How to use the should cost price?

(ppt summary of this article will follow soon)

How to use the outcome of a should cost model (the should cost price)

Although I only discussed the should cost model method based on industrial averages, I thought it might be interesting to write a piece about what one can do when you have calculated the should cost price of a product.

So, once you have the should cost price, what next? How are you going to use the should cost price? What is the best method to use a should cost price?

There is actually not one best way. It is dependent on many (contextual) factors, though some main techniques are discussed here. But let these methods/techniques not be a constraint in using a should cost price, be creative and develop your own method, because there is not one best practice in this case. Especially not because should cost models are still in the exploring phase and not yet widely used. Consider yourself as a ‘should cost model pioneer’.

The main distinction made in the use of the should cost price, is whether it is used in a pure adversarial buyer-supplier relationship (one of distance in which a buyer and supplier conducting transactions on the ‘market’) on the one hand or in a close alliance between the buyer and the supplier on the other hand. Of course this is not as neat divided as stated above; consider it as a continuum on which the market and the hierarchy are the two extremes (see figure 1). An adversarial relationship is closest to the market and the collaborative relationship approaches the hierarchy.

Figure 1 Relationship continuum 

On the left, you can see the buyer-supplier ‘relationship’ as one of distance, the should cost price can be used as a negotiation technique between the buyer and the supplier. On the right extreme a buyer-supplier relationship is depicted in terms of a hierarchy. This last means that the supplier is actually part of the organization, you have internalized the production of the product; in other words the production of the product is executed within the boundaries of your organization. In between these extremes you will find many other forms of relationships between buyers and suppliers. The more the kind of relationship is located to the left extreme, the more the alliance is one of distance (e.g. a formal agreement for one year to buy a certain amount of non-strategic products with no options for future deals already defined). Conversely, the more the more the relationship is located to the right extreme of the continuum, the more you speak of a closer relationship between the buyer and the supplier (e.g. joint venture).

In this last case it is more logical to use the should cost model as a method for searching together for cost reductions in order to strengthen the competitive position of the buyer-supplier dyad. In case a relationship is more located to the left side of the continuum, an adversarial relationship (relationships of distance), the use of should cost models is more restricted to that of a negotiation tool.

But bear in mind that you’re still a SCM-pioneer which means that the use of a should cost model is not restricted to the options displayed in this model. Choosing for one of the two methods above, does not imply that the other method is excluded. Combinations of, or changing of method during the process is possible of course. Especially when the relationship between the buyer and supplier is located somewhere in the middle of the continuum in figure 1.

1 Negotiation tool

The negotiation techniques discussed in this manual, are techniques with respect to the should cost model. This implies that besides these techniques, a lot of other negotiation techniques and strategies exist. It should be clear that it is not the goal of this article to discuss all existing negotiation techniques, just bear in mind that the negotiation techniques discussed below are not exhaustive.

First of all the should cost method can be used for opening up the discussion with your supplier concerning the product price. Using a should cost model in a negotiation provide some grips in the discussion where you can fall back on. Based on one of the three (or a combination of) should cost model methods, you have a (rough) idea about what the costs are (or better: should be) which settle a certain price level. This in contrast in case you approach your supplier without any pre-knowledge of the costs and accepting the price composition as a kind of black-box.

In case you know the percentages of the cost elements, whether it is based on industry averages or an annual report, you can confront the supplier with those figures. A great chance that the percentages are not exactly right. No problem; let the supplier explain why those figures are not right and why according to theme their costs and the corresponding price is right. In case the supplier has nothing to hide the supplier will be open for discussion (to a certain extent). This will provide valuable information of your supplier to you.

1.1 Bottom up strategy

Two main approaches of using a should cost model as negotiation tool can be distinguished: The bottom-up approach and the top-down approach. First the bottom-up approached is explained, the top-down approach will be discussed in the next paragraph. The bottom-up approach holds that you know the percentages of the costs-elements (based on one or more of the should cost methods) and at least one of the corresponding absolute figures. Take the cost element of which you know the corresponding absolute figure[1] as a start (the ‘bottom’) and add, percentage-wise, the costs of the other cost- categories. This will result in the should cost price (the ‘up’). See figure 2 for a schematic depiction of the bottom-up approach.

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[1] if for more than one cost element the percentages and the absolute figure are known, take the most accurate and reliable cost element. Normally this would be the ‘direct material cost element’ because the absolute figures of this element are relatively the easiest to calculate.

Figure 2 Bottom-up strategy

Of course if you have the percentage and the absolute figure of one of the cost element, you are able to calculate the should cost price instantly. If for example the direct material cost element is 50% of the total costs, and the accompanied actual absolute figure of €500. This will result in a total should cost price of €1000, because:

€ 500	50 %
€ X	100 %

‘€ X’ represents the total price (100%) of the product in euro’s and can be calculated as follows:

On the other hand you have the top-down approach which act the other way around, this one will be discussed in the next paragraph.

1.2 Top down strategy

This method is actually pretty much the same as the bottom-up method, but instead of constructing the should cost price by summing up the costs (based on one or more of the methods before) this top down method takes the price level provided by the supplier as the starting point.

Besides the different starting point, this method also differs from the bottom-up method because it provides the opportunity to focus on one specific cost-category of interest. This does not mean that you cannot discuss all cost-categories, but you aim for one cost-category at the time or just the cost-categories in which you are interested. Compared to the bottom-up approach the top-down approach is acting conversely.

With the top-down method you actually say to your (potential) supplier, ‘well okay, let’s assume you are right on your price level, let’s take a walk through the percentages and the absolute figures’. For example: the price level of the product set by the supplier is €1000 and the percentage of direct material cost is 50%[1]. This means that according to you  €500 is spend on direct materials. If more exact calculations point out that the direct material costs are only €400, than there is a gap of €100 in the direct material cost (10% of the total price). It is now the supplier’s tasks to clarify this gap. The first reaction would be that your calculations were not right. In that case, let your supplier explain why. Why are those calculations not right? Show me your calculation. Maybe your calculation are somewhat exaggerated, but a gap of 10% is rather big, so maybe it is 5%, but it is still a large gap. Let them explain!

Of course it could also be that, whatever the reason is, the supplier is right on its costs calculation. It is than your choice what to do.

 If the actual figures do not match the figures based on the percentages, several cause can exist:

-          your calculated/assumed percentages were not right

-          Price level of the supplier is too low/high: why:

o   More/less profit for supplier

o   Inefficient processes in internal value chain of supplier (process improvements or cost reductions possible?)

o   The price of the purchased materials is too high (look at the next link in the chain)

o   Customized production

o   Other causes

In this way you can discuss all other cost elements. But it can be difficult to find out which reasons are the cause, because suppliers can be hesitant with the disclosure of information.

Several options are available if you want certain (sensitive) information of your supplier. One is to co-operate and show them what is (financially) in for them. Maybe not directly in relation to your company but with respect to other customers. But it can also be that you as an buying organization are the more powerful organization and you will be able to force your supplier to disclose information  In case of the first reason (financial revenues) they probably want some specification on paper (contracts concerning input of resources and how to divide the profits/costs, NDA’s etcetera) as they put themselves in a vulnerable position with respect to the customer because they disclose sensitive information.

An advantage of the top down strategy, is that this method is based on the supplier’s own quotation, which therefore can be no point of discussion.1.3 The should cost price is much lower

The should cost method can also be used as a very ‘aggressive’ negotiating method in which you go to the supplier and say: ‘the should cost price is X% below your price. This should cost price is for example based on industry averages or directly benchmarked to other suppliers and compared with these averages or suppliers you are too high. ‘I don’t mind how you are going to reduce your price, but manage it, otherwise we’ll go to an other supplier’.

This is of course only possible when:

-          there are other suppliers

-          you have the bargaining power to act this way (partly dependent on the existence of other suppliers).

Be aware that in case bargaining power shift from your organization to your supplier due to what kind of reason (e.g. context changes, market situation changes), the chance exist that they will retaliate in the future for example by bypassing your organization and doing business with your competitor(s).

2 Cooperation

In this method you will look together with you supplier to the costs of the supplier. This can be done by filling in together a should cost model and search on this way for potential cost reductions. It can also be that the purchasing organization takes the initiative and show where the supplier is too high in their costs (by using for example the bottom-up approach or the top-down approach) and provide them advice on how to improve their processes (to reduce costs or increase value). Of course there are a lot of other methods, but the main point here is that you use the should cost model not solely to bargain as two opposing parties but that you cooperate with your supplier. The goal is that this alliance will result in a win-win outcome (which is probably only feasible by combining the power of the supplier and the purchasing organization; synergy). In such alliances it can be of importance to develop your supplier by supporting the supplier on several aspects. There exists a huge amount of relevant and recent (scientific) literature on the subject of cooperation. Therefore it is not necessary to outline it here.

3 Combination of negotiation and cooperation

Above the distinction has been made between ‘negotiation’ and ‘cooperation’ as ways of using the should cost model. This is not as black and white as it is depicted, because it is also possible to have a combination of the two models, on a complementary way, or in a sequential way. Though the methods as discussed above remain the same in case of complementarity and sequence, therefore a brief discussion of complementarity and sequence will do here.

3.1 Complementary

Here both ways are applied at the same time. So it could for example be that the purchasing organization and the supplier are cooperating by together filling in and applying the top-down method and discussing it.

It could even go a step further, in order to reduce cost for the supplier and with that for the purchasing organization, they could decide look a tier further up the chain in which the purchasing organization is assisting the supplier to apply a should cost model on their supplier.

3.2 Sequential

In case of sequence, the purchasing organization has prior intentions to use the should cost model as a practical tool in a negotiation with its supplier or as a tool in an alliance. But as the process develops, the purchasing organization can decide to shift the use of the tool from one way of using to the other manner of using it.

In case of prior use as a negotiation model, the supplier's response on the should cost method can be that positive, that it also wants to use it and participate together with the buying organization in the process. The supplier may recognize the benefits for itself and decides to work together with the purchasing organization, in order to map its costs and tries to find cost reduction in favour of both organizations.

But it can also be other way around. The purchasing organization is starting with the intention of using the should cost model in cooperation, but along the way it seems that the supplier is not showing any willingness to cooperate and/or disclose any information. Then it can be more wise to shift the use of the should cost model towards a strategy of negotiation. Of course it all depends on the context.

The method of using a should cost model described above are of course not the only methods. The question ‘which of the methods is the best?’ does not make any sense as it is dependent on many factors. Furthermore the methods provide just some grips, or in the best case a prior framework with a certain intention, to reach your target(s) and are in practice not that clear outlined. It requires your own creativity, because although the model may be very practical and rather simple, the usage of it may be rather complex due to (among other) several factors:

1)      targets/intention (of both the buying and supplying organization)

2)      context (e.g. bargaining power, economic situation, technological innovations etcetera[2]).

3)      interaction over time

The choice how you are going to use a should cost model depends on what your intentions are with the model (targets). Furthermore it depends on the context you are in; do you have bargaining power with respect to the supplier for example? All this is also dependent on the factor ‘time’. The interactions over time of contextual aspects, organizations and their targets, economical situation etcetera may cause changes which requires alterations in the way of using the should cost model. So once again, this shows that there is not one best practice of using the should cost method. Using should cost models demands logical thinking, creativity, initiative and improvisation.

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[1] The percentages can be based on the several methods described earlier: industry averages, annual report, information of the supplier self, value chain analysis.

[2] The context is very broad, it is actually everything outside the boundaries of the purchasing organization.