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What’s in a cost? 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).

What is Should Cost Modelling?

Should Cost Modelling is a process which helps build a holistic picture of the economics behind the production of a product.

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.

1. Supplier negotiations

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.  

Helping a fastfood chain reduce costs by 10%

We developed a Should Cost Model for a global fastfood chain to inform its negotiations with beef patty suppliers. The model gave the category manager insights on the margins the supplier was charging, the final cost structure, the difference between the actual production cost and the final price charged, and the difference between packers cost and processing cost. The model found a significant disparity between the estimated beef price estimated and what the supplier was charging. The CPO successfully used these differentials as negotiation levers, resulting in a 10% cost-reduction for this category. For a global fastfood chain with more $1 billion in annual revenue, the impact of cost saving on its highest spend category (beef in this case) cannot be understated.

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.

2. 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. 

Using a Should Cost Model to find the right warehouse

A global manufacturer of food and pet products wanted to know the breakdown of the expenses incurred in warehousing services (both market-bound and inbound). But this wasn’t your straight-forward Should Cost Modelling exercise. There were no standard charges for a particular service – they would vary for the type of service used (receiving and handling, storage or selling to retailer), the product, and the geography. For instance, the price for the storage type (cold, temperature-controlled or normal) would be different for pet food compared to a chocolate bar. Our specialists developed an SCM template which segregated all the three services, and was flexible for different products and geographies. The client could now estimate how much an increase in the labour cost or equipment cost at any stage of the process would impact the final price – something it couldn’t previously determine. This enhanced the CPO’s negotiation power and helped select the right supplier.

3. 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.

 

To find out how The Smart Cube helps CPG businesses stay ahead, please read about our intelligence and analytics solutions or get in touch. We can help you understand and anticipate the forces and changes influencing your critical procurement categories today and beyond.

 

With additional inputs from Deepak Panwar, Manager, The Smart Cube