Three reasons to use Should Cost Modelling
to drive better procurement outcomes
We deal with many procurement clients seeking answers to questions around their suppliers and pricing: Is the pricing in accordance with industry standards? Is the supplier providing optimum quality relative to price? How should I address a sudden price increase from the supplier’s side? Are there other suppliers in the market offering the product or service at a better price?
A good starting point for answering these fundamental questions is Should Cost Modelling (SCM), a process which helps build a holistic picture of the economics behind the production of a product.
Giving businesses the edge
By establishing the cost structure of the inputs sourced from suppliers and the finished product – including raw material costs, manufacturing costs, process overheads, labour costs, etc. – a procurement organisation can gain an estimate of the real product cost.
The main use of this intelligence is to provide an evidence base to support supplier and cost negotiation conversations, however SCM can be applied more widely, to aid strategic decision-making and forecast future impacts on product prices. Here we explore these scenarios, with examples of how CPG companies have derived real business benefits.
Should Cost Modelling is helpful in both contract re-negotiations with existing suppliers and engagement with new suppliers. A view of the product cost-breakdown provides a good foundation for discussions and gives negotiating power to a procurement organisation, by highlighting potential areas of buyer advantage – is it in labour costs, raw materials, production costs or somewhere else? Any cost reduction, or avoidance of cost increases, has significant value in CPG, a sector which experiences relatively low margins.
But what if a Should Cost Modelling exercise reveals a huge gap in the estimated and the supplier’s pricing and negotiations do not result in the desired effect? In those situations, CPG companies can seek alternate suppliers in the market, using an estimate of the product cost to empower the business in both supplier identification and negotiation.
- Support for strategic decision-making
A cost-structure breakdown of a final product gives more transparency into how much each commodity affects the final product price. SCM can give insight into the change in the production cost of a bag of chips when including or excluding an additional spice. CPG companies can use insights like these to make informed strategic decisions. For example a company may decide to change the formulation of a product if it finds out that a substitute ingredient could lower the final product cost without affecting taste or quality. What if environmental sustainability is a strategic goal for the business? The business can check the cost differential with the inclusion of biodegradable packaging by inputting the various packaging prices into the dynamic cost model. The results enable a category manager to compare and contrast alternative options and make an informed decision based on a range of criteria.
- Forecast impact on product price
It is difficult to forecast a product price if its historical price isn’t available. But because of the dynamic nature of a Should Cost Model, if the price of all the commodities used to manufacture a product can be forecast, then the future product price can also be estimated. For instance, take the example of a beef patty. Secondary research cannot yield a forecasted price of the patty, but the forecasted price of raw beef is available. Input that in the model, along with all the other costs (manufacturing, labour, overheads, etc.) and the model will give a forecast price for a beef patty. A regression analysis can also be used to determine how the change in the price of a commodity will impact the final product price. Therefore if a CPG company can forecast the cost of a commodity, it can also forecast how that change will impact the cost of the final product.
A Should Cost Model can be of great use to category managers in their bid to add value to the business – bringing wider strategic insights which go beyond the traditional remit of procurement.
With additional inputs from Deepak Panwar, Manager, The Smart Cube