Methods to estimate the costs of your supplier

In previous articles I talked about the should cost model philosophy and about costs. This article continuous on those articles. With respect to the article on the should cost model philosophy, this article can be seen as part of the ‘methods’. It briefly introduces the methods which can be used to extract data to fill in the level of the cost-elements of a price.

There are several ways of estimating the amount of the costs varying from very general methods to very specific ones. At one extreme is the method of taking the industry averages and by doing that keeping it very general and non-specific. On the other hand you can dive into the (production) processes of your supplier and exactly calculating the costs involved with the executed activities. Important considerations which should be taken into account with respect to the general versus specific cost calculation methods are the time and information available and the precision of the estimation required. Furthermore it is also dependent on the goal of the should cost model; do you exactly want to know what constructs the price of a certain product? Or do you just want to have an indication of the price in order to trigger the supplier for a discussion? Furthermore several other aspects should be taken into account when choosing methods to identify the costs of a product such as product characteristics (e.g. is it a standardized product or a custom-made product?) and the number of suppliers available (which parties has the (bargaining) power in the buyer-supplier dyad, is it expected to change in the coming years?).

As already mentioned; modeling a should cost price can be done varying from very superficial to very specific (detailed), dependent on the time and resources available and the accuracy required for reaching your goal. Next, three ways of should cost modeling are discussed varying from a more superficial and short manner of should cost modeling to a more specific and time-consuming method. Although all three methods could be very valuable, the real strength is in the triangulation of the three methods. If all three modeling methods result in more or less the same product price, the reliability of the estimated price can be stated as high.
The most quick, but also the most superficial, should cost modeling method is based on industry averages. Although it is a quick method, it does not take certain contextual factors of the specific organization into account. But the usefulness of the model is found in establishing a starting point for a discussion with your supplier. With the estimated should cost price you go to your supplier and asks: Why do you have a higher/lower price than the industry averages? Explain it to me.

A second modeling method is based on the annual report. This method is more in line with the specific supplier as it are the numbers of the organization self. Although it provides very much information which can be very useful, the should cost price based on the annual report in itself does not say very much whether the price (composition) is high or low, right or wrong, etcetera. Therefore the usefulness in this should cost method can be found in benchmarking with industry averages (the first should cost model method) and/or other supplier of the same sort of products.

The third method takes the most amount of time but is, when doing it on the right way, the most accurate. In this method you dive into the production process of the supplier and you assess where the costs really originate from. It provides valuable insights, but the disadvantage of this method is that you are very dependent on the information provided by your supplier. The supplier can be hesitant with providing you information and disclosing their process steps, cost for each step and their value adding activities. Therefore once you have attained the requested information, you should bear in mind whether it is reliable. Is it complete? Is it correct? You should bear in mind that it might be distorted by the supplier.

All three methods have its own advantages and disadvantages which should be kept in mind when making use of one or more of these methods. In future articles these three methods will be explained, a step-by-step methodology will be provided for each method, and a practical ‘step by step’ example will be included.