Thinking Space

Current state

Predominately it’s the case that during procurement activities buyers rely on the competitive tension from the market to ensure a competitive pricing is achieved from the process.  During the business case stage projected procurement costs are developed but tend to simply be based on historical expenditure, perhaps modified to allow for changes in predicted future usage, influences from new technology and inflation factors. However, there is a high degree of uncertainty with the accuracy of these estimates.

As a result of the above, when tender responses are received and commercial evaluation is undertaken, price evaluation and price negotiations can be problematic, as the buyer does not have a detailed understanding of the tenderer’s cost structure / influencing factors. Without this knowledge the buyer’s ability to adequately evaluate and negotiate price is diminished.

With an increasing focus to obtain maximum value for their organisation, buyers are seeking to acquire additional market intelligence to reduce current costs, with one such method being ‘Should Cost Analysis’.

What is should cost analysis

Should Costs Analysis is an alternative approach to budget development / negotiation targets where the buyer undertakes detailed analysis to identify what a good or service ‘should’ cost. It attempts to put the Buyer in the Seller’s position, to determine a reasonable cost to provide the goods or services. It achieves this by identifying all the cost inputs which comprise the end user pricing including, but not limited to: material costs, currency exchange rates, logistics costs, overheads and wages, market conditions, competition, and a reasonable profit for the supplier.

What’s its history and who uses it?

Should Cost Analysis was first developed by the United States Department of Defence to enhance their procurement professionals’ ability to source requirements at a reasonable price [1]. Since this time the United States Department of Defence continues to use Should Cost Analysis as one of their primary tools to drive affordability [2]. The technique is also used by the private sector, with prominent organisations such as Cisco and Apple using it to become a better informed buyer, enhancing their capability to drive down prices.

In Australia the technique is gaining some traction however is still underutilised. Going forward there are definite opportunities to better leverage the research, experience and technology gained in overseas markets to successfully use Should Cost Analysis in Australian procurements.

Should Cost modelling in practice

A practical example of Should Cost modelling which RESOURCE2SOURCE has provided for our clients was in the oil & gas sector, for the procurement of pipeline materials. The market in question had limited suppliers available and therefore the client needed to understand the various cost inputs to ensure tendered pricing was competitive and help determine whether there were opportunities to reduce costs.

RESOURCE2SOURCE conducted market analysis and identified the various cost inputs for the particular pipe material, which included: base material costs, oil price, USD exchange rate, logistics costs, manufacturing labour costs, facility costs, price input variances based on pipe sizing (larger pipe size had greater % of material in goods price), corporate overheads and targeted profit margins for the industry. The pricing was then modelled based on current market conditions (supplier competition, trends) and client specific information (order size, frequency of orders and overall client ‘attractiveness’).

Through this analysis RESOURCE2SOURCE was able to provide our client with the necessary data to validate the tendered rates, request further pricing information on specific cost inputs and challenge rates during the negotiation phase.

RESOURCE2SOURCE was able to provide the client with cost savings through the process and also provided the client the necessary cost information to build a robust price review mechanism for the term of the Contract.

When to use it

Should Cost Analysis can be a tedious task, it requires an upfront investment of time and resources to perform the market analysis and ensure robustness of the output. It is seldom the case that a single person or department has the expertise to develop the cost estimation model themselves, but rather requires the collaborative effort of multiple internal stakeholders and even external consultants. It is never a good idea to undertake this form of costings just for process sake if the outputs will never be fully utilised. If, however the model is appropriately used it can be an effective tool in driving down prices.

Whilst it can be used successfully in the procurement of services it is often more effective in the acquisition of goods and materials – where cost inputs are easier to identify.

When used effectively Should Cost Analysis can create value for the purchasing organisation by reducing the procurement spend and/or ensuring a sustainable supplier is selected. Generally, the technique is well suited where:

  • there is a limited supply base, providing suppliers the opportunity to inflate pricing;
  • the buyer has limited information on market pricing and is unable to accurately forecast budgets;
  • a supplier has priced the goods or services well below the other tenderers and analysis on the viability of the pricing is required to ensure pricing is sustainable;
  • the buyer wishes to challenge the current specification – if the buyer identifies that any one input is going to increase the sourcing cost significantly then they can attempt to seek alternative approaches; and
  • the buyer wishes to improve their negotiating position, as a detailed understanding of what the cost structure of the product should be provides increased confidence if negotiating a price reduction, with the buyer’s arguments having increased validity in the eyes of the supplier.

Key takeaway

Should Cost Analysis is an important and often underutilised tool (especially in Australia) which can assist purchasers in reducing product costs. Like other procurement techniques it is not suitable for all sourcing activities, and when used incorrectly can be time consuming and add zero to little value to the process.

In summary it is another evaluation tool to be utilised by procurement professionals, which in the right circumstances can provide the necessary data and information to achieve an excellent outcome for a specific tender process, either in the price evaluation or negotiation phase.

References

A copy of the references is available Here

 

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