Using Cost Models to Drive Insight
I spoke at a meeting of Procurement Leaders in Boston today, and had the opportunity to share thoughts with a number of procurement professionals from organizations as diverse as Decker Shoes (producers of Uggs), MascoTech, TorontoDominion, Guardian Life, and AARP. During the discussion, we spent a good deal of time discussing should-cost analysis as a tool to drive supplier negotiations, and establish a basis for building long-term contracts.
A should-cost model attempts to quantify and isolate all of the elements associated with the Price and Total Cost of Ownership of a finished good or service. Part of the goal of an analytical approach is to uncover the elements of price, including profit. Suppliers are entitled to profit, that is why they (and we) are in business. We are not out to eliminate profit. However, it is our job of procurement leaders to understand and manage reasonable profit as well as the other costs associated with the particular good or service. In an ideal situation we can actually achieve lower prices and provide higher vendor profit by co-managing cost…and truly build a win-win relationship.
Several key points emerged in the discussion that ensued, including a role play focused on effective supplier performance measurement and the relationship of total cost of ownership:
– Many suppliers do not have a good grasp on the cost to produce a product or provide a service. They have always been able to “ballpark” the cost estimate, throwing in a lump sum percentage for overhead. Many have also never been asked to provide such a breakdown – so asking for one will drive them to be more responsive and open to becoming more transparent and accurate on costs.
– Should cost models will never be 100% accurate – but they need to be directionally correct. Utilizing a combination of supplier-provided information, comparisons of supplier to supplier responses to RFP’s, and an internally developed should-cosst model constructed based on third party data will provide an upper and lower bound for cost analytics. The model doesn’t have to be completely accurate – but needs to be accurate enough to drive the conversation and identify areas of cost that can be impacted.
– Not all costs are controllable. As such, we need to identify areas of cost that we can impact. Some of this may involve engagement of internal stakeholders who are driving specifications and who may be asked to provide rationale for doing so. Over-specification of tolerances or service requirements is a major driver of cost.
– Should cost analysis can drive supplier innovation and ideas to take cost out of the product or service. Suppliers should be encouraged to provide ideas for reducing total cost, which can also drive their operational efficiencies and reduce complexity. This is one of the biggest untapped sources of cost savings, and one that is typically overlooked by traditional procurement organizations.
One of the participants emphasized – how do I get started? I don’t know how to do this and have never done it before….my response is – there is no better time than now! Jump in, and start to build it – start with a simple cost model, with just a few categories. Do your research with whatever information you can find internally or externally – then take it to your internal partners and suppliers. You’ll be surprised how accurate it can be!