the most competitive market price for a good or service.
While such practices and tools can help unlock supplier-related value, there are many more that procurement professionals can use. One often-overlooked tool is the should-cost calculation, which can uncover significant value for many organizations. In this article, we will highlight the benefits and methodology associated with the should-cost calculation to provide insight on how you can take advantage of its value for your organization.
What is the Should-Cost Calculation?
The should-cost calculation is a self-calculation of what a good or service “should cost.” As opposed to solely relying on the marketplace to provide the price of a good or service, a should-cost calculation enables procurement colleagues to construct a “bottoms-up” perspective on appropriate prices.
Procurement professionals typically issue an RFP to understand the cost of a good or service or leverage market pressure to drive an optimal price. While a properly executed RFP is an excellent tool to determine a market price, it sometimes fails to drive optimal price, as an RFP puts the power to determine market prices in the hands of participating suppliers. The issuing organization retains the right to negotiate its final price paid from the market options; however, the market price is still derived from collective supplier input. By executing a should-cost calculation before issuing the RFP, procurement colleagues create an independent view of the fair market value of a good or service. As such, they significantly increase leverage during the RFP negotiation stage.
To bring this concept to life, take an example of an indirect procurement team issuing an RFP for project-management services associated with the launch of a new product. A strong RFP would include detailed information on the project, a description of the new product’s attributes and a summary of launch timing. A typical procurement organization would then issue the RFP to a group of consulting and/or marketing support suppliers, and leverage the following sample quotes to determine what they are willing to pay for the service:
●Company A offers US$175,000 for three resources to support the project over six weeks ($243 an hour).
●Company B offers $165,000 for four resources to support the project over eight weeks ($129 an hour).
●Company C offers $150,000 for five resources to support the project over seven weeks ($107 an hour).
The average of all offers is $163,333 for four resources to support the project over seven weeks ($160 an hour).
Analyzing the above sample data may drive many procurement professionals to conclude that the optimal offer is Company C — or possibly negotiating aspects of Company A or B’s offers closer to that of Company C. While these conclusions could be strong and identify indirect savings or cost avoidance, greater value may be possible by first creating a should-cost estimate for the work.
Designing a Should-Cost Calculation
To execute a should cost, the first requirement is a thorough understanding of the strategic and tactical needs of your business partner. Using the product launch example, the strategic need is to successfully launch the new product, and the tactical need is to obtain project management services to support it. With this understanding, the procurement professional should (1) separate the project launch process into steps, (2) estimate the resources and hours associated with those steps, and (3) multiply the estimations by relevant rates for the work.
To continue with our previous example, let’s assume that a should-cost calculation revealed the following:
●Cost range: $120,000 to $135,000
●Range of hourly rates: $100 to $125
●Range of weeks: 6-8.
Using the detail above, a procurement professional is better positioned to negotiate with Company C, as even the highest point of the cost range is 10 percent less than its offer. This does not mean the supplier will automatically drop its price, but if the calculation was executed thoroughly, it becomes an additional pressure point for the negotiation.
As you work to start executing should-cost calculations, keep in mind that they can be quite daunting, particularly if you are not familiar with the going market rates for the work. By leveraging a combination of your business partner’s knowledge, your professional intuition and your historical RFP data, however, you will gradually become proficient at calculating reasonable baselines. Additionally, as your volume of RFPs in a category reaches significant levels, you can transform your operation from executing should-cost calculations to creating and using a should-cost database of prices, rates, hours and discounts associated with various services.
Should-cost calculations can be leveraged with direct materials as well. Using packaging materials as an example, many companies can reverse engineer components like plastic bottles to determine the exact amount of resin it contains. Combining that detail with an estimation of overhead, labor and a reasonable profit margin from auditing the production floors of both the supplier’s plant and your manufacturing operation will then enable you to challenge the direct material costs from your suppliers.
Leveraging Should-Cost Calculations
The should-cost calculation provides a tool to effectively challenge market prices from your supply base. A well-executed should-cost calculation will provide incremental leverage that immediately reduces any residual value that may have been left by solely using market prices in an RFP.
Further, as your organization’s sophistication with the process grows over time, should-cost calculations will gradually push your market prices down. By pushing through any initial challenges, you will create a practice that will evolve into a should-cost database and yield incremental value with each use. Happy calculating!